Exchange-traded funds are an excellent way to generate low-cost cash flow while providing much-needed portfolio diversification.
But some income investors ignore ETFs when making buying decisions. That reluctance seems to be diminishing as ETFs gain in popularity, but I still encounter people who say they don’t understand how they work or claim they are too risky.
Yes, some ETFs can be extremely risky. Look at the Horizons BetaPro bull-bear leveraged funds, which can swing wildly in either direction on any given day, depending on price movements in the underlying commodity. If you had invested in the BetaPro Crude Oil 2x Daily Bear ETF a year ago, making a bet that oil prices would drop, you would have lost two-thirds of your money as of June 30. If, on the other hand, you had predicted oil prices would rise, you would have made 125 per cent in the BetaPro Crude Oil 2x Daily Bull ETF.
Of course, I would never recommend any fund such as this. These are for gamblers, not investors.
But, there are many ETFs that are safe, such as short-term bond funds, and others that provide the right balance between risk and return that most investors seek.
I have recommended many ETFs over the years and some have done outstandingly well, both in providing steady income and in delivering capital gains as a bonus. Here are four of them, with the dates and prices of their original recommendation in my Income Investor newsletter.
SPDR S&P Dividend ETF (NYSE: SDY)
Recent price: US$95.38
Originally recommended: Dec. 4, 2014 at US$81.07
Annual payout: US$4.66 (trailing 12 months)
Yield: 4.9 per cent
Comments: This ETF from State Street Global Advisors tracks the S&P High Yield Aristocrats Dividend Index. It includes companies that have increased their dividends annually for at least the past 20 years. They include Target Corp., AT&T Inc., Tanger Factory Outlet Centers Inc., ExxonMobil Corp., and IBM.
The portfolio is very well balanced by sector, led by consumer staples (15.9 per cent), financials (14.9 per cent), industrials (13.2 per cent), utilities (12.7 per cent) and consumer discretionary (11 per cent). Distributions are paid quarterly and will vary, with the largest payout coming in December. The expense ratio is a reasonable 0.35 per cent.
This fund has performed very well. Based on the trailing one-year distributions, it is yielding 4.9 per cent at the current price. As well, we have a capital gain of about 18 per cent, and that does not include the profit we’re making on the exchange rate as the Canadian dollar drops against the U.S. greenback.
On the risk side of the equation, this fund is fully exposed to the stock market, so it would be vulnerable if we have a sharp correction. However, historically, dividend stocks tend to hold up better in a declining market, which would tend to cushion the extent of any losses.
BMO U.S. Dividend ETF (TSX: ZDY.U)
Recent price: US$24.69
Originally recommended: Dec. 4, 2014 at US$19.04
Annual payout: US$0.678 (trailing 12 months)
Yield: 2.7 per cent
Comments: This fund also invests in the U.S. market, but uses different criteria to select its securities. The managers look at the three-year dividend growth rate, yield, payout ratio and liquidity when making their selections.
As a result, the portfolio looks quite different from that of SDY, with stocks such as CenturyLink Inc., Pfizer Inc., General Motors Co. and Procter & Gamble Co. among the top holdings. All told, the ETF holds 101 securities, all fairly evenly balanced.
The trailing 12-month yield is not as high as that of SDY, but the latter was boosted by a big capital-gains payout in December. The share price since the fund was first picked is up about 30 per cent. The management expense ratio is 0.34 per cent. The risk factor is similar to that of SDY.
First Asset Tech Giants Covered Call ETF (CAD Hedged) (TSX: TXF)
Recent price: $17.46
Originally recommended: Feb. 23/17 at $13.92
Annual payout: $1.0758 (trailing 12 months)
Yield: 6.2 per cent
Risk: Higher risk
Comments: Here again, we’re looking to the U.S. market for gains but this time in a specific sector: technology. This fund invests in 25 of the United States’ largest tech stocks and writes covered call options on the portfolio to generate extra income. You’ll find a lot of familiar names on the list including Apple Inc., Alphabet Inc., IBM, Microsoft Corp. and Facebook Inc.
Despite Facebook’s drop last week’s, this fund has performed very well since I recommended it in February, 2017, at $13.92. Based on the past 12 months of quarterly distributions, the yield is 6.2 per cent, and we have a capital gain of about 25 per cent in less than a year and a half. The management fee is on the high side at 0.65 per cent, but with results such as these, it’s worth it.
Because this is a sector fund, and a high-priced one with an average p/e ratio of 24.55, this fund would be much more vulnerable to a stock market correction. Conservative investors should be aware of that and limit their exposure.
Horizons Active Preferred Share ETF (TSX: HPR)
Recent price: $9.68
Originally recommended: Sept. 15/16 at $8.30
Annual payout: $0.3654 (trailing 12 months)
Yield: 3.8 per cent
Comments: This is one of the few actively managed preferred share ETFs in Canada, using the services of Fiera Capital to select securities. The goal is to generate steady, dependable income while minimizing risk. The managers can invest in both Canadian and U.S. preferreds, but all the top-10 holdings are Canadian.
Preferred shares used to be among the safest securities, but they became something of a minefield in the 2013-15 period when interest rates dropped, causing some issues to lose more than a quarter of their value. However, things have stabilized in the past two years, and this fund generated a return of over 15 per cent in 2017. It’s been less impressive so far this year with a gain of slightly less than 1 per cent to the end of June, but the monthly distributions of about $0.03 a unit have been steady, providing a yield of 3.8 per cent.
Since my original recommendation, we have a capital gain of about 16 per cent, which is a pleasant surprise for a fund of this type. The management fee is 0.55 per cent. This fund is suitable for more conservative investors.
Gordon Pape is Editor and Publisher of the Internet Wealth Builder and Income Investor newsletters. For more information and details on how to subscribe, go to www.buildingwealth.ca.
Follow Gordon Pape on Twitter at twitter.com/GPUpdates and on Facebook at www.facebook.com/GordonPapeMoney