Dividend ETFs are a developing feature of the Australian listed product market.

Products belonging to Morningstar’s “dividend” strategic-beta group (Australia) collectively held $2.1 billion of investors’ assets at the beginning of 2019.

And group has been growing at a blistering pace in recent years.

Total net assets - share class in Morningstar's "dividend" strategic-beta group (ASX listed), January 2009 - January 2019

Dividend etf australia growth

Source: Morningstar Direct

This should come as little surprise in the context of the prevailing low interest rates and the secular upward trend in demand for sources of investment income, as the first waves of baby boomers have entered retirement, says Ben Johnson, director of global exchange-traded fund research for Morningstar.

Of the 13 dividend-ETFs that exist today on the ASX, more than half are less than five years old, with the majority coming into existence since 2014.

As the menu of dividend ETPs expands, it is important that investors understand that not all dividend ETPs are created equal, Johnson says.

"Each has its own unique characteristics, which stem from important--albeit often nuanced--differences in the methodologies of their underlying benchmarks," he says.

Today, we're hunting for dividend ETFs under Morningstar's coverage with medal ratings – Gold, Silver or Bronze. Three funds made the cut.

Morningstar Medalist Dividend-ETFs at 3 July 2019

Dividend etfs morningstar

Source: Mornignstar Direct

Dividend ETFs explained

Unlike passive ETFs which typically replicate the performance of a market index or asset, and often use a market-cap weighted methodology (e.g S&P/ASX 200), Morningstar classifies dividend-ETPs as belonging to the strategic-beta group product group.

Strategic beta (or smart beta) products must still be index tracking, but they typically set aside market cap methodologies and lean towards other factors such value, dividends, low-volatility, momentum and quality - or a combination. 

If you'd like to understand more about smart-beta ETFs, check out our back to basics piece ' Investing basics: what's so 'smart' about smart beta ETFs?'.

When it comes to dividend-ETPs, these products typically start with a regular share portfolio, and then skew the portfolio towards higher than average dividends – current and/or projected.

Each product has its own unique charactertics, which stem from nuanced differences in the methodologies of their underlying benchmarks, Johnson says.

"Understanding three key characteristics of these funds - include dividend yield, dividend growth, and dividend durability - can help investors make more-informed choices," he says.

For example, Vanguard's VHY and Russell's RDV both use forward-looking consensus forecasts. SPDR's SYI focuses on trailing dividends and earnings, say Morningstar fund analysts.

Morningstar senior analyst Matthew Wilkinson says reading the fine print is imperative with any investment but especially in the income space.

"Many product names use "income," "dividend," or "imputation," yet the strategies can vary markedly in cost, complexity, and risk/reward profile. Several high-dividend ETFs launched since 2010. These products are similar but have their nuances," he says.

Given the risk of dividend traps (high-yielding stocks that cut dividends), Morningstar analysts say active strategies offer legitimate competition too. Although they point out that active managers are not immune to mistakes either. 

"The best active managers have been able to protect capital by sidestepping dividend traps”.

Here’s a closer look at the three names on the list.

Vanguard Australian Shares High Yield ETF (VHY)

Morningstar senior analyst Matthew Wilkinson says Vanguard Australian Shares High Yield VHY provides a worthwhile option for Australian equities exposure with good income. For a competitive 0.25 per cent fee, Vanguard tracks the FTSE Australia High Dividend Yield Index via a full-replication approach.

This FTSE index ranks companies by forecast yields and excludes those that do not expect to pay a dividend, resulting in a diversified portfolio with above-average dividends and franking credits. Wilkinson says listed-property trusts are excluded, and there is likely to be minimal technology exposure.

The portfolio has had some mis-steps, such as poorly timed buys into resources over financial year 2016 as declining share prices made the yields of BHP and Rio Tinto appear more attractive, Wilkinson says.

"This highlights the risks of "dividend traps" for a rules-based strategy," he says.

That said, Wilkinson says VHY's use of forward-looking consensus dividend forecasts should help reduce them.

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SPDR MSCI Australia Select High Dividend Yield ETF (SYI)

Former-Morningstar search analyst Sarah Fox says of the SPDR MSCI Australia Select High Dividend Yield ETF SYI that it is a low-cost, effective way to capture exposure to high-dividend-paying Australian shares.

Fox says applying a full replication approach, SYI’s portfolio closely resembles the benchmark, the MSCI Australia Select High Dividend Yield Index. The customised benchmark applies a rules-based dividend overlay that has delivered above-market yield and franking.

"It’s a concentrated portfolio with typically between 35 and 40 names represented, but diversity is sought through the ”10/40 rules”: No security is more than 10 per cent of the portfolio and positions greater than 5 per cent must be trimmed if they total more than 40 per cent," she said.

"Dividend traps are a risk with yield-seeking ETFs. SYI attempts to mitigate this by filtering out companies with unsustainably high and inconsistent dividends and large negative one-year price performance. Investors should bear in mind that dividend filters generate higher turnover than market-cap-weighted ETFs, elevating tax and transaction costs."

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Russell High Dividend Australian Shares ETF (RDV)

Russell High Dividend Australian Shares ETF RDV is a sound option for investors seeking yield at a low cost, as its use of consensus dividend forecasts helps reduce the risk of dividend traps, says Morningstar senior analyst Michael Malseed.

Malseed says RDV tracks the Russell Australia High Dividend Index, which uses a systematic approach to target a diversified portfolio of Australian equities with above-market dividends.

"Among other factors, the strategy uses the Institutional Brokers Estimate System for consensus dividend forecasts which surveys a broad sample set of institutional stockbrokers. This is a superior approach to calculating dividend yield based simply on actual dividends paid over the current market share price, as it has a better chance of identifying situations where a company is about to cut its dividend due to deteriorating operating performance," he says.

While the strategy hasn’t avoided dividend traps entirely, Malseed says it has generally resulted in better positioning versus systematic peers resulting in superior relative performance over the five years to 31 October 2018.

He adds: "while the strategy leans towards stocks with higher franking levels, expected portfolio turnover around 40 per cent, based on semi-annual rebalancing and quarterly distributions, dampens tax effectiveness."

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