Growing numbers of investors are being drawn to exchange traded funds, lured by low-costs and the potential for better returns. The investment vehicle is attracting investors of all kinds, with individuals in particular increasingly opting for ETFs instead of traditional actively managed funds.
ETFs offer investors a way to get invested in a diversified portfolio of investments by tracking various market indexes. The vast majority of investors focus on ETFs that seek to replicate the performances of popular stock market indexes such as the FTSE 100 and the S&P 500, but there's also been a rise in the number of ETFs that track a different kind of index, in which stock weights are not (solely) determined by market capitalisation.
These ETFs are typically known as smart-beta ETFs, and they offer many of the benefits of active management but at substantially lower costs. For such funds, stocks can be weighted by other equity attributes, such as volatility, momentum, value, quality or dividend yield.
For dividend investors, ETFs that focus on stocks with high dividend yields may offer an attractive way to get more exposure to dividend-paying stocks. However, it's worth bearing in mind that there are quite a few different dividend ETFs on the market today, so finding the best fund for your own needs is very important.
Some dividend ETFs follow very different approaches in selecting dividend stocks for their portfolios, meaning returns between individual dividend ETFs may vary substantially, even if they operate in the same equity space.
With this in mind, I'm taking a closer look at how three different UK dividend ETFs construct their own equity income portfolios.
The iShares UK Dividend UCITS ETF(LSE: IUKD) uses one of the simplest approaches to building its portfolio of dividend stocks. It seeks to give investors diversified exposure to high-yielding UK companies, by investing in the 50 highest-yielding stocks from the FTSE 350 Index.
Companies are picked by their forecast one-year dividend yields, giving the ETF a forward-looking aspect. And once 50 constituents have been selected, index weights are calculated by the forecast dividend yields for each stock, such that the higher-yielding companies make up a proportionately bigger share of the fund's assets.
This approach allows the ETF to regularly earn very high dividend payouts, which in turn enables it to distribute high income returns to its shareholders. As such, the ETF boasts one of the highest yields from the UK equity space, with a distribution yield of 5.2% at the writing
However, this approach has also met its criticisms. Through investing in the top one-seventh of the FTSE 350 Index by yield, and by not screening stocks based on the sustainability of their dividends, the ETF exposes investors to potential dividend traps.
Just because a stock has a high yield, it doesn't necessarily make it a good dividend stock -- as when a high yield looks too good to be true, the risk of a dividend cut can also be very high.
Dividend track records
Meanwhile, the SPDR UK Dividend Aristocrats ETF(LSE: UKDV) seeks to achieve a balance between seeking high-yields and companies that are likely to maintain their dividend payouts.
It only considers companies that have consistently raised or maintained dividend payouts over a period of 10 or more consecutive years. As such, it uses a company's dividend track record to screen out companies that have not proven themselves as reliable dividend payers.
As expected, there are big differences between the stocks held by the SPDR ETF and the above iShares ETF. iShares' top two holdings, Inmarsat and Centrica, which each account for more than 3% of its total assets, simply do not feature in the SPDR fund, due to dividend cuts in recent years. There are, of course, many overlaps too, such as SSE and Imperial Brands, which are both listed high up in the two fund's top holdings.
In addition, the SPDR ETF invests only in 30 companies, substantially fewer than the iShares ETF, due to its smaller investible universe and the desire to maintain a high average portfolio yield. But unsurprisingly -- and despite its fewer holdings -- the SPDR fund still has a considerably lower distribution yield of just 4.2%.
The past performance of the SPDR fund has lagged behind its iShares rival too, with a total return over the past five years of just 27% comparing rather unfavourably to the iShares' performance of 40% over the same period. That said, due to the fund's seemingly more defensive stock selection methodology, the SPDR could, quite possibly, outperform its rival in a market downturn.
There is another key advantage of choosing the SPDR fund over the iShares option -- that is the cheaper cost structure. SPDR has an ongoing charges figure (OCF) of 0.30%, against iShares' 0.40%.
My final consideration in the UK equity income space is the BMO MSCI UK Income Leaders UCITS ETF(LSE: ZILK). This fund, which was launched only back in November 2015, uses a fairly innovative method to pick out quality income stocks.
It utilises a two step screening process to pick out stocks based on 'quality' fundamental attributes, which include a high return on equity, stable year-on-year earnings growth and low financial leverage. The top 50% of constituents of the MSCI UK Index that score highest on three fundamental attributes are then screened by their dividend yield, to pick out only 25% of the total number of constituents from the MSCI UK Index.
It's still too early to say whether this innovative approach to selecting high-quality dividend stocks is effective over the long run, although the fund's recent, albeit short-term, performance is encouraging. Since its inception less than three years ago, this BMO fund has delivered a cumulative total return of 21%. The fund is also the top performer of the three dividend ETFs considered here today over the year-to-date, one-year and two-year time periods.
Charges for the BMO fund lie in the middle the two other funds, with an OCF of 0.35%.
Do you want to retire early and give up the rat race to enjoy the rest of your life? Of course you do, and to help you accomplish this goal, the Motley Fool has put together this free report titled "The Foolish Guide To Financial Independence", which is packed full of wealth-creating tips as well as ideas for your money.
The report is entirely free and available for download today, so if you're interested in exiting the rat race and achieving financial independence, click here to download the report. What have you got to lose?
Jack Tang has no position in any of the shares mentioned. The Motley Fool UK has recommended Imperial Brands. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.