AFR ETF Series: high yield

Smart Money, Australian Financial Review, May 2011

Most exchange-traded funds in Australia have been straightforward. They give you exposure to an index, or a sector, or perhaps a commodity – but they’re all passive. There’s no judgement involved, just a simple replication of something that’s already there.

Last year things started to change, with the introduction of high yield ETFs. They’re still pretty straightforward, but the pool of what they invest in is subtly different to what has gone before.

The simplest way to explain is simply to look at the products that have come out in this vein. The first came from Russell Investments last May, and was called the Russell High Dividend Australian Shares ETF. Instead of being based on an index like the ASX/S&P200, which is the usual model in Australian ETFs, it instead tracks a customised index devised by Russell, an index of blue chip companies expected to pay above average dividends.

The crucial difference between this and previous ETFs is given away by the word ‘expected’. Expected by whom? Expectation is a judgement. Previous ETFs have involved no judgement, just a mirroring of an index.

Russell creates its index through a fairly formulaic method, picking top companies with a history of paying dividends, dividend growth, and consistent earnings, but nevertheless it’s not quite a purely passive product.

Later that year, State Street entered the same territory with the SPDR MSCI Australia Select High Dividend Yield Fund. In this case MSCI, the global index provider, had built the index for it, once again to filter high dividend yield companies who are likely to be able to keep up those dividends.

From the investor perspective, there’s no particular need for alarm about this divergence in approach. Both products charge a low fee much like any other ETF: 0.35% for the State Street product and 0.46% for Russell. And they serve a particular purpose: investors, particularly retirees, who want exposure to the equity market but also need stable and predictable income. For many years, investors and their advisors have sought to build yield portfolios, stuffing them with Telstra and the Commonwealth Bank as much for the track record of high yield as for any particular belief in the company, beyond its ability to keep paying nice big dividends. These ETFs simply turn those high yield techniques into a fund that can be bought and sold like a stock. Rob Goodlad, State Street’s Senior Managing Director in Australia, calls it “reliable, tax-effective, sustainable high income from equities”, and “an alternative to the traditional models [investors] have used for their income stream in retirement.”

Next into the mix was a product from iShares, with its S&P/ASX High Dividend product. This one is subtly different again, because it applies a cap of 4% of the index for any stock, and 20% for any sector. “That means you’re going to get a diversified cross-section of companies delivering a high dividend stream, without being heavily focused on one sector – financials,” says Tom Keenan at iShares. Still another approach is to use a sector ETF which focuses on a high yielding area. Australian Index Investments, for example, points out that over the last 12 months its financials ETF and its financials ex-A-REIT ETF (that is, financials minus property trusts) have both delivered a higher index yield than any of the three high dividend ETFs mentioned above.

There are clearly going to be more of these products that put a little bit of a twist on the simple ETF theme. When Russell launched its second Australian ETF in March, it again did so with a rules-based approach, as this method is called in the industry. The Russell Australian Value ETF gives exposure to another Russell-built index, the Russell Australia High Value Index. This starts out with Russell’s Australia Large Cap Index and then assigns all the stocks in the index a value score and a growth score, based on price to earnings ratios and medium term earnings growth. Those that come out as value-styled – which for active managers usually means stocks that are trading below their fair value, but likely to catch up – are included and weighted in the index. Russell cites research saying passive value-based strategies have typically delivered 1.5 to 3% over the broader market in Australia. Russell built this partly with institutional investors in mind, but it also suits mum and dad investors who want to try to get a bit of additional yield on their equities exposure without paying for or trusting an active manager.

All these products are proving popular: by the time Russell launched its second fund, it had already attracted $140 million into the first one, in less than a year. Also, all these funds are backed by all the underlying stocks and are transparent, with the full portfolio available on Russell and State Street’s web sites. They do not fit into the category of synthetic ETFs that are beginning to cause some concern elsewhere in the world.

Nevertheless, in containing a twist on the usual passive equity approach, they do run the risk of underperforming the market rather than outpacing it. That’s fine so long as investors understand it’s a possibility. In a sense they’re a bit like an enhanced index fund – not straying too far from a diversified index, but with an attempt to give it a bit of juice in the returns.