The secret to finding more robust dividend-paying ETFs

Dividend-oriented exchange-traded funds (ETFs) are a tempting option for income-seeking investors, but chasing high yields can be a dangerous investment strategy. If you’re worried about the swathe of dividend cuts in the past year, a new breed of ETF that focuses on sustainable income could be an alternative option to consider.

Stocks that pay out high dividends can be lucrative but they can also be a trap. Some simple maths demonstrates why. The yield is calculated by dividing the dividend per share by the stock’s share price and then multiplying by 100. If the share price drops and the dividend remains the same, the yield will be elevated.

A falling share price can indicate there is a problem with the company, or the market thinks troubles are on the horizon. This means dividend yield alone is not a good reason to invest in a company – and the same applies to corresponding ETFs.

Dividend prospects

The UK’s biggest and oldest dividend ETF is iShares UK Dividend UCITS ETF. It invests in 50 stocks from the FTSE 350, weighted solely according to their one-year forecast dividend yield. The ETF has a 5.6% yield.

‘The potential problem is dividend cuts. There have been 13 dividend cuts in the FTSE 100 alone over the last 12 months or so and most of those cuts were preceded by juddering share price falls – BHP Billiton and Standard Chartered are good examples here,’ says Russ Mould, Investment Director at AJ Bell Youinvest.

‘This has taken its toll on the ETF which, at 850p, trades around 18% below its spring 2015 peak. The popularity of the ETF now may suggest investors think the worst of the dividend cuts are behind us and that 5.6% yield is more secure now.’

Search for sustainability

A different approach is to invest in companies that have sustainable dividends. An ETF that seeks to do this is SPDR S&P UK Dividend Aristocrats UCITS ETF. It is comprised of the 30 highest dividend-yielding companies within the S&P Europe Broad Market Index which have followed a managed dividends policy of increasing or stable dividends for at least 10 consecutive years.

In March, Source launched an ETF targeting UK stocks that offer a high and sustainable dividend, the Source FTSE RAFI UK Equity Income Physical ETF. The index checks companies’ profitability, debt servicing ability and accounting quality and selects index members on the basis of dividend yield relative to their sector. The constituents are weighted by a combination of dividend yield and economic size.

If you want global exposure, you could consider Deutsche Asset Management’s db X-trackers Stoxx Global Select Dividend 100 UCITS ETF. It tracks dividend-paying companies in the Stoxx Global 1800 Index that have a non-negative historical five-year dividend per share growth rate and a dividend to earnings per share ratio of less than or equal to 60% or 80%, depending on the respective region. All stocks in the index universe are sorted by country and ranked by their indicated net dividend yields. Only companies that have a higher dividend yield than their respective DJ Country TMI index yield will remain in the universe.

Low volatility

Invesco Powershares has a range of high dividend, low volatility ETFs such as PowerShares S&P 500 High Dividend Low Volatility UCITS ETF. All the stocks in the S&P 500 are ranked in descending order of trailing 12 month dividend yields.

The top 75 are selected and the number of stocks per sector is capped at 10. The 50 lowest realised volatility stocks are selected and weighted by dividend yield, with each stock capped at 3% and each sector capped at 25%.

DISCLOSURE: This article has been written by Emily Perryman from Shares magazine, part of AJ Bell Media. It was edited by Daniel Coatsworth, who owns shares in SPDR S&P UK Dividend Aristocrats UCITS ETF (UKDV)