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How to Pick the Right ETF? Part 5

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View Part 4 | Fees

Part 5 | Dividends

What are the best dividend ETFs to buy? How big is an ETF’s dividend? Are two questions we often hear.

Self-evidently, ETFs that buy dividend paying companies pay larger dividends than those that do not. But going beyond the obvious, and knowing in advance how big or small an ETFs’ dividend will be, is difficult. So too is knowing what the “best dividend ETF” is.

Still, for those set on using ETFs to generate dividends, below are some pointers.

Tip 1. Australian shares ETFs pay the biggest dividends

Investors wanting to buy ETFs with big dividends should stick with Australian shares. Australian companies have historically paid larger dividends than many – but not all – other countries’ companies. There are three major reasons for this:

  1. Australian pay-out ratios are higher. Our companies, especially the banks and miners, give more money back to shareholders as dividends.

  2. Foreign governments tax non-residents’ dividends. Australian residents buying US companies – like Apple – must pay a 15% dividend tax to the US government. Other governments apply similar taxes. Investing in local Australian businesses is more tax efficient.

  3. Franking credits. Australia, uniquely, taxes dividends negatively. (However, franking is only available to residents, reinforcing the point above).

Country_dividend_yield_estimate_2021_68a94bad7c.pngSource: Bloomberg, 5 May 2021

Taken together, there are compelling reasons for dividend-minded investors to stay home.

Tip 2. Currency movements can shrink and magnify foreign dividends

When global shares pay dividends, exchange rate movements can work both for and against you. When the Australian dollar weakens, the value of foreign dividends increases. Foreign companies pay dividends in their local currencies, the value of which rise when the Aussie dollar slides. But the opposite of course can occur when the Aussie dollar strengthens, with foreign dividends losing value when converted into more valuable Aussie dollars.

Currency hedging strategies attempt to minimise this. A common hedging strategy is to use derivatives like currency forwards, which can lock in an interest rate for a certain period. In this way, currency hedged ETFs can reduce – but never fully remove – the impact of exchange rates.

Currency hedging is not a free lunch though and comes with extra costs. According to research by Vanguard, currency hedging portfolios can underperform over the long term due to these extra costs.

Tip 3. Large dividends can be a warning sign – yield traps

Everyone wants large dividends. But big dividends can be a warning sign in some instances. Reasons include:

  • Taking on more debt. Where companies pay dividends with borrowed money.

  • No growth options. Management has no business growth ideas, and so gives investors cash as dividends for want of alternatives.

  • Selling off assets. Businesses can sell off assets to finance dividend payments.

For reasons such as these, focussing exclusively on dividends has risks as an investment strategy. And it can mean that companies – and by extension ETFs – paying larger dividends can underperform on a total return basis.

This means investors should always check the share price performance of dividend paying companies and ETFs. Not just the yield.

Tip 4. ETF prices have dividends priced in – “harvesting” dividends fails

The stock market is an efficient and highly sophisticated place. Trading dividend ETFs and companies is no exception.

As part of their day-to-day jobs, sophisticated traders, such as hedge funds, forecast what dividends companies and ETFs will pay and adjust prices accordingly. ETFs about to pay dividends have their prices raised higher, such that dividends are “priced in”. After dividends are paid out (the share price goes “ex-dividend”) these same traders ensure