Why investors should tread carefully with income ETFs

When investing in funds managed by professional investors performance figures tend to significantly vary from the best to the worst in a particular sector over a certain time frame.

Investors hope they will be backing a fund manager who adds value by outperforming an index, but there are no guarantees the fund will deliver, and the reality is that many underperform the index.

• Invest with ii: Open an ISA | ISA Investment Ideas | ISA Offers & Cashback

In contrast, with a passive fund – an index or exchange-traded fund (ETF) – investors know what they are getting, which is the return of the index minus (in most cases) a small yearly fee. There are a number of options charging less than 0.15% a year (£15 on a £10,000 investment) that provide exposure to the UK and US stock markets.

Cost is one of the most important considerations when sizing up passive funds. However, the charge should not be viewed in isolation. While there’s many passive funds purporting to do the same thing – such as investing in UK companies – the range of returns can be stark due to the index they are aiming to mirror.

Global equity income ETFs are a good example of funds that have wide variations in returns. The below data, sourced from FE Fundinfo, shows the best performer over the past five years is up 83.4% versus 19.4% for the worst performer.

The reason why returns differ across the seven global equity ETFs is due to a lack of consensus over how to construct dividend-paying indices.

Since there are numerous ways to approach it (for example, filtering based on yield or dividend track record), a range of indices are used by global income ETFs. Some passive firms have even designed their own.

Many indices use a quality screen to avoid potential value traps (shares with high yields that look unsustainable). However, this can lead to very different stocks versus an index that is filtering for dividend growth or high dividend yields.

• Baillie Gifford fund manager on whether the S&P 500 has become tougher to beat
• What are the cheapest ETFs to track global markets?

The top performer of the seven ETFs over five years – WisdomTree Global Quality Dividend Growth – adopts a quality approach. It tracks its own index, which consists of around 600 companies that, thanks to various filters, are deemed to be high-quality dividend paying companies in global developed markets. The filters screen for stocks with quality and momentum characteristics, while companies judged as not meeting sustainability criteria are excluded. Its top three holdings are Microsoft (NASDAQ:MSFT), Apple (NASDAQ:AAPL) and Johnson & Johnson (NYSE:JNJ).

It has comfortably returned more than Franklin Global Quality Dividend UCITS ETF GBP (LSE:FLXX) over five years, which also follows the quality-growth style of investing. One way in which this ETF differs from the WisdomTree ETF is that it has around 20% in Asia and the Middle East/Africa. Its top three holdings are Broadcom (NASDAQ:AVGO), AbbVie (NYSE:ABBV) and Merck & Co (NYSE:MRK). Overall, there are 102 holdings at present.

Fidelity Global Quality Income ETF, the top performer over three years, invests in large and medium-sized businesses that “exhibit quality fundamental characteristics”. It tracks the up and down fortunes of 256 companies, with its top three positions being Microsoft, Apple and NVIDIA (NASDAQ:NVDA). 

Those lower down the performance table over five years have more of an exposure to traditional high-yielding value stocks. As a result, the yields of these ETFs tend to be higher, but overall total returns over the period have been lower.

At the bottom of the pile, SPDR® S&P Global Dividend Aristocrats ETF tracks the performance of 100 high-yielding stocks that have maintained or increased their dividends for at least 10 consecutive years. It has some exposure to emerging markets. In contrast to the quality-focused ETFs there’s very little weighting to tech stocks, with utilities, financials and real estate favoured. Those three sectors account for 25%, 24.8% and 10.7% respectively, which is far higher than the amount held by the high-quality focused ETFs. The top three holdings are Highwoods Properties (NYSE:HIW), Solvay (EURONEXT:SOLB) and KT&G Corporation.

• How stocks, bonds and cash perform when interest rates fall
• Why I won’t be switching from investing to cash

This ETF has a higher amount of exposure to value and cyclical stocks, which have underperformed over the past five years. That’s not to say this performance gap will continue in future; investment styles and approaches don’t go up in a straight line. As ever, balance is key and part of having a diversified portfolio is including a mix of investment styles.

Overall, the key takeaway is that with so many different ways to construct an equity income index, investors need to be aware what they are actually buying.

All data sourced from FE Fundinfo to 1 February 2024. Past performance is not a guide to future performance.