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

Major flaw

One major flaw of many standard dividend ETFs and index funds 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 index funds. 

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 index funds underperformed the market by a wide margin.

Given this kind of underwhelming performance, I’d treat passive dividend funds 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.

The post UK dividend ETFs: why I believe investors need to be careful appeared first on The Twelfth Magpie.

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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.

With that in mind, today I want to highlight two dividend funds that I’d be happy to buy for my ISA now.

Evenlode Income

Evenlode Income is an under-the-radar dividend fund from West Oxfordshire-based, boutique investment firm Evenlode. It currently yields around 3% (paid quarterly) and is available on the Hargreaves Lansdown platform with an annual fee of 0.9%.

What I like about this particular fund is that portfolio managers Hugh Yarrow and Ben Peters follow a Warren Buffett-esque approach to investing, looking for high-quality businesses that have strong competitive positions and generate high returns on capital. They also look for companies that offer yield today, as well as the potential for dividend growth in the future. I see this as an excellent long-term strategy. Top holdings at 30 September were Unilever, RELX Group, Reckitt Benckiser, Sage and Diageo.

Another attribute of this fund that I like is that it has the flexibility to invest 20% of the portfolio in international stocks. This means that it has a larger investment universe than most other UK dividend funds. Given that there are plenty of fantastic dividend stocks listed overseas, I see this as a big advantage. 

Performance-wise, Evenlode Income has done very well in recent years. According to Hargreaves Lansdown, over three years the fund has returned 41%, while over five years it’s returned 81%. By contrast, the FTSE 100 has returned approximately 24% and 37% over three and five years respectively.

All things considered, I see this as one of the best dividend funds on the market today.

Franklin UK Rising Dividends

Another one that I rate very highly is Franklin Templeton’s UK Rising Dividends fund. It currently yields around 3.7% (paid bi-annually), and is available on Hargreaves Lansdown with a low fee of just 0.55% per year.

The objective of this fund is to outperform the FTSE All-Share index over a three to five-year period while also generating a growing level of income. Like Evenlode Income, it tends to invest in companies that offer yield today and the potential for dividend growth in the future. Top holdings at 30 September were Royal Dutch Shell, Diageo, Unilever, GlaxoSmithKline and RELX Group.

Looking at historical performance, Franklin UK Rising Dividends has a good track record. Over three years and five years, it has returned 27% and 54% respectively, meaning it has outperformed the FTSE 100 (quite comfortably over five years).

Given its performance track record and its low fee, I see it as a top option for those looking for a UK dividend fund.

The post Two FTSE 100-beating dividend funds I’d buy for my ISA today appeared first on The Twelfth Magpie.

More reading

• With a yield of 6.8% and a P/E ratio of 12.1, is this a dirt cheap FTSE 250 stock to consider?
• Will SpaceX, Nvidia, or Alphabet be the first $10trn stock?
• Up 95%! This FTSE 100 stock’s outperformed Nvidia over the past year
• With a 9.3% yield, is this an amazing opportunity to consider buying dirt-cheap Taylor Wimpey shares?
• How much do you need in a Stocks and Shares ISA to aim for £375 a week in retirement?

Edward Sheldon owns shares in Unilever, Diageo, Sage, GlaxoSmithKline, Royal Dutch Shell, and has a position in the Franklin UK Rising Dividends fund. The Motley Fool UK owns shares of and has recommended GlaxoSmithKline and Unilever. The Motley Fool UK has recommended Diageo, Hargreaves Lansdown, RELX, and Sage Group. 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.