Seeking Safety: The Case for Dividend ETFs

If you're not confident in your stock-picking skills, ETFs represent a good option for dividend seekers

Morningstar Europe Editor 6 March, 2012 | 3:28PM
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Given the current environment of persistently low interest rates and uncertainty in the markets, the case for dividend-paying stocks is strong, particularly for income-starved investors. Dividends are one of the few "constants" in the world of investing, (though obviously some dividends are more consistent than others). In fact, many studies have shown that dividend payments have historically contributed at least a third of stocks' total returns. Also, because dividend paying stocks tend to be engaged in relatively steady businesses, they also tend to be less volatile than stocks that don't pay dividends. As such, they are often seen as "safe-haven" investments during times of market volatility. Furthermore, many of these dividend-paying shares offer more than double the 2.0% yield on 10-year UK government bonds. And although they are riskier, they also provide more capital-appreciation potential in the long run, especially as one must assume that interest rates will eventually rise from their current extremely low levels, which will inevitably send bond prices lower.

Finally, dividend-paying stocks can also provide good inflation protection. Empirical studies have shown that those companies that tend to pay out rising dividends generally provide goods and services that are able to keep pace with inflation. For example, utilities can raise their rates fairly easily because they have substantial pricing power. Food and energy companies too find ways to pass on their input costs to consumers.

Dividend ETFs Vary in Their Approaches
In response to investors' interest in income strategies, European ETF providers offer more than 20 ETFs that focus on dividend paying stocks. And while all these ETFs provide liquid and diversified access to stocks with strong dividends, they vary in their approaches.

Some dividend-focussed indices weight constituents by their dividend yield, not by market capitalisation, so higher-yielding stocks make up a larger percentage of the fund than lower-yielding stocks. While this approach--adopted by several funds in Europe--might appeal to investors hungry for current income, it has a flaw. The largest dividend yields tend to come from stocks that have fallen in value--some of which may be likely to cut their dividend in the future. In other words, the most generous companies today (as measured by their current dividend yield) might not be able to sustain their dividend payout in the future. In fact, when looking at the top holdings of the funds adopting this strategy, you can see that they are not necessarily the largest, best known and most stable companies within their universes. For example, the iShares FTSE UK Dividend Plus ETF (IUKD), which offers exposure to the 50 highest yielding UK stocks (the ETF is currently yielding 6.0%), has TUI Travel (TT.) and a host of insurance companies amongst its top holdings. Neither the travel operator not the insurance sector has a particularly strong track record, however, given transport disasters and financial uncertainty.

One way to avoid the riskier dividend-payers is to focus on high-quality companies. Investors may want to look for ETFs that hold stocks that can sustain their current dividends or even raise them in the future. These companies usually are market leaders with strong brand names that have exhibited consistent dividend growth to date. This approach will probably appeal more to investors favouring income stability over high yields. One of the best examples we can give to illustrate that strategy is the U.S.-domiciled Vanguard Dividend Appreciation ETF (VIG). This fund uses a market-cap weighted approach and invests in firms that have raised dividends for 10 straight years. It then imposes additional tests of its constituents' financial strength in order to further ensure dividend quality. The strategy helped the fund to avoid overweighting financials before the financial crisis. While there are currently no ETFs in Europe that follow the exact same approach to hone in on consistent, high-quality dividend payers, a few (listed in the table below) still apply a handful of filters that allow the funds to focus on the companies that are most likely to sustain their past dividend growth. For instance, the iShares EURO STOXX Select Dividend 30 ETF (IDVY), which offers exposure to the 30 highest dividend-paying eurozone stocks, includes only companies that have a positive historical five-year dividend-per-share growth rate and a dividend to earnings-per-share ratio of less than or equal to 60%.

 

Searching for Yield Amongst Sector Equities
Another slightly less obvious and more risky way to gain access to dividend-paying stocks is to invest in high-yielding sector ETFs. Sectors like telecommunications, utilities, energy and healthcare tend to have a high concentration of dividend-paying stocks.

Telecom and Healthcare
For instance, telecommunications has traditionally been a high dividend paying sector which tends to offers some of the richest dividend yields. There is a caveat though: some of these ETFs' benchmark indices are highly concentrated, with the top 10 constituents accounting for almost 90% of the index's value. Vodafone (VOD) accounts for a huge share of the total value of both the STOXX Europe 600 Telecom and the MSCI Europe Telecom Services indices. To mitigate this concentration risk, there is one ETF that tracks an optimised version of the STOXX Europe 600 Telecom Index. This fund, the Source STOXX Europe 600 Optimised Telecomm ETF (SC0Q), provides a relatively higher degree of single stock diversification by employing a cap mechanism which limits the weighting of each constituent to 20% of the index's value.

In times of high economic uncertainty like we are experiencing now, exposure to utilities and healthcare--two other historically defensive sectors offering generous dividend payouts--can also provide the safety that some investors are looking for as these sectors benefit from relatively stable demand across economic cycles. Below are some examples of ETFs focusing on these sectors: 

- iShares STOXX Europe 600 Util (DE) (EXH9)
- SPDR MSCI Europe Utilities ETF (STU)
- ComStage ETF STOXX Europe 600 Utilits NR (C079)
- EasyETF Stoxx Europe 600 Utilities (SYU)
- SPDR MSCI Europe Health Care ETF (STW)
- Source STOXX Europe 600 Opt HlthCare ETF (SC0T)
- Amundi ETF MSCI Europe Healthcare (CH5)

Energy
The energy sector--another traditionally rich source of dividend yields—is also another option. Though this area might represent more of a risk at the moment because of its inherently cyclical nature. Below are some examples of ETFs that operate in this area:

- XACT Oil Service ETF (XACT/OILSE)
- Source US Energy Sector ETF (XLES)
- db x-trackers STOXX Eur 600 Oil&GasSht1C (DX2A)
- iShares S&P Comm Producers Oil&Gas (SPOG)

Financials
Finally, investors should be very mindful of the financial sector, another sector that traditionally pays big dividends. A large number of banks cut their payouts in the midst of the financial crisis as capital preservation became paramount. They have taken a serious beating and the outlook for the sector remains extremely uncertain amid the lingering eurozone sovereign debt crisis. However, if you are looking to invest in financials and are seeking income, this may be the right sector for you.

The original version of this article was published September 2011.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Morningstar Europe Editor  .