Most income ETFs aren’t worth holding
Choosing the best income ETFs means ignoring the yield on the label and checking what’s actually underneath it, according to Marcus Padley.
There are a whole load of ways to go wrong looking for income in the Australian market. Ever since 2020, when interest rates were close to zero, the ETF market exploded with income-related, high-yield ETFs. And let me tell you, if you are relying on them for income, you could be making some huge mistakes. Come another global financial crisis, if you’re in the wrong ETF, there is a lot of risk. I’m going to run you through the criteria to filter out all the risky ETFs and to choose the best ETFs for income, and I will tell you what I would do if I was chasing income using ETFs as an Australian retiree. Let’s get into it.
What we’re going to do first is look at the types of ETFs and write off some of those that we’re not going to use for income. There are two basic types of ETF used for income: equity-based ETFs and fixed interest ETFs. The fixed interest ETFs are broken down into a few different types.
Where fixed interest ETFs stack up
There are bonds. Think of US Treasury bonds, global Treasury bonds, Australian Treasury bonds. Bonds are issued by governments. They are essentially risk-free – unless the country goes bust, which is unlikely, and if it does, you’ve got other things to worry about. I would not bother with any ETFs that are looking at overseas markets unless they were hedged. The last thing you want to do as an income investor is have a currency risk.
When you’re dealing with income, you’re looking at anywhere between 4 to 6% as your return, and that’s what you’re trying to achieve at the moment. So, apologies to all those ETF issuers who have created these lovely ETFs over US bond yields and global bonds – if they’re not hedged, not interested, you can write those off. So, we’re left with Australian fixed interest or hedged fixed interest ETFs.
Staying with fixed interest ETFs, the next issue is what type of fixed interest they’re in. I’ve talked about the bonds issued by governments – they’re the best. The ones to avoid, in my humble opinion, are anything that is less than government grade. In other words, as we look down the list of fixed interest, we’ve got senior floating rate bonds, investment grade corporate bonds, corporate fixed interest. These are all lower-grade debt that I wouldn’t bother to get involved with.
It’s a matter of risk. In the GFC, you had some corporate fixed interest issues drop 30–40%. If we had another GFC, you cannot afford to be holding corporate, subordinated, riskier debt. The reason these ETFs have been created is to create a higher income for you, and in my humble opinion, a lot of that extra risk is exponentially larger for an incrementally larger yield.
The other group of ETFs, which are some of the largest and which we use in our fund, are the cash and bills ETFs. The most obvious ones here are an ETF called BILL – the iShares Core Cash ETF (ASX: BILL) – and an ETF called AAA – the Betashares Australian High Interest Cash ETF (ASX: AAA). AAA simply does what you could do yourself, which is deposit money into a diversified number of bank accounts that pay a deposit rate.
You can sort of do that yourself, but it is the largest ETF in Australia in the fixed interest category, with $5.19 billion worth of assets under management. And that’s one of the best ways to sort ETFs as well – sort them by assets under management. It’s also called market capitalisation in most cases.
As we look for the top fixed interest and bond market ETFs that are out there – cash and bills and bonds – we’re looking at AAA as the largest. VBND, the Vanguard Global Aggregate Bond Index (Hedged) ETF (ASX: VBND) – and that one’s hedged, which is why I’ve left it in. And then we have BILL, with a $1.2 billion market cap, which shows you that that’s well used as well.
Size is a good gauge of whether this has been vetted by a lot of people and is used by a lot of people – how safe it is relative to some of the others. Amazingly, as I look down the list of 70 fixed interest ETFs, when you get to the bottom of the list, 10 of the 70 have a market cap below $10 million, and half of them have a market cap below $100 million. If you’re looking for safety in numbers, you can write off half of the fixed interest ETFs straight away, by virtue of their size. Big is better.
The Macquarie savings account test
But let me tell you the most important part of looking to invest for income in ETFs, and that is what’s your benchmark. This wipes out 50–60% of ETFs claiming to be high yield. Your benchmark is whatever you could get in a term deposit or a deposit saver account, and if you look at Macquarie at the moment, you’ll see that they are advertising a 5% return for balances under $2 million. That should be your benchmark.
I can tell you the majority of ETFs do not yield that much, and you need to first of all compare any ETF yield to what you can get completely risk-free, hassle-free, no management fees, no spread, no market risk, in your bank. So look at that first, then start to look at ETFs.
