A step-by-step process for choosing an ETF
My journey to find an income generating ETF for my portfolio.
Mentioned: BetaShares Australian Div Harvester ETF (HVST), iShares S&P/ASX Div Opps ESG Scrnd ETF (IHD), Russell Inv High Dividend Aus Shrs ETF (RDV), SPDR® MSCI Australia Sel Hi Div Yld ETF (SYI), Vanguard Australian Shares High Yld ETF (VHY)
I’ve made the decision to buy an ETF. Not exactly an earthshattering event as people do it every day. But I thought it would be helpful to take readers along on this journey.
There are over 300 ETFs available on Australian exchanges. Narrowing this down to just one can be a daunting task.
In deciding one to pick, am I going to jump right into an investment screener? Consult my friends? Find our what complete strangers are saying on an investing message board? I will do none of those things. This ETF is for me. And I need to start with me. My goals and my investment strategy will form the basis of any decision that I make.
This is the process I used to choose the Vanguard Australian Shares High Yield ETF (ASX: VHY).
Step 1: Know your goals and investment strategy
I have two goals that I am working towards. One is retirement. But this ETF will not be purchased in my retirement account.
This ETF is for an account that will fund my other goal. That is to generate income during my working life to help support spending on things I want to do. Specifically travel.
My criteria: Investing for income
I want to generate income over the next 30 years and my investment policy statement is reflective of that goal.
An investment policy statement is a bridge between a goal and the security selection process. It outlines what types of investments I am looking to purchase and hold to achieve my goal. We all have unique goals and circumstances which means that we should all approach investing differently. There is no right or wrong way to invest. There are right and wrong ways to invest to accomplish a specific goal.
My investment policy statement is straightforward:
‘Create a stable and growing income stream by investing in shares and ETFs. Identify securities with above average, sustainable and growing dividends by focusing on quality companies with sustainable competitive advantages, strong financials and low business risk.’
Step 2: Narrow down the universe of ETFs
As my investment policy statement outlines, I am looking for an ETF that generates income that is higher than the overall market and will grow over time.
Specifically, I am looking for an income ETF that holds shares because shares present the best opportunity to grow income over time while supplying the highest expected returns over the long-term. That aligns with my 30-year time horizon.
My criteria: Investing locally
An ETF provides the opportunity to purchase shares from all over the world. An abundance of choice. But a quick scan of my portfolio shows that the vast majority of my income is currently generated from US and global multinationals. As a result, I’m looking for something with local Aussie shares in it. That narrows my search significantly.
The decision to invest in an ETF and not individual shares is a reflection of my current Australian portfolio. It is made up of individual shares and all of my ETFs are held in US and consist of US and global shares. Australia only makes up around 2% of global indexes so this is an opportunity to further increase my exposure to Australia and diversify with one trade.
When building an income portfolio it is important to view diversification through a market value and income lens. Different sources of income protect against single security risk if a company cuts their dividend. The varied sources of income also protect against sector risk and local economic risk that can impact a collection of companies and lead to slow growth or drops in income.
Currency risk also comes into play. I plan on staying in Australia. But the vast majority of my assets still remain in US dollar dominated assets as I spent most of my career there. More Australian dollar denominated assets will help protect my global purchasing power if the US dollar declines in value.
Step 3: Select an ETF
The first step is to identify candidates that have above average dividend yields. I can then assess the candidates to see if they meet my other criteria.
In Australia finding an above average yield is a higher bar than most other global markets. The ASX 200 is currently yielding around 4.4%. That is the hurdle I’m looking to clear.
I can immediately eliminate a couple of options. I have an aversion to frequent trading. I am a buy and hold investor and I expect any ETF or fund I invest in to adhere to those same standards.
That eliminates dividend harvester ETFs like Betashares Australian Dividend Harvester ETF (ASX: HVST). They churn through holdings looking to capture a dividend before it is paid and then move on to another set of securities.
I think a good starting point is the income ETFs under over coverage universe.
The four that we cover are the iShares S&P/ASX Dividend Opportunities ETF (ASX: IHD), the Russel High Dividend Australia Shares ETF (ASX: RDV), the SPDR MSCI Australia Select High Dividend Yield ETF (ASX: SYI) and the Vanguard Australian Shares High Yield ETF (ASX: VHY).
I will explore each of them to help me decide which ETF to buy, factoring in:
- The criteria for security selection
- The ETF composition
Let’s expand on each of these topics before we compare each ETF.
Before even starting a review of an ETF I check the fee. High fees cause poor investment outcomes. High fees detract from the income generated by the ETF holdings.
Evaluating the criteria for security selection
Any ETF that tracks an index requires a careful evaluation of the criteria used to select its holdings.
For a passive ETF tracking a broad index, this exercise is often less comprehensive. For an income-oriented ETF or any ETF designed to identify certain attributes to pick holdings the effort can be more time consuming.
In my case, I want to evaluate the way an ETF chooses high-yielding stocks.
