Income streams

Investors chasing high yields look to new breed of ETFs

STORY SUSAN HELY

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INCOME IS THE CURRENT investment obsession. Investors poured $225 billion into deposits between 2008 and 2011, or $90 billion more than in the previous three years, according to the Reserve Bank of Australia (RBA). But as interest rates drop and the bond market is under pressure, how do investors make a return that outstrips inflation?

“Investors should consider moving away from the comforts of term deposits and rebalance back into other asset classes which have a higher potential for growth,” suggests Jonathan Philpot, partner at HLB Mann Judd Sydney.

“2013 is looking like it could be a good year for investment markets, while interest rates from term deposits could continue coming down, or at least stay at current low levels. Investors should think about whether they want to buy back into markets before they start to rise.”

One popular source of income is the dividend stream from high-yielding Australian company shares. If you can tolerate the volatility of the Australian sharemarket, mining the rich stream of dividends certainly makes good financial sense.

For a start, no other country in the world has franking credits – a tax credit – that can be used to offset tax liabilities, says Amanda Skelly, head of SPDR ETFs at State Street Global Advisors (SSgA).

Dividends can be fully (100%) franked, in which case the entire 30% company tax paid will be refunded to investors. Depending on the company’s structure and earnings, some dividends may also be partly franked, or unfranked.

For low tax or zero tax-paying investors, such as those in pension phase, franking credits can be exchanged for cash through the tax office.

Dividends contributed 4.4%pa of the total Australian sharemarket return over the three years to the end of September 2012, and a further 1.4% was attributed to franking credits, according to Russell Investments. In fact, 45% of the return from Australian equities over the past 10 years has come from dividends, according to research by SSgA.

In a slow-growth environment, dividends can play an important role in getting the most out of your portfolio return, says Scott Bennett, portfolio manager, direct investments, at Russell Investments.

But rather than cobble together a portfolio of high-dividend shares and risk getting the wrong companies, why not leave it to the professionals who select a diversified portfolio of high-yielding companies?

There is a range of low-cost, high-yield exchange traded funds offering a diversified portfolio of high-dividend shares on the ASX, as well as listed investment companies (LICs) and managed funds that specialise in dividends. Bennett believes a high-dividend investment is suitable as the core of an investment portfolio. The catch is there is more risk with an investment strategy based on shares rather than government-guaranteed cash and term deposits. With shares, investors may lose capital when the sharemarket goes down.

The risk has prompted investors to move $67 billion out of direct shares during 2008-11, according to the RBA. But the providers of high-dividend funds argue they have constructed their portfolios to have lower risk than the general sharemarket.

“Generally investors looking for income are more conservative,” says Bennett. He believes investors want low earnings volatility. Russell carefully selects defensive companies that pay a decent dividend.

For example, rather than buy a highly cyclical company such as Harvey Norman that benefits from discretionary spending, it holds consumer staples companies – such as grocery, hardware and liquor group Metcash – that offer much more stable earnings.

High-yield ETFs

Dividend-paying companies are often healthy with growth prospects and stable earnings. But Bennett warns investors to tread carefully and select companies with sustainable, robust dividends rather than “the imitators” – or companies that offer a high dividend that may not be ongoing.

There are currently four “rules-based” (not index-based) ETFs listed on the ASX that focus on dividend yield: iShares S&P/ASX High Dividend (ASX code: IHD), Russell High Dividend Australian Shares (RDV), SPDR MSCI Australia Select High Dividend Yield Fund (SYI), and Vanguard Australian Shares High Yield (VHY).

“High-yield ETFs are a very easy way to get access to equity income and diversification,” explains Tom Keenan, a director at iShares.

Each high-yield ETF holds different investments and has a unique way of selecting its shares. The providers base their portfolios on different indices: iShares uses the S&P/ASX Dividend Opportunities Index, while Russell tracks the Russell Australia High Dividend Index, SPDR the MSCI Australia Select High Dividend Yield Index, and Vanguard the FTSE ASFA Australia High Dividend Yield Index.

