Dividend exchange-traded funds (ETFs) offer investors the opportunity to generate attractive income in today’s low-yield, high-inflation environment.
Not only can dividend ETFs provide investors with relatively attractive yields, but some strategies intentionally seek to grow income above the rate of inflation.
In this article, we’ll explore the world of dividend ETFs and what to look for before investing in these products.
- Dividend ETFs aim to invest in companies that are expected to pay high, reliable and/or growing income streams.
- Dividend ETFs can invest in a range of different types of assets, including Australian shares, international shares and Real Estate Investment Trusts (REITs).
- Distributions can be paid monthly, quarterly, semi-annually, or annually.
- ETF issuers do not keep dividends as performance fees – they are generally paid out to investors as distributable income.
What is a dividend ETF?
First, the basics. How do dividend ETFs work exactly? And what’s the difference between ETFs that pay distributions versus “dividend ETFs”?
While it’s true many ETFs pay distributions, the term “dividend ETF” refers to a broad category of funds that employ strategies specifically focused on generating income from equities, as opposed to ETFs that invest in value or growth stocks.
Most dividend ETFs traded on the ASX aim to achieve one or more of these goals:
- Track an index made up of, or actively select, companies that are expected to pay high, reliable and/or growing income streams.
- Exceed the yield offered by the broad market (for example, the S&P/ASX 200 or S&P 500 benchmarks).
- Deliver a level of income growth that’s higher than an important financial indicator such as the Consumer Price Index (CPI).
What can dividend ETFs invest in?
Depending on the fund, dividend ETFs will invest in either one or a combination of the following asset classes:
- Australian shares
- International shares
- Real Estate Investment Trusts (REITs)
- Infrastructure securities
How do ETFs generate income?
The best way to look at ETFs in the context of dividends is that they are simply a ‘conduit’ that seek to pass income.
- Collect dividends paid by underlying companies, as well as other earnings, such as income from writing options (depending on the ETF).
- Pass those earnings to unitholders on a periodic basis as cash, or reinvest those distributions via a distribution reinvestment plan (DRP), depending on the unitholder’s preference.
- Publish periodic statements detailing the components of distributions for unitholders.
How often do ETFs pay distributions?
The frequency of ETF payments depends on the issuer and the fund. They usually vary between:
All Betashares’ dividend ETFs remit distributions either monthly or quarterly, which can benefit investors who are seeking income payments more frequently than most ASX companies, which typically pay dividends only twice a year.
Similar to individual companies, each dividend ETF sets an ex-distribution date, a record date, and a payment date. These dates determine who receives the distribution and when it gets paid.
Tip: Betashares’ distribution timetable for all ETFs can be found here.
What happens to an ETF’s unit price when distributions are paid?
Like shares, an ETF’s unit price usually falls by the same amount as the distribution to be paid to reflect the fact that new investors are not entitled to that payment.
For example, if an ETF announces a final distribution amount of $1 and trades at $20 per unit immediately before the ex-distribution date, then the unit price of the fund can be expected to fall to $19 on that date (all else being equal).
How is income from an ETF treated?
A distribution from an ETF represents your share of the income earned by a fund and will be taxed depending on your individual circumstances.
Where things become a bit different with ETFs is because they’re structured as unit trusts, rather than as companies, the distributions they provide can potentially be split across several different categories including:
- Dividend income
- Franking credits
- Realised capital gains
- Interest income
- Foreign income
This is because ETFs invest in many securities and potentially across different asset classes, meaning they collect different types of income from their underlying holdings. Capital gains may also be generated due to periodic rebalancing or sale of assets.
If you manage your own ETF portfolio, the income components required to complete your tax return will be shown in the annual tax statement posted to you or available to download from the registry website associated with each particular ETF.
For Betashares ETFs, the registry is Link Market Services.
Do ETF issuers keep dividends as performance fees?
One of the misconceptions we often come across is that ETF issuers pocket dividends for themselves, which is simply not the case.
It’s important to remember that one of the main factors in determining whether an ETF pays distributions to unitholders is if the underlying holdings themselves pay income to the fund.
Why consider dividend ETFs?
Here are a few reasons why dividend ETFs can have a place in a diversified portfolio:
According to Market Index, Australian shares (as represented by the S&P/ASX 200) have consistently provided an average yield of around 4-5% p.a. (before franking) since May 2011, apart from the COVID lockdowns period in 2020 and 2021. Compare that to bank deposit rates, which have gradually drifted to around 1%, according to the Reserve Bank of Australia. Meanwhile, SQM Research data shows gross rental yields on houses nationally have tumbled below 4% (as at July 2022). This figure doesn’t account for agent fees, council rates, and inevitable repair expenses. Of course, it’s important to remember that share prices are subject to market risk, are more volatile than bank deposits and other asset types, and their value can go up and down. Before making any investment decision you should consider your particular circumstances and tolerance for risk.
Source: Bloomberg. Past performance is not indicative of future performance. Provided for illustrative purposes only. Dividend return is the difference between the rolling 3-year return (annualised) of the S&P/ASX 200 Total Return Index (represented as the ‘Total return’ in the above graph) and the S&P/ASX 200 Index (the price return).
