A retirement income from ‘smart’ ETFs

Many months ago, I promised to look at the practicalities of using income-seeking ETFs to generate an income in retirement.

It seemed sensible to split the post into two parts:

• The first, already published, looked at purely passive income-seeking ETFs.

• A second post – this present one – looking at so-called Smart Beta income-seeking ETFs.

That said, as I’ve remarked before I’m not necessarily a fan of ‘smart’ income-seeking ETFs. Countless investors had their fingers burned investing in the popular iShares’ FTSE UK Dividend Plus ETF (Ticker: IUKD) ten years ago, having mistakenly seen it as a lower-cost and less-risky way of getting an income from higher-yielding shares.

I’ve also revised the intention of this post. As I was writing it, I increasingly saw less point in trying to construct an example portfolio, as I did with those purely passive ETFs.

There are so many choices to make – many of them very personal – and the chosen Smart Beta methodology plays a critical role. My own selection would arguably be arbitrary compared to yours.

Rear view mirror

Smart ETFs aren’t smart in the sense that a real-life manager of a fund or investment trust might be. There’s no judgement at work, or years of investment experience.

Instead, a theoretical index is constructed containing shares that meet specified criteria – criteria that for the purposes of this post would supposedly correlate with high, robust, and reliable levels of income.

By definition, then, these smart income approaches necessarily look backwards. They extrapolate into the future a set of dividend-paying characteristics that have been observed in the past.

And the past, as the financial services industry is duty bound to remind us, is not a reliable indication of what may happen in the future.

The consistent growth approach

A number of ETF providers offer ETFs that aim to track S&P’s family of Dividend Aristocrat indices. These contain shares with a history of increasing their dividend payments for 25 consecutive years or more, subject to a (large-ish) minimum market capitalisation. The final decision on inclusion is made by a committee.

On the face of things, this is a reasonable approach. Not least because a consistently growing dividend may speak to substantial free cash flow, which is always a good thing.

But as an income investor, I know all too well that there is no guarantee that a company that has grown its dividend for 25 years or more will continue to do so. Or indeed, that it will continue to pay dividends at all.

Consider Tesco, for instance. The grocery giant abruptly cut its dividend by 75% in August 2014, and abandoned paying it altogether in January 2015 — and it, too, had that golden 25 year reputation.

More recently, America’s gigantic GE—a member of the Dividend Aristocrat index for 35 years—was booted out after incoming chief executive John Flannery cut the dividend. Pfizer offended similarly.

Perhaps more fundamentally, the Dividend Aristocrat approach excludes any consideration of yield. As an income investor, I want consistency, but I also want income.

Granted, the Dividend Aristocrat approach has been shown to deliver superior overall returns, but at the end of the day, we’re talking income here.

The higher-yielding approach

An alternative approach goes gung-ho for income, building indices of higher-yielding shares.

Vanguard’s High Dividend Yield ETF, for instance, tracks the FTSE Russell’s matching FTSE All-World High Dividend Yield Index. MSCI also has its own High Dividend Yield Index, while Dow Jones maintains a series of Select Dividend indices.

iShares ETFs often (but not exclusively) use the Select Dividend series, while providers such as WisdomTree and Amundi often use the MCSI indices.

STOXX and Société Générale maintain their own flavours, the latter under the Quality Income index. These are less widely available than the majors – and when ETF market capitalisation has a bearing on charges, that can be a disadvantage.

• To see the wide range of dividend-touting ETFs available, check out this list from the JustETF tool. We only cover a taster of what’s out there in this article. Be sure to research exactly what you’re buying if you choose to invest!

Methodologies vary. FTSE Russell’s approach is to capture the highest-yielding 50% of the market, ranked by forecast yield, for instance. Others are pickier: STOXX wants to see positive dividend growth over five years, and a dividend payment in four of the last five years, while Société Générale adds nine ‘quality factors’ to the mix, including profitability and solvency.

So how to pick an ETF constructed on ‘higher yielding’ basis? My suggestion would be to start with the index methodology, and choose the one with which you are most comfortable. Which comes closest to your own stock-picking approach, or seems the most sensible?

Don’t be surprised if that leads to some awkward decisions. The iShares STOXX Global Select Dividend 100 ETF (Ticker: ISPA), for instance, seems only to be available on the German bourse with some brokers, while hunting for Lyxor’s SG Global Quality Income ETF at your broker may take you to Paris (although it is available on the LSE under the ticker SGQP). From a ‘smart’ perspective, both of these seem to me to be ‘smarter’ than ETFs based (say) on the more simplistic FTSE Russell approach.

But if you look to buy on costs – as many people do with ETFs – then Vanguard’s FTSE Russell-based ETFs are undeniably considerably cheaper than Lyxor’s SG Global Quality Income and iShares’ STOXX offerings.

What would I do?

On the one hand, you have fairly sophisticated products based around Société Générale’s Quality Income index methodology, and on the other you have the broad simplification of the FTSE Russell approach. Both have their merits.

Which is best? There isn’t a simple answer.

On the whole, I remain to be convinced of the worth of smart income-focused ETFs – compared to say income investment trusts.

None of these Smart Beta products feature in my own portfolios, nor are likely to.

But if I were to seek to build a retirement income from such a set, I’d want to spread my risks by opting for multiple providers, and multiple methodologies. Nor would I buy solely on cost – diversification has a price, and it’s probably one worth paying.

Why the emphasis on diversification? Simple: to try to minimise the downsides of ETF algorithms blowing up, à la IUKD.

Finally, I know that I’ve been away from the site for many, many months. Sorry about that: sometimes, real life gets in the way.

But I know – from the nudges I’ve had from The Investor – that at least a few of you have missed me. It’s good to be back.

You can catch up on all Greybeard’s previous posts about deaccumulation and retirement.