I also want to avoid dividend traps. The fact that a yield is high could be because the share price has fallen and investors are concerned that the dividend will be cut. What I care about is the dividend that a company will pay in the future. Dividends are not guaranteed and the past can sometimes be a poor indication of what will happen in the future.
The other thing I’m interested in is how frequently the ETF uses the screening criteria to find new securities to replace current holdings. This can be measured by the frequency of reconstitution and is reflected in the turnover rate which measures how often changes in holdings happen. The buying and selling of holdings in the ETF can be taxable events which get passed along to the holder of the ETF as capital gains.
A review of the ETF composition
Once we know what stocks it selects, it’s important to conduct a sense check.
Is the ETF too concentrated in one sector or country? Does it lean too much towards companies that are of a certain size, or style (value/growth).
These factors will affect future income generating potential.
This exercise should be done in conjunction with the role the ETF will play in your overall portfolio. If it is going to be a large core holding then the make up of the ETF will play a huge role in your overall portfolio. If it is small non-core holding then this review can be based on how the holdings fit into your overall portfolio and how much overlap there is between your other positions.
Option 1: iShares S&P/ASX Dividend Opportunities ETF (ASX: IHD)
The iShares S&P/ASX Dividend Opportunities ETF tracks the S&P/ASX Sustainability Screened Dividend Opportunities Index. The index cuts the 300 shares in the ASX 300 down to 50.
In this case the fee is .30%. Completely reasonable.
The ETF does provide higher levels of income when we look at a trailing yield. It checks the box of above average dividends with a 6.58% trailing yield vs a 4.4% trailing yield for the ASX 300 (as of April 17th).
There are two criteria that are used to screen out companies.
The first is an ESG screen that eliminates companies that are involved in carbon/emissions related businesses. The second looks at forward estimates of dividends.
If we look at the portfolio we can see a 37.5% allocation to Financials and a 34% allocation to Materials. Both of those allocations are meaningfully larger than the ASX 200 which has a 27% allocation to Financials and a 25% allocation to materials. There is more of an allocation to value shares than the overall index. The ETF falls squarely in the large cap value section of the Morningstar style box. This makes sense given that the Financials and Materials sectors are typically made up of value shares.
There is nothing inherently wrong with a value orientated ETF but it may have implications related to dividend growth. In general value shares are companies with slower earnings growth. Less growth can result in higher dividends as the company doesn’t have as many growth opportunities to fund with the cash generated from operations. Instead, they return it to shareholders in the form of dividends. This makes intuitive sense from the company’s perspective, but future dividend growth is fuelled by earnings growth. Hence my concern about future income growth.
This is a very top-heavy ETF with 69% allocated to the top 10 holdings. but the Australian market is very top heavy with 48% of the ASX 200 in the top 10 holdings and over 11% allocated to BHP.
The turnover rate is quite high at 48%. That means that every two years the holdings are completely turned over in the ETF.
Option 2: Russel High Dividend Australia Shares ETF (ASX: RDV)
Starting with fees, the ETF charges .34% a year. A bit higher than the iShares S&P/ASX Dividend Opportunities ETF but still reasonable. One hurdle cleared. The trailing yield is 6.58% which also surpasses the overall ASX 200 trailing yield so the ETF is delivering above average income.
The ETF tracks the Russell Australia High Dividend Index and identifies securities from the FTSE Australia 100 Index.
The index uses four different criteria to score Australian shares and then picks the 50 shares with the highest scores for inclusion in the index.
The score gives a 40% weighting to consensus forecast dividends. Another 20% is based off projected growth rate of the dividends which is also positive and forward looking. 20% of the score is based on historical dividends. The last 20% of the score is based on earnings volatility over the past 5 years. I believe this is intended to ensure dividend sustainability as a company with large swings in earnings would likely also have large swings in dividends.
One difference in the Russell ETF is that it does not remove Real Estate Investment Trusts (“REITs”) from the universe of potential holdings which differs from the other ETFs I am reviewing. And we can see that REITs make up 5.75% of the portfolio. The only consideration with REITs is that they do not pay franking credits. Not a deal breaker but something to consider as franking credits do add to returns and increase the after-tax income generated from a portfolio.
A further examination of the portfolio shows a 29% allocation to financial services and a 26% allocation to basic materials. This is about in line with the overall index. We also see a heavy tilt towards value with the Russell ETF also falling in the large cap value section of the Morningstar Style Box. 48% of the portfolio is in the top 10 holdings with over 9% allocated to BHP which is the largest position.
The turnover of the ETF holdings is 27% which means that about a quarter of the holdings are changed on an annual basis.
Option 3: SPDR MSCI Australia Select High Dividend Yield ETF (ASX: SYI)
The next ETF is issued by State Street and tracks the MSCI Australia Select High Dividend Yield Index. The ETF charges a fee of .35% which falls within the reasonable category and the trailing 12-month yield of 7.38% which meaningfully outpaces the overall index.
