Beware passively seeking yield

Helping clients find income has been a tough gig for many years now, yet pandemic-induced dividend cuts have made that task even harder. Business development executive Julianne Smith explains why chasing yield in ETFs could be painful.

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By Julianne Smith

If you’re searching the stock market for income right now, be aware of the potential pitfalls of buying passive options like ETFs and trackers. By paying for a portfolio built by a real person, you may get a better result.

The portfolios of some dividend-chasing ETFs are determined solely by ranking the dividend yield of the companies in an index. The ETF will buy, say, the 50 or 100 stocks in the FTSE 350 Index that have the highest dividend yield. And the higher the yield, the more money is invested in that stock. On the face of it that sounds like a good idea: you want income, so you buy the stocks that offer you the highest payouts for each pound you invest. However, this has several pivotal flaws.

First, remember that a dividend yield has two parts to it: the dividend and the price of the stock. A yield can rise because a company is paying more income, but it could also rise because the share price has fallen precipitously. For example, a company could halve its dividend, its share price could fall by 60%, and the yield would rise. Therefore, our yield-chasing ETF would buy more of the stock, even though we’re actually getting fewer dividends from it and have lost 60% on the investment. And, if the stock cuts its dividend to zero or its share price slumps so much that it falls out of the index, the ETF will then sell all of the investment, having bought more of the failing investment all the way down.

Second, dividend yields are highly dependent on assumptions. Most of the time, investors use forward-looking dividend yields, so when calculating the dividend yield of a company you’re dividing the dividends you expect to get in the next 12 months by today’s share price. Those estimates tend to come from company’s stated dividend policies, and they have a habit of remaining static until they finally hit breaking point and snap.

Third, you’re not typically looking for just one year’s dividends – you probably want dividends for years to come. A company may have a good dividend yield for the year ahead, yet it may not be able to increase those payments much – if at all – in subsequent years. In our experience, investors tend to prefer companies that can consistently grow dividends over time, because that tends to mean the spending power of the income isn’t eaten away by inflation and you should also enjoy capital growth.

These pitfalls have particularly come to the fore over the past few months. As the coronavirus crisis peaked, central banks slashed interest rates and restarted quantitative easing schemes – creating money to buy bonds at any price – sending the price of government bonds ever higher (and therefore yields ever lower). For investors holding these bonds, it has meant strong capital gains and increased liquidity. Yet these measures have made income even harder to come by for investors of all stripes. Equity investors have been particularly squeezed, as many dividend stalwarts have been hard hit by global lockdowns and had to slash their payouts. We estimate that just less than half of UK dividends will be cut this year.  

The pandemic is a good reminder that dividends are discretionary – paying bills and meeting interest payments come first. Investors should always keep that in mind when choosing stocks for income. As lockdown measures ease and an economic recovery beckons, we are aiming to buy companies that should do well over the coming years and supply us with improving dividends. There will be large divergences in the company prospects, and those with the highest yields are probably not the ones that are set to do really well. Rather, they are more likely to have to cut their dividends or stop them altogether.

Actively managed portfolios have the flexibility to make judgments about these assumptions and how the world is changing, and invest accordingly. ETFs on the other hand can be forced to roll straight for the highest yields, which has all the pitfalls highlighted above.

This is why we believe that active management is better suited to income investing.

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