By PATRICK CAIRNS
Investors looking for income at the moment are in a tough spot. The UK 10-year government bond is yielding just 0.7%. Cash in the bank might earn you 1.0%.
These traditional sources of income are therefore not very attractive.
The alternative is the stock market. The FTSE All Share Index currently has a dividend yield of 2.8%. If you invested in a broad market index tracker, you could therefore earn an income four times higher than through a 10-year government bond.
You will also have the advantage of long-term growth in your capital.
Investors are not, however, limited to only buying the whole index. There are ETFs that follow specific dividend strategies.
These ETFs track indices that only include dividend-paying companies. This means that the dividend yield, and therefore the income, can be even higher.
It is, however, important to be aware that these strategies can vary quite a lot. They do not all do the same thing.
When choosing a dividend index tracker, it is therefore important for investors to take a step back and ask some questions about the index being tracked. How does it determine which stocks are selected, and how does it rank them?
A good way to explain this is to look at the three UCITS funds with a focus on UK dividends – the iShares UK Dividend UCITS ETF, the SPDR S&P UK Dividend Aristocrats UCITS ETF, and the WisdomTree UK Equity Income UCITS ETF.
It would be easy to assume that because all three are focusing on dividends, that they are similar. However, the strategies are quite different.
The iShares UK Dividend UCITS ETF tracks the FTSE UK Dividend+ index. This index includes the 50 highest-yielding companies in the FTSE 350. This is based both on the dividends they paid in the past 12 months, as well as analyst forecasts for the next 12 months.
This is a high yield strategy, and the fund’s current dividend yield is 4.5%. However, it is important to understand why a company might have a high dividend yield in the first place. The most likely reason is that its share price has gone down.
This makes the iShares UK Dividend UCITS ETF very much a value-type strategy. It is buying shares that are cheap relative to the dividend they are paying.
The SPDR S&P UK Dividend Aristocrats UCITS ETF takes an entirely different approach. It tracks the S&P UK High Yield Dividend Aristocrats index, which does not consider a company’s dividend yield at all.
To get into this index, a company must have increased or maintained its dividend payout for at least the past seven years. In other words, it is not the stocks with the highest dividend yields that make it, but those that have been the most consistent dividend payers.
The yield on this fund is therefore much lower – only 2.7%. Currently, that is even lower than the yield on the FTSE All Share Index. The quality and reliability of those dividends should, however, be much higher.
Essentially, this is quality index. It holds companies that have shown the ability to grow what they return to shareholders over time.
The WisdomTree UK Equity Income UCITS ETF offers a third alternative. This fund tracks an index that WisdomTree created itself.
This index picks the stocks with the highest dividend yields in the UK, but excludes those that don’t meet WisdomTree’s ESG criteria.
It also then filters these stocks using two factors – momentum and quality. This means that it is not just dividend yield that matters, but also positive stock price movement, and how strong the company is. In a way, it is a combination of ideas.
The fund is currently yielding 5.3%, which is almost double the yield on the FTSE All Share.
None of these funds is inherently better than the others. They each offer something that may be attractive to different investors. In some cases, a combination of all three might even make sense.
The important point is that, as with all ETFs, it is crucial for investors to understand what is actually in the fund. Don’t just go on a name. Understand the index that is being tracked, how it works, and what that means for how the fund will perform.
One of South Africa’s most respected financial journalists, PATRICK CAIRNS is a trusted commentator on the world of investments and the quirks of behavioural finance. Over more than a decade he has built a reputation for keeping the industry honest, and putting the interests of investors first.
Here are some more articles by Patrick Cairns:
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