Exchange traded products have not traditionally been the first port of call for investors looking for income, with bonds, cash – before interest rates tumbled – property and some high-profile equities the mainstays for investors looking for attractive yields.
Core stocks such as BP, Royal Dutch Shell and the banks provided the income investors required for many years, with high growth rates and a benign interest rate backdrop fostering the perfect environment for rising dividend payments.
The world, however, has changed dramatically. Cash now pays next to nothing, bond yields have dived, and many stalwarts of the income universe are under pressure to maintain payouts even in the face of regulatory pressure or, in the case of the miners, as the oil price tumbles to multi-year lows.
Markets also remain volatile, with fewer investors willing to risk large parts of their portfolios on single stocks simply because of the yields on offer.
Amid such an environment, alternative sources of income – such as ETFs – are coming to the fore, as investors seek ways to maximise their exposure to high or growing dividends while limiting the risk individual stocks or bonds pose to their portfolios. With many traditional income stocks increasingly under strain, and dividend cover falling, income-focused ‘smart beta’ ETFs should only grow in popularity.
ETFs focused on equities all produce a natural yield as a function of their exposure. Typically, these yields are around 3.9 per cent a year for UK equities, but a specific focus on income stocks in either a concentrated or diversified portfolio can have a major impact. So while the yield on index funds tracking the FTSE 100 is currently 4 per cent, tailored strategies which focus on the highest income payers in the UK outstrip this significantly.
Yields closer to 5.5 per cent, and even near 6 per cent, are achievable from some tailored ETFs, thanks to a series of criteria providers focus on.
Many income ETFs focus on forecast dividend yields for the year ahead, and this approach will typically provide a basket of stocks containing many mid-cap companies, as well as large caps.
These strategies will produce the very highest-yields, near 6 per cent in some cases, with significant weightings in individual securities which rival the amounts some active fund managers will hold. However, there are other options available, including those focusing on the latest annual cash dividends already paid by companies to dictate their weightings in a portfolio.
The idea is simply to expose investors to companies that consistently pay dividends while avoiding overexposure to those that have benefited from one-off dividend payments which may not be repeated.
In practice, this approach tends to expose investors to the consistent payers in the FTSE 100 rather than smaller companies. Therefore, such strategies have significantly less exposure to mid-caps than other income-focused ETFs.
As a general rule, investors should consider how large positions in individual stocks are allowed to become: many trackers have no upper limit and therefore they can become skewed to a few core names, increasing stock-specific risks.
Conversely, capping exposure to individual securities at every annual rebalance can help to keep portfolios diversified, providing a degree of protection and reducing the impact on the overall return of an ETF from a stock-specific event.
Buying stocks with the highest dividend yields has historically enabled investors to outperform quite dramatically. Even taking into account the sell-off in 2008 when some previous income stalwarts – including HSBC, Barclays and Lloyds Bank – saw share prices virtually wiped out, the highest dividend payers have delivered substantial returns over low-yielders and the benchmark indices.
Higher dividend-payers have been rewarded by investors over the long-term for a number of reasons. For instance, dividends have theoretical and empirical importance when it comes to determining the value of a stock, and they also indicate the willingness of management to deliver returns for shareholders, both of which are welcomed by investors.
As well as providing a yield substantially above traditional trackers, the income these solutions produce also compares favourably to other asset classes such as fixed income.
UK and US government bonds currently pay significantly lower incomes, with the yield on benchmark 10-year UK gilts just 1.77 per cent, or 2.04 per cent for benchmark 10-year US treasuries.
Investors can go up the risk scale and obtain higher coupons by looking at areas such as emerging market debt, picking up yields above 5 per cent, but with the strong US dollar continuing to act as a headwind, the asset class is not yet out of the woods and could see further capital losses.
UK property has enjoyed a successful 2015 in terms of both the income generated and capital growth, but whether or not the sector can deliver 5 per cent-plus income again in 2016 remains to be seen. The income level also remains below that achieved by dividend-focused trackers, albeit marginally.
Infrastructure has been a reliable option for those seeking the highest yields, but following a wall of investor demand for income, these now face two key risks. First, yields – previously around the 6 per cent mark – have moved sharply lower over the last few years and now sit nearer to 4.5 per cent.
Second, many of the UK-listed infrastructure funds are now trading on a premium to net asset value, leaving them open to questions over valuations and just how sustainable their yields are. At 4.5 per cent, the income on offer remains attractive compared to some other assets such as fixed income, but the risks to the downside in terms of valuations have increased.
With the significant drop in yields across the fixed income spectrum, coupled with the volatile moves in individual stocks – expected to rise as central banks remove support from the market – income-focused ETFs are increasingly an attractive option for investors.
In particular, products which limit exposure to individual holdings can provide the diversification investors concerned about market valuations need, while still producing an income well in excess of most other asset classes.
Indeed, we expect dividend-focused ETFs to really take off in the post-retirement market. Savers will have already had to contend with the volatility inherent in any investment throughout their working lives, and will be keen to put the lump sums they have saved to effective use.
However, with annuity rates coming down sharply in the wake of new pension freedoms, many products now pay less than 2.5 per cent income a year. A product producing more than double that could clearly be attractive, and while the underlying capital will fluctuate in value, diversification across more than 100 companies should help ease concerns over wealth preservation.
Viktor Nossek is director of research of WisdomTree Europe
Key points
Alternative sources of income – such as ETFs – are coming to the fore.
ETFs focused on equities all produce a natural yield as a function of their exposure.
It is expected that dividend-focused ETFs are to really take off in the post-retirement market.