Exchange traded funds provide investors an easy and cost effective way to have exposure to a diversified basket of stocks. A dividend ETF is a sub sector of the index or exchange traded fund universe where the fund’s investment strategy replicates the performance of a portfolio of dividend stocks. This is usually made up of dividend paying companies with a history of increasing dividends overtime and can sustain the rate of dividends in the future.
But not all dividend ETFs are the same. Just as there are several ways to construct a portfolio of dividend paying stocks, there are just as many funds created to replicate the dividend focused strategy.
We have sorted through the list of ETFs on the ASX by those with an investment strategy to provide a steady stream of dividends for investors.
Source of Dividends and Risk Profile
One of the key metrics of valuing an asset is its future stream of cashflows. Dividends are simply the distribution of the company’s income to the owners and can come in many forms. In the context of investors looking at high dividend yield ETF, the source of the distributed cashflow stream can come from many sources/asset classes or different parts of the capital structure.
Types of Dividend ETFs
Not all dividends are the same as different parts of the capital structure have their own risk and reward profile. We have sorted the best dividend ETFs based on similar risk profiles to allow a direct apple to apple comparison.
- Equity Dividends ETF own shares hence take equity risks. Dividends from these funds is an aggregate portfolio of dividend stocks and usually have a dividend yield higher than the rest of the market. It only owns medium to high dividend yielding stocks.
- Income from bond funds is based on interest earned on funds lent to companies.
- AREITs receive distributions that aggregate the rental payments from owning shopping centers and buildings.
Investors should not compare the bond ETF to REITs’ dividend yield as the underlying risk profile to achieve the income can be very different.
Dividend ETFs investing in shares
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The common theme from the list of dividend ETFs investing in equities is that the key strategies are investing in a portfolio of stocks that have a higher dividend than the rest of the market, such as Vanguards Australia Shares High Yield ETF (ASX VHY) to the funds range track offshore dividend shares (ASX WDIV).
Actively managed dividend funds
Exchange traded funds are passive investment funds. BetaShares Top 20 equity max ETF (ASX YMAX) provides an active approach to this by implementing a call write strategy coupled with a traditional fund investing in ASX 20. The fund sells calls to generate additional income and enhance the yield of the portfolio of otherwise dividend stocks.
Strategies like this will lead to outperformance in market downtrends flat markets vs ASX benchmarks. However, there is always a price to offset this, and it will underperform when markets are trending upwards.
Downsides of International Dividend ETFs
Franking credits are essentially a tax credit for the company’s taxes, which is valuable for Australian investors invested in the funds above.
The dividend yields of foreign equity ETFs are disadvantaged in several ways to dividend ETFs, which only invest in Australian shares.
- Management fees are usually higher due to the need to hedge foreign exchange exposure, and fees are higher for international ETFs than domestic ETFs.
- The most significant disadvantage of investing in funds investing in foreign benchmarks is the tax impact on the distributions. Even if the offshore equities have a higher yield, the net post-tax yield for investors could be lower as the dividends from these funds will not have franking credits.
A-REIT Dividend ETFs
One of the key tax requirements for REITs is the trusts have to distribute a large portion of their income. Because these are essentially pass through investment vehicles, income is not taxed, and historically, the yields on the REITs have been attractive relative to investors looking for yield.
Investors can either buy listed property trusts directly or through a REIT ETF, commonly known as A-REIT index funds. The advantage of owning the A-REIT index funds is that it provides an avenue for investors to position across a portfolio of REITs.
The REIT ETFs list shows a large portion of Australian investors prefer investing in local property trusts as the market capitalization of ASX VAP and ASX SLF is a multiple of foreign REIT ETFs.
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Dividends from Fixed Income ETF
Another sub segment of ETFs which pays regular income is fixed income ETFs. These index funds track the performance of a specific income benchmark. For example, these can either focused on corporate credit, government bonds or high yield bonds, which are much riskier borrowers.
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The current fixed-income ETFs yield is below its historical yield because the RBA cash rate is near zero, and borrowers pay a margin plus the swap rate (or RBA cash rate). The low base rate means returns from fixed income in the zero interest rate environment comes from the interest margin and duration (term risk).
Risk of focusing on just dividends
Research shows that dividend makes up an essential part of long term investment returns. Investors need to realize that the over emphasis on dividends can sacrifice long term growth in capital.
A key risk is focusing too much on the current dividends, even for blue chip shares and not understanding the current payout ratio’s sustainability. The ideal emphasis should be on the future trend of the business performance, which has big implications on future dividends. Key question investors should ask are:
- Do one time gains inflate the current payout amounts?
- Is the management sacrificing the long term value to satisfy the immediate demand of investors? Examples include cutting crucial maintenance capex or failure to invest to capture growth in the market for its products
- What are the key drivers of growth for the business that it lead to higher dividends down the track?
- What the balance sheet look like after paying out all the earnings?
It pays to have a forward perspective in evaluating investments.