Income Investing with Exchange-Traded Funds: Can It Be Done?

ETFs have matured but they’re not done evolving. Morningstar’s Scott Burns urges income-seeking investors to expand their minds and their research.
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That’s right. ETFs have matured, but they’re not done evolving. Morningstar’s Scott Burns urges income-seeking investors to expand their minds and their research.

Interest rates are in the cellar, which means that investors may not be able to rely solely on the old standards (bonds come to mind) for income. That leaves some investors rethinking how they might construct portfolios to potentially work a little harder. For some, select, lower-volatility exchange-traded funds (ETFs) may increasingly fill an unexpected role as a potential income generator.

Morningstar’s Director of Fund Research for North America, Scott Burns, shares some insight on how combining the familiar (think dividends), with an unexpected format, such as an ETF dedicated to dividend-issuers from emerging markets, may help investors run down that elusive income.

Ticker Tape Editors: Income and ETFs don’t necessarily seem like an obvious fit, but does it work? 

Scott Burns: Yes. ETFs can be an under-appreciated, lower-cost, and more-efficient way to play many investing themes. Income investing is no exception given the myriad of choices available, whether it is an income generating strategy or asset class. Income ETF investing is no different than any other investment in an ETF and an investor needs to check the ETF for suitability and risk. Another thing investors need to be mindful of is overall portfolio impact because you are sometimes adding hundreds of stocks with just a few ETFs. Do they all fit with your goals and risk profile? Is there correlation overlap? And then, check the nuts and bolts: how are the indexes tracked by the ETF constructed? What’s their underlying liquidity?

TT: Investors might consider income pursuit through dividend-focused ETFs. Why does this potentially make sense for some investors now? 

SB: We’re working under this thesis: given lower interest rates, lower economic growth, and greater economic uncertainty, high-quality large caps that pay a dividend are currently attractive, especially relative to bonds and relative to lower-quality small caps. The risk to this view, however, is that if we enter a recession, bonds will potentially outperform stocks. If economic growth accelerates, that tends to bode well for small-cap stocks, which have outperformed large caps over the past 10 years. So if you expect the economy to stay fairly range-bound as we do over the next several years, then collecting dividends from a basket of higher-quality equity names is one way to generate return in this maddening environment.

TT: But this isn’t the phenomenon that many investors might think it is, there’s actually a track record… 

SB: It is correct that this isn’t necessarily a new phenomenon. Data back to 1927 show that stocks that pay dividends returned 11.1% versus 8.4% for non-payers. There’s anecdotal evidence from folks like Mr. [Warren] Buffet, and the data show it too.

TT: Certainly it can’t be (and shouldn’t be) as simple as picking the ETF with the highest yield? 

SB: You have to weigh risk versus dividend yield. By and large, as you move out along the risk curve, you are getting yield to compensate for it. Picking the highest-yielding ETF means that you are also picking the highest-risk ETF. You have to consider your own risk tolerance and review how this meshes with the rest of your portfolio.

TT: Talk about potential international exposure. How do investors weigh diversification and income opportunity against global volatility? 

SB: International indexes tend to be a lot more top-heavy and concentrated in a handful of large names. International dividend ETFs are generally overweight telecom and utilities. They’re potentially more volatile, but foreign companies tend to be less reluctant to cut dividends when profitability weakens. The currency effect can also create a bumpier ride for you as an investor as well, but this also provides diversification against any weakening in dollar-denominated dividends in your portfolio.

TT: The notion of getting emerging market exposure through income- generating dividend ETFs is compelling. Talk about this area. 

SB: Significantly better risk-adjusted returns over the last five years suggest that dividends may be a good screen for corporate governance and quality in emerging markets. Plus, relative to cap-weighted ETFs, which tend to be overweight government-owned entities that at times may put political goals ahead of shareholders, many emerging market dividend ETFs are structured so that they have greater exposure to smaller, more entrepreneurial companies that truly leverage domestic growth trends. You’ll get the local grocery chain, not a global petrol company that’s more reflective of global economy.

TT: It looks like one of the latest news and analyst swarms is to low-volatility ETFs. What should investors watch for? 

SB: By skewing toward low volatility you end up potentially boosting yield on the fund versus if you just looked at cap-weighted funds. But there is a trade-off in terms of returns. Excessive movement up or down in the markets in general will deliver a muted response from a low-volatility ETF. When investing, it’s not just about total return, it’s about the ride you took to get there and a smoother ride may make you happier in the long run. Keep in mind that a muted response in a downward-trending market does not mean that a low-volatility ETF will not post losses and that the sector exposure likely to come with low-volatility ETFs will be very heavy in consumer defensive, healthcare, and utilities.

TT: Are you suggesting that there’s no place for fixed-income ETFs in a hunt for yield and income? 

SB: Not at all. The quest for income has caused a lot of folks to wade into more risky territory such as high-yield bonds. High-yield bonds are positively correlated to stocks; it’s not 1:1, but it is high, and they’re negatively correlated to Treasury bonds. For us, high-yield bonds are more tactical than strategic. They have a role, but not as an equities diversifier. I find more and more and more investors are looking at the toolkit that ETFs provide in terms of building a more specialized fixed-income portfolio.

TT: This sounds like a good place to bring up multi-asset ETFs as a diversified approach to income, which includes, among other investments, a bond component. 

SB: With this demand for income I have seen a surge in new ETFs that utilize a multi-asset approach to generate income. This is still a relatively young area for ETFs and there are only five or so options on the market, none with a very long track record. Beyond that, investors on their own can invest in U.S. and foreign dividend-paying equities, REITs, Master Limited Partnerships (MLPs), high-yield bonds, and emerging-market debt all through diversified ETFs.

TT: It sounds like this is a growing space, both for multi-asset ETFs and low-volatility options like dividend-focused ETFs, for investors to keep an eye on. Thanks, Scott.

Editor’s Note: This article was originally published in September 2012.

Carefully consider the investment objectives, risks, charges, and expenses of an exchange traded fund before investing. A prospectus, obtained by calling 800-669-3900, contains this and other important information about an investment company. Read carefully before investing.

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