The unsurprising evolution of dividend ETFs

Rebecca Hampson

Dividend paying companies in the FTSE 100 have been doing fairly well recently. The average dividend from the top ten paying companies in the last year was 6.89%.

Investors looking for this type of investment have traditionally gone through active managers such as Neil Woodford, Adrian Frost, and Mark Barnet. But with an ageing population the need to save more while we work and ensure there is enough for retirement makes the search for income relentless. Along with the drive for lower costs and the boom of the exchange traded fund market the rise of dividend-based ETFs is no surprise.

Dividend ETFs have many benefits; they enable investors to take cash from their pot without depleting their initial investment, they are also less volatile than the use of equity dividends, which requires a lot of research to select the right securities to issues such as companies maturing at different times and dividends being cut based on company performance.

Typically, because the ETF tracks an index of dividend paying companies it means that performance is generally less volatile than individual stocks, because there is reduced risk of over exposure to any single stock or particular sector, and losses are generally offset by gains. Another advantage is that the research into selecting the right stocks is already done. The ability of the index providers to turn large amounts of data into clever index construction gives ETF investors dividend access at a lower cost. A dividend ETF costs around 0.35%, which is cheaper and more competitive than the average management fee of roughly 1% charged by active managers.

However, not all dividend ETFs are made equal and there are some pitfalls with various dividend ETFs that investors should be aware of. Firstly, the availability and range on offer significantly trails that in the US.

According to data from State Street, there are currently 345 Dividend ETFs available globally (as defined by Morningstar) with assets of $217bn. In EMEA, the universe is smaller with $26.7bn of assets across 87 funds.

Secondly, some of the older dividend ETFs have a relatively narrow underlying index with fewer companies in the portfolio/index when compared to newer ones.

For example, the FTSE UK dividend plus index is tracked by ETFs such as IUKD and AUKD and has 50 constituents. IUKD - iShares UK Dividend UCITS ETF launched in 2005 costing 0.40% and is one of the most popular ETFs with an AUM of £730m. Similarly, Amundi's FTSE US Dividend Plus ETF (AUKD) also tracks the index having been launched in 2011 and costs 0.3%; it has £5.83m in AUM.

Sector bias

These are popular ETFs and have been around for over a decade however the index is not perfect. It is prone to sector biases - of the 50 constituents in the index nearly 25% are in financials. It also suffered in the aftermath of the crash in September 2010 with a total return of -5.8% year-on-year in 2011. The index selects the 50 stocks by looking at a one-year forecast dividend yield. These are then weighted within the index by their dividend yield as opposed to market capitalisation. This in itself could be an issue and could mean that investors are exposed to the possibility that companies come up against dividends they need to pay but simply cannot afford.

As a result, for this type of ETF Morningstar rates IUKD with just one star, ranking it low return and high risk. In fact, there are only three dividend ETFs that have a 5-star rating from Morningstar. The first two are the iShares MSCI USA Quality Dividend UCITS ETF USD (Dist) (QDIV) and its GBP offering. QDIV has assets of $294m and is four years old. It has a TER of 0.35% and a low risk, high return rating from Morningstar. There are 125 holdings in the index with the largest exposure to any sector currently at 20%.

The other ETF is the Xtrackers MSCI North America High Dividend Yield UCITS ETF 1C (GBP) (XDND) which has a TER of 0.39% and assets of $158m. Morningstar rates it as having low risk and above average return. The index is diversified with 146 holdings and its maximum exposure currently accounts for 18%. The securities in the index have to pass dividend sustainability screens, one of which involves a check to make sure the securities have sustainable dividend returns. This means that securities are not considered for inclusion if they have a dividend payout that is either extremely high (defined to be the top 5% of securities within the universe of securities with positive payout); zero; or negative, and therefore future dividend payments might be in jeopardy.

These points highlight just how different these ETFs are. At a very basic level the number of securities investors are exposed to is vastly different. However, they still aim to get the best possible dividend payout, be it best performing stocks or high quality companies, but whether investors know what options are on offer is unclear.

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