Spotting equity ETFs that aren’t really about income
So once you’ve discarded 99% of the fixed interest ETFs because they don’t yield enough, the next group to come along and look at are the equity-based ETFs. And here you’ve got a chance of earning more than the Macquarie saver account, earning more than 5%, because some stocks yield more than 5%. But that straight away brings in another benchmark, which will filter out 80% of the equity-based ETFs that are claiming to be high yield or dividend-focused – and there are only 40 of them.
Your first filter is to look at the ASX 200 and see what it yields. The A200 ETF – the Betashares Australia 200 ETF (ASX: A200) – paid 4.5% including franking over the last year; on their website at the moment, 3.4% plus franking. So any ETF that doesn’t yield at least 4.5% including franking isn’t making it compared to the whole index. That’s one of your first filters – does it beat the index?
The second filter is that you will find that most ETFs claiming to focus on the higher-yielding stocks – I really don’t want to name them, because I don’t want to destroy the billions of dollars that are in them – but there’s one particularly large Australian ETF in the equity space that focuses on ASX 200 higher-yielding stocks because it’s just higher yielding, and includes resources, which are higher yielding one day and not the next, and are unreliable. But if they happen to have a high yield that year, on whoever’s forecasts, they’ll include it.
You have some income-based or income-marketing ETFs that are holding enormous amounts of non-yielding, highly volatile stocks, which just goes against the ethos of income investing, which is: I don’t want volatility. I don’t want dividends that pay out one year and not the next. I need consistency.
And so many of the ETFs that are purporting to be high-yielding are using non-income stocks, in the traditional sense of reliable, consistent quality. So if you look at your high-yielding ETF and it’s got stocks like Woodside (ASX: WDS), BHP Group (ASX: BHP), Rio Tinto (ASX: RIO), and Fortescue (ASX: FMG), because they might happen to have a decent yield – they’re extremely volatile stocks. They’re cyclical stocks, and they shouldn’t be relied on for income, because the capital is moving so rapidly compared to other more stable income stocks.
One of the other things to have a look at is how many stocks are in the ETF. I can tell you in any equity market there are maybe 20, if you think a bit harder, 10 stocks that are quality income stocks. We’ve pulled them out in our income portfolio in the Marcus Today membership – you can have a look at those. If an ETF has got 100 stocks in it, they are clearly not filtering properly for income stocks.
They are including a whole load of stocks that happen to have a high yield on some forecast or last year’s dividend at the moment, and this is not a focused ETF focused on income. It is simply a don’t-sue-us, we’ll-include-everything ETF. And the likelihood is it’s doing exactly what the index is doing anyway. In which case, the only reason they’ve got high yield on the description is because they’re trying to market to people that want yield – not because they’re actually giving it to you.
Filtering by size and by manager
The other filter for equity-based ETFs, just as with fixed interest, is size. There are a lot of ETFs that just haven’t made it – they get started hoping to get traction, but their performance isn’t fabulous and they never grow, and there’s a reason they never grow. Anything with a market cap under $100 million, you’ve got to have a look. If they’ve been around for a long time, the likelihood is that they are not achieving their goals and haven’t sold very well. If they’ve only been around a short time, then they’re still growing, and that might be okay.
If you filter by size – if you filter out anything under $100 million – you are going to get rid of 10 or 15 of the 40. The other way I would filter is to filter out active fund managers. Some active fund managers are very good at what they do, are very focused – again, check the number of stocks. If an active fund manager’s got 100 stocks, then they’re not actually doing any work. But an active fund manager who’s got 5, 10, 15 stocks is pulling out the income stocks for you, and it might well be a good ETF to be in.
So I can’t write off all active-fund-manager-based ETFs, and you can spot those very easily because they haven’t got a major issuer behind them. So if it’s Global X, Betashares, iShares, VanEck, Vanguard – all those are algorithm-driven, and haven’t got a fund manager behind them making decisions. That’s a passive ETF, as opposed to an active ETF, where you’ve got a fund manager making decisions. If you have, check they haven’t got 100 stocks, and if they haven’t, the likelihood is they’re doing some decent work.
What to check once you’ve filtered down
So after we’ve filtered by active or passive, by size, by number of shares, we get down to the obvious things that you can now start looking at, and this is really a question of what you are after, what suits you. The first thing, of course, is obviously what’s the yield. Every ETF issuer has a page up which will give you all the details you need to know, and it’ll tell you what the distributions are, what the yield is, what it was last year. You can start to pick up on which ones are meeting your criteria in terms of yield.
