Mark LaMonica: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or need. 

Shani Jayamanne: So Mark I've been going away a lot. I've had some very short weeks - I don't think I've been at work much of April and that means I've also been missing our BodyPump classes, so you've been going alone.

LaMonica: I know which is terrifying for me so I went alone on Friday and the I went alone Monday this week. And Monday is the instructor that screams at us, so I had to face that by myself. And this guy - we're always next to each other - and so

Jayamanne: You mean you and me.

LaMonica: Yeah - and then some guy took your spot, which of course is in the back of the room because we hide.

Jayamanne: Yeah behind the pole.

LaMonica: Yeah, and so I kept looking over during the whole BodyPump class because normally I look over and I'm like "this sucks" and complain about it and there's just some random guy there.

Jayamanne: So but I'm back.

LaMonica: You're back.

Jayamanne: We'll go to BodyPump again, you won't have to deal with this on your own.

LaMonica: Well that's good, as long as you're always there.

Jayamanne: So we've had a few investing compass episodes before on income investing. We've covered how to find sustainable income through equities, we've covered the importance of passive income, we've covered Mark's' approach to income investing, we've recently had Jody Fitzgerald on the podcast from Morningstar Investment Management who covered the advantages and disadvantages of income investing. 

LaMonica: So that's a lot of episodes on income.

Jayamanne: We have but there is a reason for that - it's a goal for a lot of investors and these episodes have always ended up being up there in terms of our most popular episodes. 

LaMonica: We're just giving the people what they want. So passive income, as Shani mentioned, is a goal for investors because it's an incredibly appealing concept. All of us are investing to try and improve our lives and generating income outside of our day to day jobs is a pathway to doing that, while moving towards more financial independence. For those in retirement, income from investments is their sole income.

Jayamanne: Investors can derive income from a variety of assets - from property you can collect rent, from equities you collect dividends, from fixed income you collect interest payments.

LaMonica: And there are a number of ways for investors to get income and also a variety of products. 

Jayamanne: ETFs are increasingly popular with investors. They traditionally tracked indexes but they've broadened the remit. They now cater for all tastes, preferences and persuasions. There's passive ETFs, there's active ETFs, there's factor based ETFs, there's real return ETFs, there's ETFs covering every asset class. We've combined income and ETFs and asked today's guest about the in's and out's of picking a good income ETF.

LaMonica: And he's in a pretty good place to do that. Our guest today is Justin Walsh - he's an associate director in our Manager Research team.

Jayamanne: And for those of you who attended our conference - you would be familiar with Justin. Justin did an ETF elevator pitch.

LaMonica: He did Shani, but today we've asked him to give an overview of how the team rates ETFs, how successful they've been, and what they see as shining stars in the income ETF space.

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Alright so we have another guest today on Investing compass and we have Justin Walsh. Now Justin is the second member of our Manager Research team we've had on. So we had Annika Bradley on a couple of episodes ago talking about super so go back and listen to that episode. But Justin, welcome and I guess just if you could give a brief introduction about your role at Morningstar and what you cover that would be a great way to start.

Justin Walsh: Thanks Mark and thanks for having me. I'm one of the analysts in the Manager Research team here at Morningstar - we have more than 10 of us, and I cover all asset classes - so that would be both equities and fixed income. And as part of that as well, I also oversee our coverage of passive or index funds, and both funds and index ETFs as well, so I've got a very wide spread of what I'm responsible. 

LaMonica: Yeah, no it sounds like it - everything, just cover everything.

Walsh: More or less.

LaMonica: Yeah exactly. So we talk a lot about our medalist rating on this show and you know talk a little bit about the process but it's always better to hear from the people that actually do it. So maybe just a brief overview and we'll talk about medalist rating a little bit later with some specific securities later but just a brief overview of that process.

Walsh: Sure Mark. When we talk about the medalist rating, there are 3 key aspects that we focus on. The first one is the people - who are the investment personnel who are running the strategy and responsible for it? So that's a very big and important consideration that we have. The next one is the investment process that is used, so how do they actually build portfolios? How do they research whatever asset class that they're responsible for? And then the other consideration is the parent. So these are the three key 'P's'. And the parent is important because you're really looking at or you want to look for organisations that care for investors. Now obviously they're commercial enterprises but you want people to have cheques and balances to try and get the right outcome for investors overall.

Now one additional point is there are two main differences between how we look at active and how we look at passive. In our looking at active funds, both the people and the process have equal weighting, and the parent has lower rating. Whereas when we look at index or tracking funds, ETF tracking passive indices, the most or the highest rating there is for the investment process. And that's basically the bulk of the rating because the important thing there is that, as it's passive, what you want is a really good and efficient index that you're tracking, and no matter how good the people are, if the underlying index that you're tracking is an inferior one, it will be reflected in the investment outcomes. 

LaMonica: Okay great, well how about I guess if we go and look in the past - not to put you on the spot, but of course we talk about these medalist ratings all the time. How successful have they been?

