The Den of Dividends

So, you have decided that 1.5% interest on your money is unappealing. Bank account returns no longer beats inflation. Your pile of money in the bank is worth less every day. Your research into what new investors should start investing in will find a pervasive theme that Exchange Traded Funds or ETFs are a good idea. Rather than pick one or more individual companies, purchasing an ETF instead represents many stocks within one. The best part is that you can buy these ETFs through your stockbroker just like a normal company share.

The US market is the biggest in the world and has seen incredible growth since the Global Financial Crisis. The investing community usually suggest two ETFs to gain exposure to the US markets. These are VTS, Vanguard US Total Market Shares Index ETF, and IVV, iShares S&P500 ETF. Both these ETFs trade on the ASX in Australian Dollars.

The US Market is now reaching some quite dizzying heights. Financial analysts are questioning if the market is overvalued. Will the low interest rates and cheap debt cause a market correction and see the US economy slip into a recession? Are these two ETFs a good idea to invest in today? Looking at what is on offer, I do not believe these ETFs are suitable for new investors looking to start their investing journey with a Dividend Growth Investing (DGI) strategy. Lets discuss why I have come to this conclusion.

High unit cost & unfavourable AUD rates

After the GFC, pricing on the US Index ETFs were quite low for Australian Investors with a strong AUD, at one point buying in excess of USD$1.10 per AUD courtesy of our stronger interest rates and the carry trade. This maintained pricing within a range even as the US Market started to improve. Once our interest rates started to come back more in line with the US, the carry trade unwound and the AUD slid back below the 80 cent mark. Meanwhile the US markets started to fire on Helicopter money in Quantitative Easing from the US Federal Reserve.

Today, we are seeing VTS above AUD$230/unit, and IVV at an eye-watering AUD$457. This means a $2,000 investment in either only sees 8 and 4 units of each respectively. Since the price is so high, the inability to take dividend returns and reinvest to get the compounding effect that we all love to drive our wealth higher simply does not exist.

Yield dragged down by Tech Stocks

One of the major changes to the S&P 500 over since the dot-com bubble popped is that massive tech stocks are now some of the most valuable companies in the world, and take up a huge chunk of the index. While Microsoft and Apple are the two largest companies in the world and do pay a dividend, both are yielding less than 1.4% p.a. each. The remaining big tech companies in the ten largest companies on US Markets, Amazon, Alphabet (Google) and Facebook all do not pay a dividend.

Between all 6 companies (Google counted twice with two separate stock listings) the overall yield is very low. Adding to this low yield, Berkshire Hathaway famously run by Warren Buffett is the 5th largest company on the US Market. Berkshire also infamously do not pay a dividend. All you are left with is Johnson & Johnson (JNJ), Exxon Mobil (XOM) and JP Morgan Chase (JPM) who do pay a reasonable dividend of 2.8% p.a. or greater.

An overall dividend return between 1.40% and 1.60% p.a. on these indexes is really not strong enough for dividend-focused investors. Much of this low yield is caused by a vast number of overvalued companies at P/E ratios that are generally to high. You can get better returns on a Bond ETF, or even sticking your money in a bank with far less risk.

Reinvestment problems

Most of the audience here will prefer dividends to be paid at reasonable yields, lets say greater than 2.8%. We also want to grow investment positions over time by reinvesting these dividends and unlocking compounding returns over a period of 20 years or more.

Only IVV provides a Dividend Reinvestment Plan (DRP) as part of the ETF. This allows for your dividends to be ‘paid’ as shares onto your holding balance without incurring brokerage fees. At the much higher level of unit cost, you would need around $50,000 invested in IVV in order to gain one single share per year at the current yield. I do not believe you are really going to see any meaningful compound effect with that unit quantity increase.

