Hooked on dividends? Time to think again

Too often investors only look at the income and ignore the total returns on offer to their detriment. Here are the top tips from our investment experts.

The key to making money

Australian investors love their dividends. But do they love them too much? If we’re talking about payouts from ASX-listed companies then the answer, it seems, could be yes, according to Sydney-based fund manager Russel Pillemer.

The problem, according to Mr Pillemer, the chief executive of Pengana Capital, is that the vast majority of Australian dividends – a whopping 80 per cent – are concentrated into just four sectors.

With rising inflation, higher interest rates and slowing economic growth posing threats to payouts, looking overseas to spread the risk makes sense, he says.

“Such concentration creates several problems for investors. It forces income investors to choose between buying potentially overvalued companies to meet their income requirements, or appropriately diversifying their equity exposure,” Mr Pillemer says.

Pengana chief executive Russel Pillemer Picture: Jane Dempster

“Many of these companies have share prices that are exceedingly sensitive to dividend payments, potentially leaving them under pressure if dividends falter.”

The materials sector now accounts for 45 per cent of total dividend payments in the S & P/ASX All Ordinaries index, up from 28 per cent at the end of 2020, with the Financial, Real Estate, and Energy sectors making up the rest of the 80 per cent of total paid out.

With external threats on the rise, it makes sense to spread the risk and consider other dividend-paying options, including international stocks, Mr Pillemer says.

But there is a downside: Australian investors don’t typically get any franking credit on global stocks. (The exception is when investing through a listed investment company on the ASX – more on that later.)

Then there is the risk of getting caught out by currency moves, warns Stockspot’s Chris Brycki.

“The risks of going global for dividends are the same as the risks just generally when investing globally,” he says.

“There’s foreign exchange risk, so you‘ve got to decide whether to hedge or not. Look at the Aussie dollar moves this week, it’s probably moved 10 per cent just in the last couple of weeks. You might be trying to capture 2 or 3 per cent of dividends, but you can lose them pretty quickly as well.”

Equity investors can access global income-focused stocks through direct investing, exchange traded funds and listed investment companies. Only LICs – this does not include listed investment trusts – give investors the benefit of franking credits as well as exposure to global equities.

But some of the most high-profile international-focused LICs, including WAM Global and Pengana International, have posted pretty dismal performances of late, mirroring the beating their underlying holdings have taken as part of a broader market decline. Shares in both WAM Global and PIA are down more than 30 per cent over the past 12 months.

This makes the dividend yield look very attractive – PIA has a grossed-up yield of 7.7 per cent, while WGB’s sits at 5.5 per cent, but this yield assumes the managers can keep paying out dividends at the current level.

The franking element adds to the appeal of LICs: Mr Brycki puts the benefit of franking at equivalent to 1 cent per year in returns.

Another option is going for a low-cost, passive ETF.

Local investors can access two dividend-focused ETFs for global shares on the ASX: the BetaShares Global Income Leaders ETF (INCM) and the SPDR S & P Global Dividend Fund (WDIV).

While INCM has a lower dividend yield, at 3.9 per cent versus WDIV’s 5.9 per cent, it wins out on the total return over the past 12 months, at negative 1 per cent versus WDIV’s 5.7 per cent.

Over three years, INCM and WDIV are pretty much on par with a return of negative 1.5 and negative 1.6 per cent.

Worth keeping in mind that the global dividend ETFs have underperformed compared to the global 100 ETF over the last five years. And the same goes for all Australian dividend-focused ETFs, which have put in a worse performance than the broader ETF market over the period.

This shows that sector concentration risk exists both locally and globally for dividend investors, Mr Brycki says.

But dividends aren‘t everything. Too often dividend chasers only look at the income and ignore the total returns on offer, to their detriment, Mr Brycki cautions.

“What we‘ve seen over the last 10 years is the highest dividend payers have given very poor total returns because they’ve had negative capital returns,” he says.

“Forget about the dividend, it’s just a bit of a mathematical trick. Companies can always choose whether they want to reinvest that money and grow the business or pay it out.”

Mr Brycki’s advice for dividend lovers? Look for total returns and don’t be afraid of taking profits to grab some of the capital gains.

“Investors shouldn‘t feel like it’s a mistake to sell down part of their portfolio to fund the income they need,” he says.

“If you’ve got a share that has a dividend of 4 per cent a year as well as an extra capital return of 2 per cent, so in total 6 per cent, and then you have another share that makes only 2 per cent dividend and 4 per cent capital return, then as an investor you should be rather indifferent on choosing between the two,” Mr Brycki adds.

“You can always take the 2 per cent dividend and then sell down half of that 4 per cent capital gain, and you‘re in the exact same position.“