A New UK Income ETF

03/20/2012 9:30 am EST

Focus: GLOBAL

David Kuo

Financial Broadcaster, The Motley Fool (UK)

This new low-cost ETF promises to be the silver bullet UK dividend investors have been waiting for, but is it? So asks David Kuo of Motley Fool UK.

Investing in higher-yielding dividend shares has long been a popular strategy with investors. It appeals to retirees as a means of generating an income, and to younger investors who believe the compounding effect of reinvested dividends is a surer way to increase their capital pot than trying to pick tomorrow’s go-go growth winners.

You’d have thought that providers of low-cost ETFs would have been falling over each other to offer a product that saved these investors all the trouble of building a portfolio of individual shares or agonizing over which high-charging, actively managed equity income fund to invest in.

Yet before the credit crunch—in the UK, at any rate—there was only one "dividend" ETF on the British market: iShares UK Dividend Plus (London: IUKD). Unfortunately, this fund performed absolutely abysmally when the banking crisis and recession hit the economy.

However, a direct competitor to iShares’ yield-weighted fund has just been launched, with the low-key entrance into the UK of US ETF giant State Street. The SPDR S&P UK Dividend Aristocrats ETF (London: UKDV) has a total expense ratio of 0.3%, compared with iShares’ 0.4%, but is it the silver bullet UK dividend investors have been waiting for?

The weaknesses of iShares UK Dividend Plus, which was launched in 2005, were cruelly exposed just a few years later when the economy went off the rails. The performance figures for the past five years are not a pretty sight.

Why so bad? The iShares fund invests in the 50 highest-yielding companies in the FTSE 350, selected and weighted by one-year forecast dividend yield. The fund pays no attention to dividend history and sustainability—and places no limits on the weighting of an individual company or sector in the fund.

As such, it was grossly overweight high-yielding banks and other financials going into the credit crunch. And it was duly hammered.

It’s Different This Time
The SPDR S&P UK Dividend Aristocrats ETF is employing a methodology that it evidently hopes will avoid the kind of carnage suffered by its iShares rival.

SPDR invests in the 30 highest dividend-yielding UK companies within the S&P Europe Broad Market Index. In terms of company size, this universe is not dissimilar to the iShares FTSE 350 universe, but the SPDR fund has additional rules:

  • Companies must have shown increasing or stable dividends for at least ten consecutive years.
  • Maximum forecast yield of 10%.
  • Dividend must be covered by earnings.
  • Maximum weight for each company capped at 5%.
  • Maximum weight for each industry sector capped at 30%.

So, what effect do these additional rules have in practice?

The SPDR fund’s top ten holdings look more like the kind of dividend shares I might select myself for a "Steady Eddie" income portfolio. Such apparent steadiness comes at a price. The indicative dividend yield given in SPDR’s pre-launch fact sheet was 4%. iShares was boasting a yield of over 5% at the time.

Now, a lower starting yield may be all well and good if SPDR’s aristocrats grow their dividends more reliably than their less blue-blooded counterparts in the iShares fund. But I’m not entirely convinced that SPDR’s additional safety rules will necessarily eliminate a bout of dividend carnage in the future—or, indeed, that they would have done so in the recent past.

How many financial aristocrats of yesteryear would SPDR have been holding going into the credit crunch? Are the fund’s 10% yield cap and dividend cover rules robust enough to make a material difference?

Similarly, we may balk at all those insurers currently in the iShares top ten, and at its current weighting to financials of over 30%, but SPDR itself allows up to 30% in one sector…and currently has close to that in the industrials sector. Again, does a 30% sector cap go far enough to make a material difference?

At the end of the day, I think the SPDR S&P UK Dividend Aristocrats is an improvement on iShares UK Dividend Plus, but I’m not so sure about how much of an improvement.

Read more from Motley Fool UK here…

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