VTS on the other hand is a trust structure under Vanguard and domiciled in the US. Tax laws state that they must pay cash as a dividend. While the same $50,000 investment in VTS would gain you a cash payment worth around two additional units per year, you would need to buy this as an on-market transaction and incur a brokerage fee. While some brokers can be around a $10 brokerage fee per trade, a number of brokers charge $15 or even in excess of $20 per trade. This eats into your profits and increases your cost price average up significantly. You can add additional cash to make your purchase larger to offset the impact of brokerage however.

When is VTS and IVV appropriate to purchase?

Quite simply – at far lower P/E multiples, and ideally with a strong AUD at around 85c or higher. The benefit of these ETFs is snapping them up at low prices such as the opportunity we had in 2008-2011 with the AUD so strong against the USD.

You then let the market drive the capital growth of the underlying stocks to increase the value of your holdings instead of dividends. A $10,000 investment in 2009 with dividends and capital growth would now be a holding worth around $40,000.

As a result, for dividend focused investors, these are less suitable for long-term growth of your holdings, and later converting those dividends to income in retirement.

Alternative US-market ETFs for Dividends and compounding

At this stage there really is no low-cost, high-yield ETF for Australian investors trading on the ASX. Both VTS and IVV offer very low management fees of 0.03% and 0.04% p.a. annually. This is a tiny loss in yield while the alternatives have far higher fees.

Protect yourself with a MOAT?

MOAT is one that often mentioned and seems to be a favourite with some writers at Motley Fool Australia. This is an ETF of companies with a ‘wide moat’ meaning harder to disrupt or competition is hard to come by. One concept that or that reason they are expected to do well and continue growing and paying safe dividends. The yield on MOAT of 1.0% p.a. and a management fee of 0.49% p.a. is twelve times higher than IVV for example which seems too high. Dividends on MOAT will only be paid annually. This further cuts down compounding returns. I will pass on MOAT, thanks.

This could be the answer….

ZYUS is the most interesting candidate on the ASX. The ETFS S&P 500 High Yield Low Volatility ETF gives ASX investors a compelling option. For US-based exposure with a great dividend return this ETF provides excellent yield while having a manageable management fee when taking the yield into account. I am not a massive fan of some the holdings in the fund like Iron Mountain being the single largest holding. I do hold many of the individual stocks in this ETF with my US broker.

Returning a far larger dividend payment than any other US-based ETF at comparatively high 7.72% p.a. yield on a trailing 12-month basis, it makes the competition look weak in comparison. Price is also reasonable, trading between $12 and $14 for the last 12 months which opens up a serious opportunity for reinvestment. ETF Securities has a DRP available as well, which means that you can get compounding returns without brokerage fees.

If I can get a 7% return on investment, I can double my money every 10 years. While past performance cannot indicate future performance, it seems like ZYUS is the best dividend investment on the ASX for US exposure while beating bank interest by a factor of 4. This performance does come at a price however, with a 0.35% p.a. Management Fee it is high in comparison with many other funds. It could be argued that the fee is justified by the returns. It also compares favourably with SPHD in the US at a 0.30% Management Fee, but only a 4.1% dividend return. SPYD has a sightly higher return, but a 0.07% p.a. Management fee. Based on this, I would hope for an MER reduction over time for ZYUS as the fund grows to a larger size.

Based on last closing price of $13.72, a single $2,000 investment in ZYUS would net you 164 shares. Highly beneficial quarterly dividends and compounding give approximately 11 additional shares in your holdings in the first year with DRP. The 10 year projection on dividend income reinvested alone gives a 114% gain or a doubling of your money. If you are smart with investing at a lower price and averaging down in any correction then ZYUS might be one of the ultimate long-term holdings for future income.

The data shows the incredible dividend-only compounding effect of a seven percent interest or dividend rate, before consistent additional cash added to the holdings over time. If this looks like a interesting ETF for your portfolio, then please do your research and consult with a licensed Financial Planner before making investment decisions.

DISCLOSURE: At the time of writing, the author held no positions in any ETF mentioned: VTS, IVV, MOAT or ZYUS, and no planned trades on these positions within the next 7 days. Figures shown are based on past performance. Past performance is not an indicator of future performance.