4 dividend ETFs for investors
This week's episode of Investing Compass looks at how investors can pick a dividend ETF that suits them.
Mentioned: iShares S&P/ASX Div Opps ESG Scrnd ETF (IHD), Russell Inv High Dividend Aus Shrs ETF (RDV), SPDR® MSCI Australia Sel Hi Div Yld ETF (SYI), Vanguard Australian Shares High Yld ETF (VHY)
In this episode, we take a deep dive into dividend ETFs and how investors can pick one that suits them by running through 4 dividend ETF examples.
We run through Russell High Dividend Australia Shares ETF RDV, iShares S&P/ASX Dividend Opp ESG Screened ETF IHD, SPDR MSCI Australia Select High Dividend Yield ETF SYI,
Vanguard Australian Shares High Yield ETF VHY.
Listen on:
Shani Jayamanne: 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 needs.
Mark LaMonica: Alright, so, Shani, on Friday, so this weekend, I guess to set this up, you were in Brisbane for the weekend. You were visiting some family. I went out on Friday night and I had drinks with a friend, Julia, who you know. We used to talk about her a lot on the podcast, but she's still around. And it wasn't that late. I'm walking back to my apartment and there were lots of police activity. There were all these helicopters. Have you ever seen Good Fellas?
Jayamanne: No.
LaMonica: Of course you haven't. Anyway, I felt like it was Good Fellas. There were all these police helicopters flying around.
Jayamanne: Why are there police around everywhere? Everyone's a good fella.
LaMonica: Oh my God. Well, I can't explain the entire movie to you, but please watch some movie that isn't Harry Potter.
Jayamanne: Maybe.
LaMonica: But I didn't really think anything of it. I go home. I wake up on Saturday morning and I get a text from you from Brisbane and you told me that there was a murder right by my apartment on Friday night. And you said, you know, at first this kind of sounded sweet. You said you were worried about me for a second until they identified that the guy killed was in his 30s. So you knew everything was fine with me.
Jayamanne: Yeah. I mean, well, I turned on the TV in the hotel room and the first thing that I saw was my spice shop. It's like across the road. And then I saw that it was, I was worried.
LaMonica: Were you worried about the spice shop or me?
Jayamanne: Both, but yeah, you were okay.
LaMonica: Apparently.
Jayamanne: Yeah.
LaMonica: Here I am. The other exciting thing happening in Shani's life is and also is related to murder is yesterday that JonBenét Ramsey updated 12th documentary about her, came on. And all day Shani was complaining that it was supposed to start already and it wasn't on Netflix.
Jayamanne: It came out. You watched a bit of it too?
LaMonica: I did. And basically your whole theory that you are very invested in, they just said is not true at the beginning of the documentary.
Jayamanne: I have an open mind. I have an open mind. I'm happy for them to prove me wrong.
LaMonica: Shani thinks the brother did it.
Jayamanne: Yes. And the parents covered it up.
LaMonica: Yeah. And she's very passionate about this, but we're not going to spend too much time on that.
Jayamanne: Isn't that the sign of a good investor though? That you have an open mind and you're happy to be proven wrong? Is that a good segue into the episode?
LaMonica: Maybe not this episode, but I think that is good advice. So we're going to talk about two things today that investors like. So there's income investing, which is very popular. And then there is using ETFs, so investing using ETFs, which is also really popular.
Jayamanne: And common sense suggests that because many people like both these things in isolation, they would gravitate towards dividend ETFs.
LaMonica: But much like Shani and the new JonBenét Ramsey, doc, we are going to do a deep dive today on dividend ETFs to see if that's true, because we don't think a lot of investors know how they work.
Jayamanne: Okay. Why don't we start with some basics? So a dividend ETF is also known as a factor ETF. And a factor ETF identifies certain desirable characteristics in shares and then tries to identify those shares.
LaMonica: Exactly. And this is normally done by creating an index that takes, as Shani said, this larger universe of shares and then comes up with some sort of formula to pick the shares that you want. So since this characteristic can change over time, so it will apply to different shares over time, that these indexes periodically rerun the whole universe of shares through this criteria and then will reconstitute the ETF if new shares meet the criteria and some old shares in it don't.
Jayamanne: And the challenge with a factor ETF and investing in general is that all the information that we do have is historic information. We have plenty of data on what has occurred in the past, but all we care about is what happens in the future.
LaMonica: And with a dividend ETF, this is pretty easy to illustrate. So dividends aren't guaranteed. And just because a company has paid a dividend at a high level in the past doesn't mean they'll keep doing that into the future.
