What are the best dividend ETFs?

Dividend ETFs and Dividend Harvesting
 
A client recently asked us if Stockspot would consider adding a pure income producing ETF to our portfolios to take advantage of ‘dividend harvesting’. We thought it was a great question so decided to share the answer with everyone!

Dividend harvesting is a strategy that involves buying shares just before they pay dividends and selling them just after dividends have been paid. At face value this sounds like a very sensible way to collect dividends without having to hang onto shares for too long.

However, like any investment strategy that involves timing your entry and exit points, dividend harvesting has risks. The biggest risk with dividend harvesting is shares tend to fall in price on the day they pay their dividend. Therefore any amount you gain in the dividend is likely to be lost on capital returns.

What one hand giveth the other taketh away

This is precisely what tends to happen with ‘dividend investing’ ETFs – they do well capturing dividends but badly at capturing the gradual increase in share prices over time, which is known as capital returns.

An example: The Betashares Dividend Harvester (HVST)

The Betashares Dividend Harvester (HVST) is an ETF that adopts a ‘dividend harvesting’ strategy. It invests in large ASX shares that are about to pay dividends while also selling futures contracts which is a form of hedging to reduce risk.

Over the last year HVST generated a dividend return of 10% compared to the Australian share market (ASX 200) which returned dividends of 4%. Sounds too good to be true, right? How does HVST earn much more in dividends?

The secret of dividend harvesting

Dividend harvesting strategies like HVST involve borrowing from future capital returns in order to increase dividends. There is no free lunch, just a different equation.

It would be like if a bank increased the interest rate on your account from 2% to 5% but paid the 3% difference out of the amount you deposited – reducing your initial deposit from $100 to $97.

As you can see, dividend harvesting returns are made-up from capital you invested in the first place.

Are there other dividend ETFs?

For those looking for a high level of franked dividends for tax efficiency, or lower risk, HVST could be part of that strategy. However once the additional cost and lack of growth are considered we don’t think it’s a useful ETF for our clients.

We prefer to use asset allocation (increasing allocation to bonds) to reduce risk in our portfolios and there are other ways to focus into dividend shares which don’t involve regularly buying and selling like HVST.

We offer the Vanguard High Yield ETF (VHY) as a Stockspot theme for clients who want some extra dividend yield in their portfolio. This ETF focuses on shares that pay higher percentage dividends generally. It doesn’t regularly buy and sell to harvest dividends, it just buys and holds. VHY costs 0.25% in fees compared to HVST which charge 0.65%. That extra 0.40% per year in lower costs is inevitably going to boost your returns over many years.

What are the recent returns?

Over the past 12 months to end of February 2017, HVST generated income of 10% and a capital loss of 2% so total return of 8%.

Over the same period, the Australian shares ETF (VAS) in our portfolios generated income of 4% plus a capital gain of 17.5% so a total return of 21.5%.

The Vanguard High Yield ETF (VHY) came somewhere in between on income returns, generating 5.75%. However it’s capital return was 17.25% compared to HVST which lost -2%. That’s a difference of over 19% in one year.

In other words, the basic Australian shares ETF more than doubled the total return of HVST.

ETF Dividend Capital return Total return
Vanguard Australian Shares Index ETF (VAS) 4.0% 17.5% 21.5%
Vanguard Australian Shares High Yield ETF (VHY) 5.75% 17.25% 23.0%
Betashares Australian Dividend Harvester Fund (HVST) 10.0% -2.0% 8.0%

Figures based in the 12 months to 28 Feb 2017

Of course one year of performance is not meaningful at all but it’s a good demonstration of how the higher dividend of HVST limits your ability to earn capital returns – an important component of investing in shares.

Harvest or invest?

While most of the ETFs we invest in generate some income via distributions, we don’t offer the specific ‘yield harvesting’ ETF HVST mainly because it does lots of buying and selling and has a relatively high fee. Those extra costs are going to drag down returns over the long run compared to lower-cost ETFs with a buy and hold strategy.

We think the Vanguard High Yield ETF (VHY) can help boost dividend returns without giving away the potential for capital returns.

 

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Chris Brycki

Stockspot Founder and CEO