Walsh: Short term it's been mostly positive and longer term, as in 5- and 10-years’ timeframes this approach has been successful in terms of those that we ranked gold coming out with a strongest relative performance against their category peer group and those that we rate negatively having negative outcomes overall – on balance overall which is what you would want to see. One other thing that I should point out too in our approach is that fees are very important and that when we’re looking at these categories and assigning weightings to a people or process category, ultimately what we’re trying to do is we’re trying to pick those funds that, after fees, will outperform the category peer. So, when we look at it in that way and look at results of that, we’ve found that over 5- and 10-year periods so far to date, that our approach has been successful.

LaMonica: The topic today is income investing, so this is something that a lot of investors are really interested in. Something that we talk about a lot on this show. And I think when a lot of people think about income investing, they’re really thinking about buying those direct equities and we’re going to talk about ETFs today. So, I mean why would an investor choose an ETF rather than going out and buying those direct share which are so popular many income investors.

Walsh: Yeah, that’s a great question – why? Well, I think there are three things that really stand out – one is simplicity. If you want to grow an income portfolio through stocks you need to buy a number of stocks, one’s not going to do it. Cost – overall you can buy these ETFs at a very low fees, so it is very cost efficient to do so. And thirdly, you get the best of the cash so as I mentioned earlier you can’t just buy one stock, or you shouldn’t just buy one stock for income. What you should do is buy multiple stocks and the most efficient way to buy multiple stocks in a cost-efficient manner is via an ETF.

LaMonica: So Justin, you’ve talked about the way, what you do at work every day and talked about the rigor that goes into our process but you know what we’ve found is that the average investor – and we certainly preach against this – but the average investor when they’re going out there and picking an ETF will generally just look at returns and just assume that if something did well in the past it’s going to do well in the future. Now when we talk about income, what a lot of people tend to do is kind of same thing but just with an income bent to the whole thing. They’ll go back and look at the distribution history and once again say if this had a high distribution in the past it will have a high distribution in the future. So, what are some of the pitfalls about that – about that approach that many people just make.

Walsh: Look the biggest pitfall with that is you can fall into what’s called a dividend trap. A dividend trap is that a stock tends to pay high dividend but falls in value. So, on your analysis yes, the distribution stays consistently high, but the value of that capital that you’ve invested falls, and that’s something you would like to avoid because at the end of the day when you’re investing in the stock market and in shares, you would like your capital to go up and you would also like your dividends to go up. And if your capital keeps on falling, over time your dividend will fall. That’s usually a natural law of what happens. But if your capital can keep on increasing, there’s a good chance that your dividend will keep on increasing as well over time.

LaMonica: And if we’re looking over here at different approaches. So, obviously you talked about this in the introduction, you know there’s this pure active approach – the manager or a team is going and picking those individual securities, there’s a pure passive approach where following a broad index we’re trying to invest in it and there’s more of a factor approach, where it may still be tracking an index, but this is an index that’s specially design to capture that factor, that income. So, do you have a recommendation among those three approaches if someone is interested in going out there and investing for income?

Walsh: Look there are different approaches you can have, one that we think that’s does make a lot of sense is to select a deliberately focused income ETF. So, something that is deliberately designed and built to try and capture a higher yield than the market. So that does make sense, there are other approaches you can do as well. But I think if you are looking for something that is efficient, simple and cost effective, it’s hard to beat a yielding ETF.

LaMonica: And this is the difference, right? You were talking earlier you know obviously when you’re looking at passive, you’re spending a lot of time looking at that process which is basically the index, so a lot of these, they’re indexes. They’ve been created for a very specific purpose but is that really the time that you spend on these trying to find a good income ETF, is well looking that, how the portfolio is constructed, basically how the index is constructed that they’re tracking.

Walsh: Yeah, so the index is critical in all this – what is the index. And that has big influence in terms of use. What you want in these types of ETFs is that you want an index methodology where there is a forward-looking view about dividends, because the trouble is if you’re simply backward looking, what you’ll tend to find is that you’ll run a high risk of being caught in dividend traps. Now forward looking is not completely devoid of issues but it is a more sensible approach to mitigating them.

LaMonica: Okay let’s get into some specifics. So, we cover – your team covers, in Australia, 4 different dividend ETFs, so you’ll have to give me a second as I go through them for everyone. My favourite part is reading out lists on this. So, we’ve got the iShares S&P ASX dividend opportunities ETF, so that has the ticker symbol IHD, we have the Russell Investments High Dividend Australia Shares ETF with the ticker symbol RDV, the SPDR MSCI Australia Select High Dividend Yield ETF, with the ticker symbol SYI and the Vanguard Australian Shares High Yield ETF, with ticker VHY. So, of all of those, we have the highest rating on the Vanguard product that I just mentioned. So maybe just in summary, and I can ask a few follow up questions, but why that Vanguard product?

