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.