The other thing to look at is franking. Bonds don’t have franking. Fixed interest doesn’t have franking, but obviously Australian retirees are very interested in franking. You need to go to the individual websites of the individual ETFs and look at what’s the yield, what’s the franking. That is a personal preference – some people in self-managed super funds are franking hungry, in which case check it out first.
The next thing, of course, is management fee. ETFs are very cheaply run, most of them, it has to be said. Management fees are not a big issue – they’re very competitive, especially amongst the big issuers. They look at each other’s ETFs and undercut each other. The trend’s good that way. But just bear in mind, whatever you think the yield is, the management fee comes straight off it.
The next thing I would look at is the performance relative to the ASX 200. Say that is the benchmark, and you want to see: income stocks tend to be defensive – they’ll generally underperform the ASX 200 when it’s going up, and outperform when it’s going down. But just have a look at the ETF relative to a benchmark and make sure it’s not consistently dropping over time, as some do.
Again, I can’t mention the names, but if you look at the net asset value or the price of the ETF, you might find some of them are just trending lower endlessly. That’ll filter out a few. Probably the last thing to check, just to see if it suits you, is what is the frequency of paying out dividends. Some of them, especially the yield-based ETFs, do try and pay out regularly, so once a quarter.
The payout in the Australian market – the ASX 200 – generally is lumpy because of the results seasons. You get two big lumps, and then you get the bank season dividends in between. Just check out whether these ETFs smooth things for you, which is quite good for some people. Check out how often they pay. Most of them should be paying once every three months, so quarterly – four dividends a year, whatever suits you.
I can’t name them, but there are some ETFs that promise you a really good yield, and they pay you a really good yield – up to 9%. But I can tell you, where there is no income, there is no income. The only way some of these high-yielding ETFs can pay you a yield which is higher than any dividend that any stock pays in Australia is because they’re effectively handing you back their capital.
So what happens is the price of the ETF constantly drifts, as they pay out whatever dividends they’ve received, but they also pay you back some of your capital. And it looks great, but the price is going down. So you’re swapping capital for income. That may suit some people – the total return isn’t that bad. But just be aware, for anybody who is looking to grow their nest egg, these are not the ETFs for you.
Once you go and have a look at their share price charts, they become pretty obvious, so just look out for those. Nothing terribly wrong with them, especially as there is a level of franking attached to paying your capital back, but they certainly won’t suit people who are trying to make money and have a long runway through which they want to be earning income.
The one ETF I’d actually use
So that brings me to what I would do if I was trying to achieve income through ETFs. Let me tell you, there is one ETF that is just obvious to me, and that is the MVB ETF – the VanEck Australian Banks ETF (ASX: MVB) – which holds the major banks, along with Macquarie, Bendigo and Adelaide Bank, and Bank of Queensland, and it pays a decent yield. It’s franked.
I believe the banks are some of the best income stocks in the world, and our income portfolio is absolutely stuffed with banks. The banks are maybe a 25% weighting in the ASX 200. It just doesn’t make sense to put a lot of money in other stocks just because they’ve got a high yield, because they don’t have the quality, consistency, reliability, and they don’t have management that knows its responsibility to pay a decent dividend out to its shareholders.
The problem with it, of course, is that if a seismic moment came around for the bank sector – and they do come around; in the last 20 years, for instance, the global financial crisis in 2008 saw the bank sector drop 54%. The banking inquiry was seismic for the banking sector as well – they cut dividends and underperformed. So there are moments where you have to time the banks.
And the reason to time them is not because they’re going to go wrong in the long term – it’s because there is a fantastic opportunity to sell them and buy them back lower down. And when they come out of a trough, they come out with accelerated returns in short periods of time. If you just sat in the banks after the global financial crisis – I think it was 11 years till they recovered their highs – you can use that instead of losing time. You can use that as an opportunity to time the banks and get back in, make accelerated gains, and you get this sort of step performance.
So what I would be doing if I was using ETFs for income, I would be timing the MVB ETF, and only around seismic events. The problem with that, of course, is that you won’t know when to sell and when to buy back in. If you’re really looking for income through equities that beats a Macquarie saver account paying 5%, sitting in the major banks – with a good level of franking, a decent yield, and timing them well – is probably the way to do it, with lower risk.
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