Avoid equity income dangers with ETFs

SPDR's Dividend Aristocrats ETF range tries to mitigate the risk of investing in volatile income stocks that pay unsustainable levels of income by only tracking stocks with long-term records of increasing their payouts.

SPDR S&P UK Dividend Aristocrats UCITS ETF (UKDV) tracks the S&P UK High Yield Dividend Aristocrats index, which is composed of 30 UK companies that have increased their dividends for 10 years or more. SPDR S&P US Dividend Aristocrats UCITS ETF (USDV) selects companies that have increased their dividends for 20 years or more, and SPDR S&P Pan Asia Dividend Aristocrats UCITS ETF (PADV) contains stocks with at least seven years of increases due to the difficulty of finding a sufficient number of stocks to include in that market.

James McManus, investment manager at Nutmeg, says this strategy is a way to avoid some of the most expensive income stocks, which investors have flooded into in recent years due to low interest rates and bond yields.

"As longer-term investors, we really favour the sustainability aspect of the income provided by these strategies, rather than chasing higher-income stocks, which we think leads to overcrowding in some markets where the search for yield has been particularly strong," he says.

However, due to their more conservative approach, the income generated by these ETFs can be lower than that from comparable ETFs and their portfolios are concentrated on a smaller number of stocks. SPDR S&P UK Dividend Aristocrats UCITS ETF yields 3.95 per cent and has paid out dividends worth £4.24 on a £100 investment between May 2016 and May 2017, according to research company FE Trustnet. iShares UK Dividend UCITS ETF (IUKD) has a higher yield of 4.62 per cent.

iShares UK Dividend UCITs ETF has also made a greater total return over five years, of 66 per cent compared with SPDR S&P UK Dividend Aristocrats UCITS ETF's 53.4 per cent. However, iShares UK Dividend UCITs ETF focuses solely on dividend yield, which can indicate a high income but also be a sign of a value trap - a company with a falling share price and potentially unsustainable level of payout.

SPDR S&P US Dividend Aristocrats UCITS ETF tracks US companies with the longest records of dividend increases, but has a lower yield than some other US equity income ETFs, including WisdomTree US Equity Income UCITS ETF (DHS) and WisdomTree US SmallCap Dividend UCITS ETF (DESE).

SPDR S&P US Dividend Aristocrats provides exposure to a portfolio of 107 companies that have increased their dividends for 20 years or more. The longevity of the screen applied means the ETF tracks long-term stable businesses that sustainably increase dividends over time. It has an ongoing charge of 0.35 per cent but because of a US withholding tax advantage, due to the ETF being domiciled in Ireland, it typically outperforms the index it tracks.

WisdomTree tries to avoid the risk of investing in yield traps by weighting the stocks in its indices by cash dividends paid rather than market cap, and WisdomTree's small-cap dividend ETFs in particular are standout performers on a total return basis.

WisdomTree Europe SmallCap Dividend UCITS ETF (DFE) has generated better total returns than comparable equity income ETFs from iShares, Deutsche Asset Management and SPDR. Over five years the ETF returned almost 150 per cent compared with around 90 per cent for three other ETFs in this space. However, WisdomTree's ETFs have lower yields than many comparable ETFs.

iShares Euro Dividend UCITS ETF (IDVY) and db X-trackers Euro Stoxx Select Dividend 30 UCITS ETF (XD3E) track the Euro Stoxx Select Dividend 30 Index, which is composed of the 30 stocks listed in eurozone countries that pay the highest dividends. Its strict focus on yield rather than income sustainability means that it has a higher income than comparable ETFs, but it is also more likely to suffer the effects of dividend cuts - the highest weightings in the index include energy companies like Total SA (FP:PAR)

ETF yield and performance

Source: FE Analytics, as at 2.05.17. *Provider's own data

A number of income stocks have become expensive due to their popularity with investors who have abandoned low-yielding bonds. So Alan Miller, chief investment officer of wealth manager SCM Direct, says the ETFs offering the best value in terms of potential income growth and stock prices are iShares Euro Dividend UCITS, SPDR S&P Emerging Markets Dividend UCITS (EDVD), Lyxor SG Global Quality Income NTR UCITS (SGQP) and SPDR Global Dividend Aristocrats UCITS (GBDV). He favours high-income ETFs that track stocks that do not look overvalued based on their price/earnings ratio and growth prospects in terms of earnings per share (EPS).

He says: "The danger of many income funds, whether an ETF or other structure, is that they focus on very low growth companies that tend to underperform over the long term. Also, until relatively recently many of the staple income stocks were highly valued as they were seen as an alternative to holding bonds and became extremely overbought as a result."

Alan Miller's suggested income ETFs

Source: SCM Private, 24.04.17 *Morningstar data, as at 2.05.17