The index primarily screens for shares in three ways. The first is used to identify shares that pay high dividends but is entirely based on historic yields. To guard against dividend traps the ETF eliminates the lowest 5% of securities with a negative one-year price return. In other words any shares that fell significantly in price are removed.
There is also a screen that attempts to identify companies that are high quality, factoring in return on equity, debt/equity, and earnings volatility.
Finally, any eligible companies that do not exceed the dividend yield of the overall market index are removed. This is clearly a nod to the stated purpose of the ETF which is to provide income. Some investors may find this attractive but I have some reservations in light of my own personal situation. I want to generate a growing income stream over the next 30 years. There is often a trade-off between current yield and dividend growth. And ultimately a reliance on historic yields and this cut-off of lower yielding shares may eliminate companies that grow their dividend faster in the future and may not maximise my income over the next few decades.
A look at the holdings data shows some pretty significant differences to the other ETFs. Basic Materials has nearly a 37% allocation which outpaces the overall index. Financial Services comes in at just 5.70%. This is a result of the approach taken by the ETF to solely focus on historic yields. The banks did go through a period of dividend cuts during the COVID disruption but most analysts saw this as temporary and forecast a return to higher dividends as conditions normalised. A prediction that has come to fruition.
The ETF is very top heavy with 60% of assets in the top 10. The ETF also falls very much into the large cap value portion of the Morningstar Style Box. One interesting thing to note is that almost 70% of the assets fall in cyclical sectors with that high allocation to basic materials and a 27% allocation to consumer cyclical.
Cyclicality refers to the impact that changes in the overall economy have on the prospects of the company. In general I would not consider this a good thing for dividend stability because as earnings fluctuate dividends can fluctuate as well. However since this is Australia with such a large concentration in the cyclical sectors of basic materials and financials services this is hard to avoid.
The turnover of the holdings in the ETF are quite high at 44%. That turnover may be a result of the rule to exclude shares with below index dividend yields although a buffer has been built into the screen so that companies are not excluded if their yield has fallen slightly below the yield of the overall index. However, given that yields fall when share prices rise this could be another trigger for generating capital gains as the holdings turnover in the ETF.
Option 4: Vanguard Australian Shares High Yield ETF (ASX: VHY)
The last ETF to evaluate is Vanguards income offering. As is often the case with Vanguard the fee is highly competitive and comes in at .25%. That is the lowest of the income ETFs I’m exploring. Vanguard also has the lowest yield of the ETFs at 5.7% but that still outpaces the overall market yield.
The ETF tracks the FTSE Australia High Dividend Index. The index is constructed by ranking each share by their forward estimated dividends based on consensus analyst opinions. I like that approach as it is forward looking.
There is also a mechanism to lower portfolio turnover which is reflected in a 20% turnover which is the lowest of the 4 ETFs I am exploring.
The portfolio is quite top heavy with 64% of the ETF allocated to the top 10 holdings. The allocation to financial services is 38% and 25% is in basic materials. This puts about 70% of the ETF in cyclical sectors.
The ETF I chose
All of the above ETFs share similar attributes which reflect the nature of the Australian market.
They are heavily concentrated in the top 10 holdings and within the basic materials sector. With the exception of SPDR MSCI Australia Select High Dividend Yield ETF they are all highly concentrated in financial services. Normally this would cause me concern, but this is not a core position in my portfolio and it reflects the reality of investing in Australia.
My strategy is to capture a higher yield than the overall market and have that income stream grow over the next 30 years. All four ETFs have a higher yield than the overall market so no need to eliminate any of them on that basis.
However, I have concerns with the ETFs that overly rely on trailing dividend yields for its stock selection. That cuts the SPDR MSCI Australia Select High Dividend Yield ETF (ASX: SYI) from the race. The relatively high fee and turnover don’t help.
I will also eliminate the Russel High Dividend Australia Shares ETF (ASX: RDV) which uses a blended approach for inclusion criteria but still has a weighting of 40% allocated to past dividends.
That leaves two ETFs that both use forward looking estimates to identify holdings.
The iShares S&P/ASX Dividend Opportunities ETF (ASX: IHD) includes an ESG screen which has some implications on the portfolio. In December 2022, iShares owner Blackrock changed the index this product tracked from a dividend index to a dividend ESG index. As a result, the ETF has no holdings in the energy sector which could be a good source of income going forward as they generate lots of cash and may not have as many projects to spend it on as oil, gas and coal exploration gets curtailed. This leaves more cash to distribute to shareholders.
As an investor this bothers me a bit as previous investors were not given a choice if they wanted to track an ESG index. The switch in index likely results in capital gains as the energy shares and other non-ESG friendly investment were sold. I just don’t think this is very investor friendly.
Ultimately, I’ve chosen to buy the Vanguard Australian Shares High Yield ETF (ASX: VHY) as it has lower fees and lower turnover and I have more confidence that Vanguard will continue to put investors first.