Jayamanne: And we're going to go through a couple of real life examples soon, but we want to go through a hypothetical example of how a dividend ETF works. We'll start with a very simple one. The characteristic we're looking for is dividends. So let's say that an ETF just identifies the shares with the highest dividend yields. Let's say the universe of shares is the ASX 200 and the ETF simply finds the members of the ASX with the highest yields and puts the top 20% into that ETF.
LaMonica: And we'll say that the screen is rerun every six months. So for a share that used to be in the top 20% of yields is no longer there. It's exchanged for another share that's now in the top 20% of yields.
Jayamanne: So in this simplistic example, we can see a couple of potential issues here with the approach. And the first is the issue that we touched on earlier. If the shares in the top 20% of dividend yields don't end up continuing to pay out dividends at that level or more going forward, the investor in the ETF won't get the income they want, which is high dividends. This is called a dividend trap.
LaMonica: The first issue touched on one reason people invest for income. They want high levels of income right now. The other reason that people are income investors because they want a growing stream of passive income. This can either be because they're trying to create a passive income stream to live off of in the future or because they're spending the money now and they want it to at least keep up with inflation so that they can keep their purchasing power.
Jayamanne: So when we put this lens on an ETF, we need to consider how income from the ETF could possibly grow over time. A dividend yield can go up under a few different circumstances. The first is that the share price falls and the dividend either grows, stays the same or falls less than the share price. The second is the share price stays the same and the dividend grows. And the third is that the share price goes up. The dividend increases more than the share price.
LaMonica: So when we look at our hypothetical ETF, where we have 20% of shares with the highest yield in the ASX 200, we need the same things to happen to those shares in aggregate for the ETF income to grow.
Jayamanne: And the inherent problem in this is that shares don't typically work this way. Investors naturally pay high valuations for shares that are supposed to grow earnings faster in the future. The only way a dividend can grow over time is if earnings grow. So naturally, the shares with the highest dividend yields generally have the slowest growth. And some of those shares are dividend traps because investors expect their dividends in the future to go down.
LaMonica: So that presents some challenges from a growth perspective, just by the way our hypothetical ETF is set up. The second challenge relates to the makeup of the Australian market. So the dominant sectors in the Australian market both have cyclicality. That is, resources and financial services specifically banks. Investors typically pay lower valuations for cyclical companies, which means they typically have higher yields. And in a market so dominated by these industries, you could see a lot of them in our hypothetical ETF.
Jayamanne: The issue is, of course, is that if the earnings are cyclical, the dividends are also typically cyclical.
LaMonica: Okay, so that's our intro, our hypothetical ETF intro. And this just gives us a couple things to consider as we start to look at dividend ETFs. And we would recommend that people do this for any factor ETF they're looking for. Try to understand overall. What's happening? And then when you're looking at those ETFs, you can use that framework to apply to them. So we're going to go through some real examples. So we're going to go through 4 ETFs, Shani.
Jayamanne: That's a lot of ETFs.
LaMonica: Not compared to how many ETFs are out there, but yes, you have drawn the straw of doing the first ETF.
Jayamanne: All right, let's do it. So we can start with the Russell High Dividend Australia Shares ETF with the ticker symbol R-D-V. The index uses four different criteria to score Australian shares and then picks the 50 shares with the highest scores for inclusion in the index. The score gives a 40% weighting to consensus forecast dividends. Another 20% is based off projected growth rate of the dividends, which is also positive and forward-looking. 20% of the score is based on historical dividends. The last 20% of the score is based on earnings volatility over the past five years. And the fee is pretty reasonable at 0.34%, and the turnover is 27.14%. So I went through the dividend ETF Mark.
LaMonica: Now it's my turn to what? Tell you what I think?
Jayamanne: Yes.
LaMonica: Yeah, so let's define one thing that we added in there, that turnover. So turnover, of course, is how much the holdings in that ETF typically turnover in a year. So we're going to talk about it a little bit today. So when we say the turnover, Shani, did is 27%. That means in a typical year, 27% of the holdings are new. And just in that lens of a dividend ETF or any factor ETF we want to think about, okay, as this criteria is changing, how does that impact the shares in the portfolio? And also important to note that turnover can cause capital gains to be distributed to investors. So back to the actual ETF that we're talking about. So we did say earlier that all that matters is what happens in the future. And I do think this ETF does a reasonable job of looking forward. So much of that criteria that Shani went through is actually forward-looking. I like that earnings volatility measure because as we talked about the Australian market is very cyclical and that can impact dividend. So by looking at earnings volatility, they're trying to address that.
Jayamanne: And if we look at the top holdings, we can see how that criteria plays out. And I will say it's pretty standard. The top holdings are CBA, BHP, Westpac, ANZ and NAB. And it's very concentrated with 47% of the ETF in the top 10 holdings.