Walsh: Firstly, it has sensible index – that is the most critical thing. So the FTSE Australian High Dividend Yield Index which Vanguard uses, we think captures the opportunity set for high yielding stocks in the Australian market well because it’s got a forward looking index methodology that mitigates this risk that I mention of dividend traps. And it does that by ensuring it has a forward looking view on the estimate of what companies will pay in terms of dividends and I think that is probably one of the standout things of why we rated this particular index higher than its competitors. So, it’s deliberately targeting stocks that pay high dividends, and it’s got added to that, not only is the index good, but it’s got the most competitive fee of it’s peers - and that makes a big difference on your after-tax returns.

And it’s got a blended portfolio where the other three have more of a value style portfolio -this one has a blended. So, what that tends to mean is that over time, and this reinforces the point I was saying earlier that you also want to see your capital improve overtime, or grow over time, by having a more blended portfolio and not being too different to the ASX 200 index, that over time you won’t grow the same way as the overall broad market will but you will tend to have similar style returns over time. And that means that when we have periods like we have recently have had in Australia where growth stocks have falling very strongly compared to value stocks, you will be able to tend to wear the differences between growth and value much better than some of these other ETF tracking indices will.

LaMonica: Okay, and maybe let’s talk a little about that forward-looking piece of thing. So obviously you know, this is an index. The index has rules that govern what goes in there – this isn’t somebody going in there and doing that. So, when we’re looking at those forward estimates, what is the approach that’s taken, what are these rules that are put in there to try and identify those shares?

Walsh: Well, what it does, it takes in consensus analyst views and there’s various ways that the professional index providers can source that and what they’re doing is they’re looking at the forward essence of what companies will pay for dividends and then they’re looking at how high that projected dividend will be, and they’re also looking at the history of the dividends as well. So, they’re looking at the highest possible dividends that can be paid and making sure that they’re constructing a portfolio so that there is a trend towards companies that are growing their dividends and going forward. And so, there’s those two important things, those two important components of growing dividends and consistency of dividends that are very important.

LaMonica: Yeah, and those are both really important because obviously we’re thinking about investor outcomes and typically if you’re trying to generate income, it may be that you are retired and you’re actually living off that income stream and you know, you think about your own salary, what do you want? Consistency and growth at the end of the day so, yeah no, those are really, really important.

So, the other question I guess I have is that you talked about how a lot of these other ETFs are more value focused. And typically – I don’t even know if typically is the right word, this is a broad generalisation – value companies are potentially companies that don’t have opportunities to invest in that business and grow. A growth company of course hopefully does so they want to invest more in the business. Are you seeing any trade off I guess between yield, current yield, and growth and how should investors think about that?

Walsh: Well certainly in the US market is probably where you see this more starkly is that you will have growth companies that just do no pay dividends, they tend to repurchase stock and they tend to buy businesses etcetera. So, what that means is that there is not the same corporate attitude or corporate desire to pay dividends in the US and that’s because of taxation considerations.

So, in Australia we have imputation credits and it’s far more rewarding for companies and their shareholder base in particular individual shareholders to receive a dividend. In Australia, similarly what you do find is that growth companies pay lower dividends, because you’re right, they invest more in their businesses, but there is more in terms of capital discipline or desire for boards to ensure there is some dividend paid to shareholders. But typically, what you do find is that value companies have less growth options. They’re good businesses, they generate a lot of cash and the best way to return that cash, particularly in the Australian market is to pay a dividend. And this is one of the issues that you tend find with the dividend trap is that they’re value companies that have pretty businesses – they generate good cash, but they can be in declining market share, they could be in a business that is gradually dying, or you know has really hit a dead end. And that means you have great dividends being throw off, but the business doesn’t grow. And the reason why we do like a spread of value and growth companies is that you again, want that underling portfolio - your capital base to be able growth over time. And if you’re too exclusive on high paying dividend stocks, you can tend to find that you’ve got a stagnant portfolio that’s throwing off quite a good bit of cash but slowly dying in terms of capital value.

LaMonica: Alright great and the last question – and this should be a very easy one but, I get this all the time and I think people are confused about this. You talked about franking credits and obviously a big driver for investors in Australia is franking credits. Do you get a franking credit if you invest in a dividend ETF.

Walsh: You will get what the underlying companies pay because it’s a passthrough structure, the ETF, like a managed fund, an unlisted fund is. So yes, if you are investing in a, these ETFs typically have about 50 stocks and if you aggregate all the dividends that they pay, and they pay 80% of the dividend is fully franked then that is exactly what you will receive that’s why they’re such an efficient vehicle to invest in.

LaMonica: Perfect, yeah, it’s amazing how much I get that question. I don’t know where people – they think that Vanguard keeps the franking credit or something like that, but yeah, it’s amazing that everyone seems to think that. But anyway, thank you very much for joining today – really appreciate it. I know this will be an episode that people are really interested in because they’re very interested in income obviously so yeah, no this is great and a good example of different things you should look at when you’re investing in an ETF –not just looking at the past, having a forward view, and yeah thanks for joining me I appreciate it.

Walsh: Thanks very much Mark.

LaMonica: And thank you for everyone else that listened. If you have any questions of course my email address is in the show notes and also we would love any comments in your podcast app.