It is up to an investor to work out which selection process and index suits them.

Forecast dividends

The oldest high-dividend yield ETF, Russell High Dividend Australian Shares, selects about 50 companies based on forecast dividend yield for a three-year period.

Vanguard is the only other ETF that looks at forecast dividends, projecting them one year ahead. The other two ETFs from SSgA and iShares use historical dividends, looking at past performance.

“We don’t have a backward-looking approach – that is like looking in the rear mirror,” says John James, the managing director of Vanguard in Australia.

SSgA uses a historical 12-month dividend yield while iShares looks at earnings per share before extraordinary items.

Bennett says the Russell ETF is unique because it considers the forecast franking credits of a company. Franking credits can add extra income value of up to 2%. “Franking credits make a 5% dividend yield gross up to 7%,” says Bennett. But RDV has a flexible approach and does include companies without fully franked dividends as long as they have a strong dividend, which is the case for some real estate investment trusts (REITs).

Russell makes sure a company consistently pays dividends by looking at its dividend history over the past five years. Russell scrutinises dividend growth too.

For example, an investor who made a $10,000 investment in Telstra 10 years ago would have received an income of $750 a year, including franking credits. In contrast, miner BHP Billiton is not a traditional high-dividend-yielding stock, says Bennett. But it has consistently increased its dividend and, for an $10,000 investment, paid out almost double Telstra’s dividend in the same 10 years, at about $1400 a year, including franking credits, on top of capital growth.

Look at growth prospects too

“We don’t screen companies,” says Bennett. “We score each company based on the metrics and skew the portfolio to the companies that scored well.

“If an investor looks beyond yield alone, they can benefit from a growing income stream that is delivering a greater dollar value while also maintaining the potential for capital growth over time.”

The Russell ETF rebalances after companies have paid out their dividends in March and September, just after reporting season. It typically invests in large-cap companies “because the dividends are more stable than those from small companies”, says Bennett.

And it is more costly to trade small caps because of the lack of liquidity. “Dividends hold up well in times of stress,” says Bennett.

He likes companies such as energy infrastructure company APA Group because it keeps abreast of inflation; Bendigo and Adelaide Bank; and REITs such as CFS, Mirvac and Stockland.

“You do need to be flexible to take advantage of good dividend opportunities.”

Vanguard’s Australian Shares High Yield uses the FTSE ASFA benchmark, a market capitalisation-weighted index consisting of companies with higher forecast dividends compared with other listed companies.

The index includes about 70 stocks and restricts the proportion invested in any one industry or company. There is no more than 40% in one industry or 10% in any one company.

iShares S&P/ASX High Dividend ETF is based on the S&P/ASX Dividend Opportunities Index that tracks 50 high-dividend-paying shares from the S&P/ASX 300. It restricts any sector weighting to only 20% and any stocks to 4% of the portfolio.

Keenan explains the reason behind this is that iShares considered that most investors already own the big four banks and Telstra. “It doesn’t make sense to have a large exposure to the financial sector, so the fund caps all sectors at only 20%.”

LICs can be more variable

Listed investment companies may also track high dividend-paying shares. The big difference between LICs and ETFs is that LICs are closed-end funds and can trade above or below their net asset backing.

ETFs are open-ended and tend to trade at about their net asset backing, explains Skelly.

There are a number of new income products being launched, including one from BetaShares: BetaShares Australian Top 20 Equity Yield Maximiser Fund (ASX code: YMAX) invests in the top 20 Australian blue-chip shares and uses covered call options to enhance the yield of the shares.

“The feedback we are hearing from investors and advisers suggests there is strong demand for equity strategies that deliver attractive, regular income distributions combined with less volatility than traditional equity portfolios,” says Drew Corbett, head of investment strategy at BetaShares.

In falling, flat and gradually rising markets, BetaShares’ strategy could be expected to outperform a strategy of holding the underlying share portfolio alone. But it would be likely to underperform the share portfolio in a strongly rising market.

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