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UK dividend ETFs: why I believe investors need to be careful

Exchange-traded funds (ETFs) can be a great way to access the stock market cost-effectively. Through just one listed security, you can own a whole portfolio of stocks for a very low annual fee.

However, if your focus is on dividends, I believe you need to be a little bit careful with ETFs. Due to the way that many dividend ETFs are constructed, some of these passive funds underperform the market by a wide margin.

Major flaw

One major flaw of many standard dividend ETFs is that they tend to have a strong focus on high-yield stocks.

For example, Vanguard’s FTSE UK Equity Income Index invests in stocks listed on the London Stock Exchange’s main market that are expected to pay dividends that ‘generally are higher than average.’ Similarly, the iShares UK Dividend ETF provides exposure to the ‘higher-yielding sub-set’ of the FTSE 350 index.

The problem here? Stocks with high yields are often experiencing difficulties, meaning their share prices are falling. So, while the yield can be attractive, total returns (capital gains plus yield) may actually be negative – which is certainly not what you want.

For instance, look at the top holdings of the iShares portfolio, and you’ll see the likes of BT Group and Micro Focus International. Over the last three years, these stocks have fallen 44% and 49% respectively. Similarly, the Vanguard ETF owns Vodafone and British American Tobacco – down 25% and 38% respectively over the last three years. Owning these kinds of stocks could lose you money.

Poor performance

This fundamental flaw is well illustrated by looking at the performance track records of these two dividend ETFs.

For the five years to 30 September, the iShares UK Dividend ETF iShares returned just 2.8% per year on a total return basis while Vanguard’s FTSE UK Equity Income Index returned 4.4% per year. By contrast, the FTSE 100 and the FTSE All-Share indexes returned around 6.3% per year and 6.6% per year respectively over that period. So, both dividend ETFs underperformed the market by a wide margin.

Given this kind of underwhelming performance, I’d treat dividend ETFs with caution. Ultimately, there’s a lot more to dividend investing than just focusing on a stock’s yield. Speak to any experienced investor and they’ll tell you that investing on the basis of yield alone is a very dangerous strategy.

Dividend alternatives

So, what are some alternative ways UK investors can pick up dividends?

Well, one option is to simply invest in a vanilla FTSE 100 tracker fund. Given that the FTSE 100 has a high yield (the yield on Vanguard’s FTSE 100 ETF is currently 4.2%) you’ll still pick up a decent level of income.

Another option is to consider investment funds that pay dividends. You will pay a higher annual fee with these, but plenty of these funds have beaten the market and have provided excellent total returns.

Finally, you could also consider picking dividend stocks yourself. With a little bit of research, it’s not that hard to put together a robust portfolio of high-quality dividend-paying companies that is capable of outperforming the market over time.

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Edward Sheldon has no position in any shares or funds mentioned. The Motley Fool UK has recommended Micro Focus. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.