Morningstar has assigned ratings to three dividend focused ETFs, crediting them with doing a good job avoiding dividend traps and keeping costs low.
The three funds – all rated ‘bronze’ – are Russell Investments High Dividend Australian Shares ETF, State Street SPDR MSCI Australia High Dividend Yield ETF and Vanguard Australian Shares High Yield ETF.
Morningstar senior analyst Matthew Wilkinson says many products use labels such as “income” “dividend” or “imputation” but the strategies can vary markedly in terms of cost, complexity and risk/reward profile.
The biggest issue for investors is that dividend traps are a significant risk for yield-seeking ETFs.
Another issue is that dividend filters can generate high stock turnover, elevating transactions costs and taxable gains.
The Vanguard fund tracks the FTSE Australia High Dividend Yield Index using a full replication approach. It charges a fee of 25 basis points.
The index ranks companies by forecast yields and excludes those that are not expected to pay a dividend. The aim is to create a diversified portfolio of stocks paying above-average dividends and issuing franking credits.
Morningstar says the portfolio has had some missteps, such as a poorly timed move into resources stocks in 2016, as declining share prices made the yields of BHP and Rio Tinto appear more attractive.
“This highlights the risk of dividend traps for a rules-based strategy,” Wilkinson says.
The State Street ETF is based on the MSCI Australia Select High Dividend Yield Index, which applies a rule-based dividend overlay that has delivered above-market yield and franking.
The fund attempts to mitigate the risk of dividend traps by filtering out companies with unsustainably high and inconsistent dividends, as well as large negative price performance.
The Russell fund tracks the Russell Australia High Dividend Index, which targets a diversified portfolio of equities with above-market dividends. It also uses consensus dividend forecasts – the Institutional Brokers Estimate System – to help reduce the risk of dividend traps.
Morningstar says: “This is a superior approach to calculating dividend yield based simply on actual dividends paid over the year.”