Our favourite income producing ETF

Low interest rates over recent years have resulted in investors exploring exchange-traded funds that specifically target a dividend yield higher than that provided by the market. And as interest rates rise, inflation soars and the share market becomes increasingly volatile, it is understandable that investor interest remains high in these funds. But not all dividend yield funds are the same. In the table below are four passive ETFs, specifically designed to track an index with an objective to provide a higher dividend yield than the market index (represented by the S&P/ASX 200). Although the overarching objective of each of the funds is to generate dividend income, each asset manager has a distinctive style and set of rules by which the underlying index is constructed. Vanguard Australian Shares High Yield ETF (ASX: VHY), with a Bronze Morningstar Analyst Rating is our pick of the lot.

Why VHY?

First, an inherent risk of higher-dividend yield strategies is the inclusion of dividend-paying stocks with declining share prices that gives the impression of a deceivingly high yield. Although not immune to such "dividend traps," higher-yielding equity funds generally have a mechanism to mitigate such occurrences. We believe the forward-looking portfolio construction methodology of VHY, which is based on forecast dividend yields, is a superior approach. In comparison, iShares’ IHD and SPDR’s SYI offerings use the dividend history with certain momentum and profitability screens. Meanwhile, RDV employs a hybrid approach using multiple historical and forecast metrics.

Second, the price of the product or the expense ratio is an obvious yet frequently overlooked metric that predictably affects the future performance of a fund. A low fee is a reliable way to supplement your returns once you affirm the suitability of a certain product for your overall portfolio. At 0.25% per year, VHY is currently the cheapest listed product offering domestic high-yield equity exposure.

Spot the difference

Unsurprisingly, the differences in methodology lead to vastly different portfolios. At Morningstar, equity funds are classified under three broad styles: value, blend, or growth. The classification is based on the types of companies that form the fund portfolio. A higher-dividend-paying stock is more likely to be value-oriented, reflecting a mature company that does not need to reinvest all the internally generated income back into its business. As such, VHY teeters on the border of the blend and value category and is chiefly composed of giant-cap stocks. Meanwhile, the other three ETFs fall squarely within the large-value category and have relatively higher exposure to mid- and small-caps.

The underlying sector exposure and stock concentration of each of these funds also differs and has an impact of the funds’ volatility. Noting that the emphasis on dividend-paying stocks and index construction results in varying levels of concentration (measured by percentage of exposure to top 10 stocks) across IHD, RDV, and VHY despite all of them holding a similar number of stocks, while SYI’s concentration percentage lies closer to VHY’s despite having fewer stocks.

Another important factor to consider is how different these high-dividend ETF portfolios can be from the standard index being the S&P/ASX 200 Index, which is a popular barometer for gauging the Australian equity market. The higher the deviation, the more we can typically expect a fund’s returns to diverge from the broad market, particularly during large rallies or corrections or during disruptions confined to certain segments of the market. On this measure, we see a clear division between the high active shares of IHD and SYI and the relatively lower active share of VHY and RDV. Thus, one would expect the latter pair to track the performance of the market more closely as compared with the former pair.

Through Thick and Thin

The past year—especially the past six months—has been a troublesome time for equity markets, but those funds classified as value have demonstrated some resilience in the downturn. This can be seen in the recent one-year returns where all the four ETFs have curbed their downside better than the S&P/ASX 200, with the SYI doing particularly well.

As shown by the historical growth in the graph above, the story is a bit different in terms of the long-term returns, as value stocks have significantly underperformed growth stocks over much of the past decade. However, investors should heed that the sole objective of the funds is not merely maximising returns through capital appreciation. The funds have a primary objective to deliver stable income in the form of dividends across market cycles and that capital appreciation is secondary.

In conclusion, term deposit rates are slowly ticking up as interest rates increase, but we understand that investors are still searching for yield elsewhere. Higher dividend-yielding equity funds may be one answer for investors. And in our view, Vanguard Australian Shares High Yield ETF prevails as a compelling option among the high-dividend Australian ETFs on offer.