Beware the (income) trap

The ETF juggernaut continued in 2019, passing through the $6 trillion mark. No active, open-end fund manager appears to be shielded from this growth, with ETF usage becoming widespread in fixed income, ESG and factor investing – alongside the bread and butter of equities – all of which has taken market share from active managers across the board.

However, one area of resistance to index trackers has been equity income investing. When buying a portfolio of stocks for its income, it is not only important that the current level of income it generates is high enough to cover your spending needs, it is also vital that the future stream of income payments steadily grows to protect against the effects of inflation.

This complex balancing act has allowed equity income investing to remain in the realms of active managers, with investors wanting assurances that they are not falling into traps, purchasing high income now, but risking it falling significantly in the future if the stocks aren’t able to maintain their high payments.

A recent example of a ‘yield trap’ was Carillion. As recently as May 2017, its trailing dividend yield was 10%, as it increased its dividend year-on-year despite struggling to generate profits to cover the payments. By January the following year, the stock had been suspended, the dividend stopped and the share price was down 95%. This sort of move, although rare, is not a one-off. A skilful manager who is able to distinguish the Carillions from the BATs (which increased its dividend every year for the last 30 years, even with the struggles of the tobacco industry) will have experienced success through strong asset growth.

On the other hand, passive or rules-based income strategies have emerged over the last decade, but investors have remained extremely sceptical. The common retort over the last couple of years has always been finger-pointing towards the likes of Carillion – a passive strategy is just going to fill my portfolio with yield traps.

A decade ago this would have been true. Launching in 2005, the iShares UK Dividend ETF tracks the FTSE Dividend + index. This is roughly the 50 highest-yielding securities in the FTSE 350 index, weighted by the trailing yield. At the end of May 2017 Carillion was the biggest holding at a 3% weighting.

However, high-income index strategies have come a long way since then, becoming much more sophisticated. The industry has not made it easy for investors to understand all the different income methodologies and, to add salt to the wounds, sometimes the more crude methodologies actually charge higher fees.

In April 2019, we launched our Income Funds. These portfolios use different types of index-tracking income strategies. When selecting income ETFs, we categorise them into one of three buckets:

Source: AJ Bell; illustrative purposes only

Where possible, we avoid using first-generation products, instead use a combination of second- and third-generation products. Indeed, the third-generation products are constructed in such a way that they are able to do some of the work of the active manager, separating the income traps from the consistent payers.

To illustrate this, I will explain exactly how the iShares World Quality Dividend ETF works.

Step 1 – Identify investment set

It filters out any REITs, as these tend to pay high dividends and would dominate the ETF holdings (we allocate to property separately in our income portfolios).

Step 2 – Find the high payers

Identifies stocks paying a dividend yield at least 30% higher than the broad index.

Step 3 – Identify persistent payers

Removes any company that has shown negative dividend growth over the last five years – this is to ensure the dividend was sustainable on a historic basis.

Step 4 – Remove unsustainable payers

The top 5% of companies ranked by dividend pay-out ratios are removed – this is to ensure the dividend is sustainable on an ongoing basis.

Step 5 – Remove the traps

The bottom 5% of companies based on trailing 12-month performance are removed; these companies will typically have a high yield because of falling share price rather than strong dividend records, so are potential traps.

Step 6 – Identify strong balance sheets

A composite relative metric is calculated for each company to estimate the quality of its balance sheet. This is based on return on equity, leverage and earnings volatility. The universe is cut in half through this process.

Step 7 – Weighting

The remaining stocks are weighted using the market capitalisation, subject to a maximum weight of 5%.

Step 8 – Rebalancing

The holdings are reconstituted and rebalanced twice a year. Buffers are applied to avoid unnecessary turnover.

Source: MSCI

The final high-yield index contains about 20% of the securities from the parent index.

Hopefully the above shows how Income ETFs have come a long way from the original iShares UK High Dividend ETF. It also highlights the amount of due diligence required when selecting ETFs for income purposes – we implore the ETF industry to simplify the names, methodologies and costs!

The quality bias means this sort of product will underperform when value is in fashion, but in times of market sell-offs the quality tilt should provide some protection.

Much like an active manager, the methodology can sometimes fail to catch the traps however, given the diversified nature of the product (over 300 stocks in the example given), one-off cuts are immaterial. At the same time, it has been able to deliver a yield 50% higher than the MSCI World Index and at a significantly lower price compared to an active income fund.

We think the ETF industry is now at a point where it can deliver sustainable income, and we expect to see strong growth in the space, especially whilst bond yields remain so low!

These articles are for information purposes only and are not a personal recommendation or advice.