Dividend ETFs may disappoint income investors

Investors love income. Investors also love ETFs. An income ETF seems like a match made in heaven. Income ETFs can play a role in a portfolio but like any investment it is important to understand what they can and can’t do to help you achieve your goals.

A good place to start is understanding how the typical income ETF works. Most income ETFs will take a group of shares represented by an index like the ASX 200 and will select shares that meet income related criteria.

Some ETFs use backwards looking criteria like the dividend yield. Some look at forward projections of dividends to weed out dividend traps. All things being equal we believe that investors are better served by the latter. Periodically these same criteria are re-applied and shares that no longer meet the criteria are exchanged for new shares that do.

An example of an ASX listed income ETF

An example is illustrative. Vanguard Australian Shares High Yield ETF [ASX:VHY] is an ETF that receives a Bronze Medallist rating from Morningstar analysts. I also happen to own this ETF and went through the process of comparing it to other income ETFs in this article.

The ETF tracks the FTSE Australia High Dividend Index. The index is constructed by ranking each share by their forward estimated dividends based on consensus analyst opinions. There is also a mechanism to lower portfolio turnover and avoiding too much concentration. There are currently 66 holdings in the dividend index out of 200 in the overall universe of shares that may be selected.

I am going to use the approach that VHY takes to a hypothetical example of a dividend ETF. In my simplified approach I will use an overall universe of 10 shares with the top 6 selected by the ETF which rank highest based on forward estimated dividends. The ETF goes through the ranking exercise twice annual at the end of the financial year and the end of the calendar year and the holdings are adjusted.

Many dividend ETFs weight holdings by dividend yield or forward projected dividend yield. This is used to keep the yield high. Not only will the highest yielding shares be in the ETF but more of the ETF will be allocated to the shares in the highest yield.

These are estimates for the future and anything can happen but if the projections come to fruition this gives investors a high yield. And many income ETFs do provide investors with high yields.

This checks one box for income investors by providing high levels of income. However, I’ve long argued that income investors are best served long-term by both higher levels of current income and income growth. As an income investor the goal is to grow an income stream in real or inflation adjusted terms. Whether income is currently being spent or not this increases the purchasing power of the cash flows from a portfolio. And to do this growth is key and an income portfolio should balance both higher yields and growth potential.

For many income ETFs the track record for growth is less appealing. Below is an example using two popular dividend ETFs in Australia.

Why is income not growing from income ETFs?

The structure of many dividend ETFs makes growth challenging. We need to start with some generalisations about share investing. This isn’t a universal rule, but investors tend to pay higher valuations for shares with higher expected growth. Companies with higher expected growth often invest more resources in the business to take advantage of those growth opportunities. They dedicate less of their earnings to dividends which results in a lower dividend payout ratio.

In general, this means that companies that are expected to grow earnings quickly will have lower yields – both forward-looking yields and backward-looking yields – than companies where growth is expected to be slower. Since earnings growth is often a pre-requisite for higher dividend growth it means dividend growth will be lower. Many of these lower yielding shares with higher expected growth will be excluded from dividend ETFs that use yield as a selection criterion.

There is an example from the US that is illustrative of this fact. We can compare the Dow Jones US Select Dividend Index and the S&P 500 Dividend Aristocrats Index.

The Dow Jones Select Dividend Index contains the 100 highest yielding US dividend shares and weights them by dividend yield – meaning the higher yielding shares get a larger weight in the index. On August 30^th the index yielded 4%. This yield may seem low in Australia but given the overall yield of the S&P 500 is 1.3% it is high in comparison to the US market.

The S&P 500 Dividend Aristocrats Index contains US companies that have raised their dividend for 25 consecutive years. This index is equal weighted. On August 30^th the index yielded 2.33%.This alone illustrates that shares with consistent dividend growth – driven by consistent earnings growth – trade at higher valuations and have lower yields. 

Since 2006 the S&P 500 Dividend Aristocrats Index which focuses on companies that have long track records of growth has had annualised dividend growth of 7.72%. The Dow Jones Select Dividend Index which focuses on high yields has had growth of 4.86%.

This is a real-life example of the generalisation about higher yielding shares growing dividends at a lower level. But it is a US example. And the Australian market is different. Unfortunately, the differences in the markets make dividend growth harder to come by in the Australian dividend ETFs.

In the US there is more of a stigma around dividend cuts. And companies respond to this stigma by doing everything possible to not cut their dividends. The dividend payout ratios are lower, and the yields are lower but most companies won’t cut a dividend unless absolutely necessary.

In Australia companies tend to set dividend payout ratios as a range of earnings. Payout ratios are higher, and yields are higher but as earnings fluctuate dividends will fluctuate. And due to the cyclical nature of many companies that dominate the ASX in the mining and financial services sector those earnings and dividends tend to fluctuate a lot on an aggregate basis. This explains why the examples of the local dividend ETFs bounce around so much.

Why this matters for most dividend ETFs that rely on yield to select shares

Given this relationship between yield and dividend growth it becomes obvious what the issues are with many dividend ETFs that are constantly adjusting into the highest yielding shares. That adjustment is also constantly rotating into shares with lower dividend growth prospects.

These dividend ETFs are not completely turned over every year. There are some shares that are held in the portfolio over the long-term. These shares constantly have high yields which is likely an indication that investors have low expectations for future earnings growth that is needed to fuel dividend increases.

The yield of the ETF will often mirror the directional changes in yield of the overall market – just at a higher level. In a rising market when yields drop as prices increase the yield will likely go down. In falling markets when yields rise the yield of the ETF will likely rise. Relative performance between higher yielding shares and lower yielding shares will impact this dynamic.

For the issuer of the ETF, they can continue to market a higher yield than the overall index. But the impact on investors over the long-term is a little less clear. If an ETF uses a backwards looking yield, there is a risk that the ETF can hold dividend traps that cut dividends.

If the ETF uses a forward-looking yield dividend growth will be constrained by holding the highest yielding shares and will be directionally impacted by the overall trends of dividend growth or cuts in the market. Afterall a higher forward yield is not an indication that a dividend will be higher on an annual basis. A forecasted dividend reduction may still result in a higher yield than other shares. Especially in a market like Australia where dividends fluctuate.

The impact on dividend investors

A higher yield has an advantage for investors who want current income even if the level fluctuates on an annual basis. For long-term investors I would argue that dividend growth leads to better outcomes. Consistent and growing levels of dividend income matter if an investor is living off of income and wants to at least maintain a consistent standard of living given inflation.

This doesn’t mean avoiding dividend ETFs or high yielding shares. They have a role to play in an income portfolio. Reinvesting the higher dividends provides an investor with growth. But balance is important to ensure growth. And that means having ETFs and shares that will grow their dividends over the long-term. These are often shares and ETFs with lower yields. 

Mark Lamonica is Director - Editorial and Content at Morningstar. This article was originally published by Morningstar.