How to ensure your ETF engine has the right parts

It pays to look under the hood when comparing high yield exchange traded funds (ETFs) as the mechanics of competing products can be significantly different. Advisers could otherwise find their clients holding a vehicle which is ill-suited to their needs

High yield ETFs have become a widely accepted means of generating above-average income from a portfolio of Australian shares since the first product, Russell Investments’ High Dividend Australian Shares ETF (ASX ticker: RDV), was listed on the ASX in mid-2010.

The fact that Australian shares pay amongst the highest average yield in the world at around 4% is likely a contributor to investor appetite for the products, as is the roughly 1.3% ¹ extra tailwind that imputation credits have provided to the after-tax returns of Australian-based investors since their introduction in 1987. By contrast, global shares offer a dividend yield of some 2% generally without the benefits of franking. ²

Whats under the hood?

These twin factors have entrenched dividends as an accepted supplementary income stream for investors who desire it, without requiring them to give up the extra potential for capital growth that shares provide over more defensive asset classes.

Indeed, the total return of the benchmark S&P/ASX200 Index – as measured by price appreciation plus dividends – was 8.56% in the 10 years to June 30, and more than half of that figure was attributable to the dividends paid by companies.

High yield ETFs offer the potential to tap into more of these dividends by creating a diversified basket of high-yielding stocks.

It’s a strategy that may have more appeal if margins for Australian companies come under pressure in an economic slowdown. In such an environment, total returns may be on the minds of investors even more than previously.

The catch-22 is that dividends broadly would likely fall in a slowdown, even if some companies increase actual payout ratios to appease investors.

Cash might seem a suitable alternative but inflation erodes its real rate of return, whereas investing in shares over the long term can mitigate the impact of rising prices.

High yield ETFs may therefore be worth adding to a portfolio. But not all the available products are the same and understanding the difference is critical to choosing the best match for individual clients. The key difference between products is the strategy they employ to choose stocks. These strategies vary widely and can result in wide ranging returns, with some products suffering losses in periods in which their peers produce gains.

The bottom line

Traditional dividend seekers who desire a steady, reliable income stream may be best suited to high yield ETFs which focus on stocks with a proven history of paying dividends over time, as well as those that display dividend growth and consistent earnings.

In Australia, typical stocks for consideration in such a portfolio are likely to include banks and real estate investment trusts, including Stockland and Dexus. Recently, stocks in the materials sector such as BHP and Rio Tinto have paid dividends significantly higher than the broader market too.

There are other differences between high-yield ETFs too – some, for example, hold more concentrated portfolios with less than half the numbers of stock than other products. This obviously increases the risk of one-off events undermining overall portfolio performance.

To steer a portfolio safely and drive clients towards better outcomes, it pays to drill down into all the working parts of the ever-expanding range of ETFs competing for inflows. This is perhaps nowhere more evident than in high yield equity products.

¹https://www.amp.com.au/insights-hub/blog/investing/olivers-insights-australian-v-global-shares

² ibid