Conversely, capping exposure to individual securities at every annual rebalance can help to keep portfolios diversified, providing a degree of protection and reducing the impact on the overall return of an ETF from a stock-specific event.
Buying stocks with the highest dividend yields has historically enabled investors to outperform quite dramatically. Even taking into account the sell-off in 2008 when some previous income stalwarts – including HSBC, Barclays and Lloyds Bank – saw share prices virtually wiped out, the highest dividend payers have delivered substantial returns over low-yielders and the benchmark indices.
Higher dividend-payers have been rewarded by investors over the long-term for a number of reasons. For instance, dividends have theoretical and empirical importance when it comes to determining the value of a stock, and they also indicate the willingness of management to deliver returns for shareholders, both of which are welcomed by investors.
As well as providing a yield substantially above traditional trackers, the income these solutions produce also compares favourably to other asset classes such as fixed income.
UK and US government bonds currently pay significantly lower incomes, with the yield on benchmark 10-year UK gilts just 1.77 per cent, or 2.04 per cent for benchmark 10-year US treasuries.
Investors can go up the risk scale and obtain higher coupons by looking at areas such as emerging market debt, picking up yields above 5 per cent, but with the strong US dollar continuing to act as a headwind, the asset class is not yet out of the woods and could see further capital losses.
UK property has enjoyed a successful 2015 in terms of both the income generated and capital growth, but whether or not the sector can deliver 5 per cent-plus income again in 2016 remains to be seen. The income level also remains below that achieved by dividend-focused trackers, albeit marginally.
Infrastructure has been a reliable option for those seeking the highest yields, but following a wall of investor demand for income, these now face two key risks. First, yields – previously around the 6 per cent mark – have moved sharply lower over the last few years and now sit nearer to 4.5 per cent.
Second, many of the UK-listed infrastructure funds are now trading on a premium to net asset value, leaving them open to questions over valuations and just how sustainable their yields are. At 4.5 per cent, the income on offer remains attractive compared to some other assets such as fixed income, but the risks to the downside in terms of valuations have increased.
With the significant drop in yields across the fixed income spectrum, coupled with the volatile moves in individual stocks – expected to rise as central banks remove support from the market – income-focused ETFs are increasingly an attractive option for investors.
