Shares of subprime lender Provident Financial, a favourite of star fund manager Neil Woodford, have dived nearly 70% following a profit warning, the resignation of its CEO and the cancellation of its dividend. While the stock is held in many well-known equity income funds, including strategies from Invesco Perpetual’s Mark Barnett plus actively managed funds from Jupiter, Rathbones, M&G and Aberdeen, it is notably absent from the BMO MSCI UK Income Leaders UCITS ETF (ZILK) and SPDR S&P UK Dividend Aristocrats UCITS ETF (UKDV) – two smart beta ETFs that deploy rules-based screens to achieve dividend sustainability.
Provident Financial’s shares closed down 65.7% on Tuesday, impacting the performance of many actively managed equity income mutual funds.
Provident Financial had been a significant dividend-payer and among the top 50 dividend-yielding companies in the FTSE 350, but, in a flash, withdrew its interim dividend and scrapped a previously promised full-year dividend.
Woodford’s £9.8 billion Woodford UK Equity Income Fund will take a hit as it had Provident as the fourth largest holding, at 4.6%, as of 30 June 2017, according to the fund’s factsheet.
Barnett’s £800m Invesco Perpetual UK Strategic Income Fund had Provident as the fifth largest holding (2.7%) as of the end of July.
So how did the low cost ETFs, which charge fees of just 0.35% and 0.30% respectively, manage to avoid the stock when expensive, so-called star managers lapped it up?
BMO’s ZILK tracks an index called the MSCI UK Select Quality Yield Index. It has a two-step process which starts first by identifying the top 50% of constituents within the MSCI UK Index with the highest Quality score based on three main fundamental variables: return on equity (ROE), year-over-year earnings growth and financial leverage. The second step is to identify the 50% of the securities identified through the first step which have the highest dividend yield.
According to Terry Wood, head of ETF portfolio management (EMEA) at BMO Global Asset Management, Provident Financial fell at the first hurdle. “The MSCI Select Quality methodology used for our BMO MSCI UK Income Leaders ETF aims to avoid yield traps by screening for quality first, with an emphasis on stable earnings, high return on equity (ROE) and low financial leverage. Although Provident Financial screens well on ROE, it does not score so well on leverage and is therefore ineligible for the second filter which is ranked on dividend yield,” said Wood.
Meanwhile SPDR’s UKDV avoided owning Provident owing to the firm’s lack of a satisfactory 10-year dividend record. The ETF, which is linked to the S&P UK High Yield Dividend Aristocrats Index, tracks the performance of the 30 highest dividend-yielding UK companies within the S&P Europe Broad Market Index (BMI) that have followed a managed dividends policy of increasing or stable dividends for at least ten consecutive years. Provident once again tripped up at the first hurdle.[pullquote]”It is great to see rules-based investing in the form of smart beta ETFs being put to the test and coming out on top of quite a few of the active fund managers”
– Irene Bauer, CIO, Twenty20 Investments[/pullquote]
Commenting on the success of the two dividend ETFs, Irene Bauer, chief investment officer at discretionary fund manager Twenty20 Investments, said: “It is great to see rules-based investing in the form of smart beta ETFs being put to the test and coming out on top of quite a few of the active fund managers.”
As an aside, Bauer also noted that “this could be an early sign of a UK version of subprime. With consumer credit having risen by £100bn to £230bn over the last four years, and to its near all-time high in 2008, it is no wonder that the Bank of England has warned about an overheating consumer credit market.”
ZILK has assets under management (AUM) of £28m, UKDV has £100m. Both are available on the London Stock Exchange.