Some dividend ETFs are specifically designed to help you retain and increase your purchasing power, and give you access to strategies that may be too hard to replicate on your own.
For example, the RINC Betashares Martin Currie Real Income Fund (managed fund) aims to generate a pre-tax income yield above that of the S&P/ASX 200 Index and to grow this income above the rate of inflation (CPI) over the long term. The YMAX Equity Yield Maximiser Fund (managed fund) and the UMAX S&P 500 Yield Maximiser Fund (managed fund) use covered call options with the aim of generating above-market distribution yields.
Identifying individual dividend-generating stocks requires a strong understanding of a company’s financials. It can be a serious time-sink to weigh up which securities can reliably deliver dividend payments year in, year out. Dividend ETFs can save you this headache by using a clearly defined process with the aim of selecting a portfolio of income-paying stocks.
Because dividend ETFs hold a diversified portfolio of securities, selected based on their potential to pay reliable income, one or several unexpected dividend cuts could be offset by other companies in the portfolio keeping or raising their dividends.
Regular distributions help to tame your inner trading beast because they tend to reward you for playing the long game. It’s a lot easier to deal with market volatility if you know you’ll be getting income deposited into your account regularly.
As with any investment, there are risks to consider with dividend ETFs:
Like with any share or managed investment, a dividend ETF may not deliver on its intended investment objectives, and past results or distribution trends are no guarantee of future performance.
While some dividend ETFs apply a rigorous methodology to try and weed out companies with unsustainable yields, there is no guarantee that some companies won’t cut or eliminate their dividends. As a result, yields may rise or fall in any given year.
Like with any ETF, dividend funds have fees. It should also be noted that dividend ETFs are generally more expensive than simple, broad-market strategies.
Some dividend ETFs may be heavily biased towards certain sectors, such as financials and resources, as they historically have tended to be the biggest sources of dividends in the Australian sharemarket. As a result, the yields and unit prices of these ETFs can fall significantly if these industries encounter tough times.
How do dividend ETFs identify the companies to invest in?
So, what is it exactly that these funds do to identify and invest in the companies that pay reliable and attractive income?
Most dividend ETFs traded on the ASX combine one or more of the following core elements when determining which securities to include:
In the world of dividends, size generally does matter. Larger companies tend to have stronger balance sheets, which means they’re more likely to keep paying dividends on a regular basis. Some funds will require companies to have a market capitalisation of at least $500 million, for example.
Because dividend ETFs try to deliver a higher yield than the broader sharemarket, funds will typically screen for companies that have paid above a minimum annual yield over an extended period.
A company whose earnings have been negative, or declining, may be susceptible to a dividend cut and may be excluded by an index.
Dividend ETFs and indices generally aim to screen out one-hit wonders. They want companies with a solid track record of payments over several years.
If a company is paying out all or nearly 100% of its profits as dividends, then that could be a red flag as there is no safety margin for that company to maintain its dividend if earnings fall. For this reason, dividend ETFs often screen out companies with extremely high payout ratios.
Case study – Betashares Global Income Leaders ETF
Let’s examine how the underlying index of a specific ETF practically applies screening criteria.
The INCM Global Income Leaders ETF sees to track the performance of the NASDAQ Global Income Leaders Index (before fees and expenses), whose constituents include 100 high-yielding companies screened across developed markets outside Australia.
At a high level, the index sets the following eligibility criteria for inclusion:
- Have a market capitalisation of at least US$1 billion for US components and $500 million for non-US components.
- Have positive earnings over the trailing 12-month period.
- Have made regular dividend payments for each of the past three consecutive years.
- Have a dividend payout ratio that doesn’t exceed 80%.
- Not exceed prescribed volatility thresholds.
How to select dividend ETFs
Now that we better understand how dividend ETFs pick stocks, how should investors select a dividend ETF? Consider the following factors during your research:
As with the example above, each ETF has an investment methodology. Make sure the fund you’re assessing applies a rigorous process to find quality dividend-paying companies while weeding out stocks with unsustainable yields.
You’ll want to understand the ETF’s management fees and costs before making an investment. Some ETFs have very low fees, while others can run higher and eat into your returns.
Pay attention to a dividend ETF’s yield to understand what kind of income you can expect to earn over the next year and compare yields across issuers.
Keep an eye on the fund’s holdings and see if it has disproportionate exposure to certain companies or industries. If a fund has significant exposure to one stock or industry, then the yield and share price of the ETF may fall significantly if that company or sector experiences significant headwinds.
Ready to start your dividend investing journey with Betashares?
Hopefully by now, you have a grasp of how dividend ETFs work. Take a peek at our selection of both active and passive dividend ETFs to see if they could form part of your income toolkit. When you’re ready to invest, you’ll need to create a brokerage account (if you don’t already have one). Prior to making a purchase, check out the 9 things to know before investing in ETFs.
Video and Content Executive
Ben brings a unique blend of financial acumen and creative storytelling to his role. With a solid background as a portfolio analyst, Ben possesses a deep understanding of the financial markets, investment strategies, and how ETFs work.Read more from Benjamin.