LaMonica: All right, so three to go, Shani. The countdown continues. So the second ETF is the iShares S&P ASX Dividend Opportunities ETF with the ticker symbol IHD. So they start with the 300 constituents that are in the S&P ASX 300 index. And the methodology narrows the stock universe down to 50 names. The initial screens are set around profitability and sustainability to arrive at a list of eligible stocks. The sustainability screen excludes companies involved in controversial businesses and also those linked to violations of international standards or anything related to ESG risk. So the eligible stocks, only the top 50 in terms of the 12 month forecast dividend yield make the final cut. And then they're weighted by the list of stocks based on the dividend yield forecast and the market cap. There are stock and sector weight caps to ensure that the portfolio is not too skewed and is sufficiently diversified. The fee is 0.23%. And the turnover is 48.78%. So what do you now think of this ETF, Shani?
Jayamanne: So we think that the focus on forward dividends is great to avoid dividend traps. There is an ESG screen, which is a good thing if that's one of your investment goals, but I will say that the turnover is quite high. Basically, half the portfolio is new each year.
LaMonica: And it's very concentrated. So 70% of the ETF is in the top 10 holdings. The top holdings are Rio, CBA, Westpac, Fortescue and ANZ.
Jayamanne: So next up is the SPDR MSCI Australia Select High Dividend Yield ETF. They make these names very long with a ticker symbol SYI. The universe is screened for durable and persistent dividends and has a minimum cutoff for return on equity, debt to equity and earnings volatility. A price performance screen removes the lowest 5% of securities with a negative one-year price return. So to make the final cut, securities must carry a dividend yield greater than the broader MISCI Australian Shares Investable Market Index. The result is a portfolio of about 60 stocks and that's rebalanced twice a year. What do you reckon, Mark?
LaMonica: Well, I think the turnover once again is really high, 67%. So that means nearly two-thirds of the holdings are new each year. That fee is reasonable at 0.20%. So the selection criteria uses both backwards and forward-looking criteria and I think I personally would prefer if it was all forward-looking.
Jayamanne: And along with that high turnover, there is a lot of concentration. So 71% of the ETF is in the top 10 holdings. The top holdings are CBA, NAB, ANZ, Macquarie and BHP.
LaMonica: We're on the last one, which went quickly. You had some concerns about how long this was going to take. But here we are at the end. The last dividend ETFs, the Vanguard Australian Shares High Yield ETF with the ticker VHY. This ETF tracks the FTSE Australia High Dividend Yield Index an index Vanguard has exclusive rights to replicate and it consists of mostly large cap companies with higher dividend forecasts among all the listed companies on the ASX. So instead of choosing stocks based on their historical distributions, this index selects stocks based on their one-year consensus forecast dividends. After screening the universe by those dividend expectations, the selected companies are weighted according to their free float market cap. There are some sector skews, but our analysts think that the portfolio carries a very similar risk and reward profile as the broader market. So what do you think, Shani?
Jayamanne: Well, there's a lower turnover at 21.52%. The fees also on the low side at 0.25%. 65% of the holdings are in the top 10 with the largest holding CBA, BHP, NAB, Westpac and ANZ.
LaMonica: And that's it, Shani. Those are all the ETFs. So I think I've talked about this before. My preferred option is that last one we went through, VHY. I actually personally own that. I like the low turnover that you talked about, the fact that it just looks at forward dividend estimates. So there's no historical data used, and it is at relatively low fee as well. But I think in a larger sense, we can make some generalizations about all of these different dividend ETFs. And since you like making generalizations, Shani, why don't you go through them?
Jayamanne: Well, I own VHY as well, but we can make these generalizations. They're all relatively concentrated. Many of them have high turnover. And if you look historically, they have delivered high relative levels of dividends, but they do tend to bounce around a lot. And ultimately, we haven't seen a lot of growth in dividends.
LaMonica: That's right, Shani. So I think they can play a role in a portfolio for an investor, obviously, the two of us own them. But people should go into this with their eyes wide open that significant long term growth is probably not going to happen. Dividend growth, that is. I should specify, we're talking about dividend growth here. We would, of course, encourage investors to really deep dive on the criteria. We did kind of skim over it in this episode, so that it wasn't three hours long. But we think once again, forward looking measures, like analyst estimates are best. But think about what you're trying to accomplish in your portfolio and what criteria lines up best for you.
All right, we did it.
Jayamanne: We did it. That was quick.
LaMonica: Four ETFs. Five, if you include our hypothetical ETF. So that is great. We only had one technical miscue where one of the lights went out. And as I was saying, if the light went out on me for our viewers on YouTube, everyone would cheer. We would have kept going, but we had to replace it because it was on you, Shani. So that's our episode. Anyone has any questions or comments? Email me. My email address is in the podcast notes.
(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)
