Fitch Ratings says that investors should carefully review the investment processes of European dividend funds. This oversight is necessary to ensure that forward-looking analysis on dividend sustainability is at the core of the analysis.

Fitch Ratings has highlighted the importance of forward-looking index methodologies within high-dividend ETFs.

Investors need to be aware of the more constrained investment universe of dividend funds, leading to sector biases against broader European equity funds.

With 40% of portfolios on average, dividend funds are overweight in financials, utilities and telecoms, which naturally have higher levels of regulation compared to other sectors.

The sustainability of dividends in these sectors needs to be carefully considered, given recent examples of regulatory decisions (e.g. utilities in Germany, telecoms in France or banks throughout Europe).

Historically, dividend yields have offered a significant enhancement to performance, notably in a low return environment. High-dividend European stocks as defined by MSCI currently yield 2% more than broader indices. Yet, in the “new normal”, the consideration of the sustainability of dividends is key to performance and managers need to reconcile a quality growth focus with a dividend focus.

Traditional active fund managers tend to screen stocks by dividend yields, which can be backward looking. They need to develop a thorough strategic analysis covering barriers to entry, pricing power and structural sector trends. Although the above sectors were higher yielding in the past, there is no guarantee they will be in the future, with the possibility of excessive portfolio turnover occurring as funds rebalance to new high-yielding stocks.

While high-dividend ETFs almost invariably have significant exposure to financials, telecoms and utilities, ETF and index providers are certainly aware of this potential bias and include various mechanisms to help mitigate its impact and ensure dividend sustainability.

For example, the London-listed iShares EURO Stoxx Select Dividend 30 (IDVY), which has £313m in assets and offers exposure to 30 high-dividend stocks from the eurozone, includes only companies that have a non-negative historical five-year dividend-per-share growth rate and an average dividend to earnings-per-share ratio of less than or equal to 60%.

Similarly, the London-listed £460m iShares FTSE UK Dividend Plus ETF (IUKD), which offers exposure to 50 UK high-dividend companies within the FTSE 350 universe, selects and weights constitutes by using a forward-looking one-year forecast of the dividend yield.

Another increasingly popular range of high-dividend ETFs is the ‘Dividend Aristocrats’ suite from SSgA SPDR. This suite, which includes the SPDR S&P UK Dividend Aristocrats ETF (UKDV), the SPDR S&P Euro Dividend Aristocrats ETF (EUDI) and the SPDR S&P US Dividend Aristocrats ETF (UDVD) (all London-listed with other cross listings), incorporate criteria for dividend payout ratio and maximum indicated dividend yield, thereby excluding companies whose future dividend payout may be considered less sustainable.  To give preference to companies with higher dividend yields, the ETFs weight constituents by the stock’s indicated annual dividend yield. In addition, constituents must have followed a managed dividends policy of increasing or stable dividends for at least 10 consecutive years.