Dirty Harry and Dividend Income ETFs

I think of Dirty Harry when I see some of the dividend income ETFs on the market. “Go ahead, make someone else’s day”. In fact, make two other people’s day: the ETF product promotor and Rishi Sunak, the Chancellor of the Exchequer.

Many investors get comforted by the thought of income, particularly as they approach retirement. It is partly psychological – when people are used to receiving a regular salary, the idea of a ‘regular’ payment to replace it in retirement can seem very attractive. Product providers are aware of this desire, and over the last few years, we’ve seen lots of choices appear with “Income” prominently in their names. It’s not always a recipe for success on the active side, and the passive side isn’t a lot better.

Life is fraught for somebody who owns a UK dividend income ETF at the moment. ETFs are built around rules based indices, and it is very difficult to build a set of rules to maximise dividend income and match the returns of the FTSE 100. The rules tend to be based on dividends paid in the past. That has two problems. Firstly, that will tend to favour cyclical stocks – those most exposed to the business cycle, and usually the first to suffer. Secondly, a high dividend yield isn’t always a good sign – it can be because the stock price has dropped in anticipation of a dividend cut. Think of Carillion, it had a great historic dividend yield right up to the day it went bust.

An alternative route for other ETFs is to look for a long track record of paying dividends rather than the absolute level of dividend. This unfortunately has come undone recently, as the index providers are no longer sure that there will be enough companies with the long track record of paying dividends to go into the ETF. How can a rules-based index account for coronavirus with many companies being told not to pay dividends? The situation is under review and the rules may have to be flexed – but it may be too late for those already invested.

There are other ways to construct dividend income ETFs, but very few of them have been successful in matching a plain index ETF, where you receive more of a balance of income and capital appreciation. Yet investors continue to make ETF providers’ day by buying an underperforming dividend income ETF, which costs around 0.4% when they can have something like a FTSE 100 ETF for as little as 0.05%, or about one eighth of the price.

Dividend income also makes the day for Rishi Sunak because of the large differential between income tax rates and capital gains tax rates. Nearly all investors use up all their income tax allowances and many suffer tax on dividend income at the highest rates of up to 38.1%. If capital gains and income were more balanced, an investor might be able to fully use up their allowance of £12,300, plus a much lower marginal maximum rate of tax of only 20%.*

You may remember President Ronald Reagan who hated taxes. When Congress threatened to raise taxes, Reagan, who was an actor, threatened to use his presidential veto also saying “Go ahead, make my day”. Investors should be the same as President Reagan and think about reducing your tax bill by balancing your income and capital gains and save a fist full of dollars on ETF provider fees.

* Tax rules are subject to change and taxation will vary depending on individual circumstances.