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Buckle Up for a Bumpy Ride With Foreign Dividend Funds

Look out for greater volatility and additional tax issues.

Patricia Oey, ETF analyst, 08/09/2011

Investors know that dividends are a key component of long-term returns. Indeed, more than half of the real return provided by U.S. stocks in the past century came from dividends. In the international developed markets more companies pay dividends and their yields are higher than U.S. companies'. As a result, foreign large-blend exchange-traded funds and foreign dividend ETFs each have yield premiums of about 100 basis points relative to their U.S. counterparts. In addition, because dividends are more common across foreign equities, foreign dividend funds tend to be better diversified across sectors. However, while dividends tend to suggest safety, we highlight that there are some risks that are specific to international dividend funds that do not exist for domestic dividend funds.

Greater Short-Term Volatility
In the past 15 years, a dividend-focused strategy produced better risk-adjusted returns than a market cap-weighted strategy in the World, EAFE, Europe, and Pacific equity categories (see Table 1). In the United States, dividend-oriented strategies are not more volatile market-cap-weighted strategies. Outside the U.S., however, the risk-parity paradigm does not exist. Dividend-oriented strategies internationally are generally more volatile than their market cap-weighted counterparts, and that differential has widened in the past few years.

One reason for this is the fact that foreign companies are not as reluctant to cut dividends when compared with U.S. companies. And following the 2008 global financial crisis, many foreign companies did cut their dividends. In 2009, the U.S.-focused iShares Dow Jones Select Dividend Index DVY saw its dividend fall by 31%, while iShares Dow Jones International Select Dividend Index IDV saw its dividend fall by 62%.

Another issue to consider is that currency fluctuations have a greater impact on volatility in the short term than in the long term--exchange rates in the long term tend to be mean-reverting. As such, the gap in the three-year standard deviation between the S&P 500 and the international indexes was wide relative to the gap in the 15-year standard deviation. Currency volatility in the past three years was also further amplified by the financial crisis. Those who invest in foreign dividend funds for a steady income stream would not have gotten it in the past few years.

 

Mind the Tax Complications
Investors in international dividend funds also face additional tax issues, including withholding taxes on dividend income. On average, investors in a broad international fund (such as iShares MSCI EAFE Index EFA) and international dividend funds experienced annual withholding rates of around 9% in the past few years.

The U.S. government, in order to prevent double taxation, allows investors to claim this withholding amount as a tax credit. At the end of the year, fund companies provide investors with tax documents, which list the amount of foreign taxes paid per share. Investors can aggregate the amount of foreign taxes paid across their international funds, and claim it as a tax credit on Form 1040, up to $300 for single filers, and $600 for joint-filers. Those who have paid more than $300 in foreign taxes will have to complete the more cumbersome Form 1116 to claim a credit. The one upside of all this paperwork is that investors would actually realize a yield that is slightly greater than what is quoted by Morningstar (as well as other data providers), as international funds' dividend yields are calculated net of the foreign taxes withheld. But, practically speaking, investors lose out on the opportunity to efficiently reinvest the withheld dividends. We also note that claiming a tax credit only works for funds held in taxable accounts. Because Uncle Sam does not take his cut from funds held in tax-deferred accounts, investors cannot claim a credit on funds held in 401(k)s or IRAs.

Then there is the issue of U.S. taxes and qualified dividends. Foreign dividends are considered qualified (for the 15% rate) if they are paid by a company domiciled in a country that has a tax treaty with the U.S. and if the fund has met the holding-period requirement for the stock. Most countries have a tax treaty with the U.S. but notable exception include Singapore, Taiwan, Malaysia, Hong Kong, Brazil, and Chile. Dividends paid by companies from these countries are subject to regular income-tax rates. As for the holding-period requirement, if there is a surge in creations, some holdings will not have qualified dividends (this occurs in all equity ETFs, not just international ETFs). Investors can find out which of their dividends are qualified by checking the tax documents issued by the fund providers at the end of the year.

Sifting Through the International Dividend ETFs
At this time, there are a handful of international dividend ETFs that have three-year track records and reasonable bid-ask spreads (there are currently no ETFs that track MSCI's international high-yield indexes, which anchor country weightings within a regional index). The return profiles of these funds are fairly different because they have very different country weightings and sector weightings, and there are differences in the construction methodologies of their underlying indexes. One interesting thing to note that is that most international dividend funds are underweight Japan, which on one hand resulted in higher volatility (as Japan is a relatively lower-volatility country) but also higher returns (because Japan failed to rally after the 2008 global economic crisis).


Source: Morningstar Direct. Data as of June 29, 2011

Those looking for a lower-volatility international dividend ETF can consider PowerShares International Dividend Achievers PID, which weights its holdings by dividend yield while only holding companies that have increased their annual dividends for five or more consecutive years. Other dividend-yield-weighted ETFs, such as SPDR S&P International Dividend DWX and iShares Dow Jones International Select Dividend IDV, employ less-stringent selection criteria, which results in riskier portfolios.

WisdomTree International LargeCap Dividend DOL is an attractive alternative because it weighs its components based on dividends paid as opposed to dividend yield, which has resulted in a less-volatile portfolio of larger and stabler firms.

Those concerned about the tax issues can consider iShares MSCI Australia Index EWA and iShares MSCI United Kingdom Index EWU. The obvious downside to these choices is the lack of geographic diversification. But both funds are highly liquid, hold many high-quality multinational companies, pay out qualified dividends, and are subject to very low or no foreign-withholding taxes. The Australia fund, with an attractive dividend yield of 4.1%, has a 42% weighting in financial companies--mainly Australia's healthy big four banks--and a 29% weighting in materials companies, which are leveraged to emerging-markets growth. The long-term volatility of Australian stocks (in local currency) is even lower than that of the S&P 500, but EWA has greater volatility due to currency effects. During the past few years, the appreciation of the Australian dollar has been an additional source of return for U.S. investors. As for the tax issue, in the past three years, the foreign-withholding tax on EWA dividends has been about 1% to 2%.

The U.K. fund holds familiar, high-quality names such as Vodafone VOD, GlaxoSmithKline GSK, and AstraZeneca AZN--companies with good exposure to global growth. And while shareholders of EWU were subject to a 2% withholding tax in 2010, this was a one-off, as the U.K. does not have withholding taxes. So those who want to avoid foreign-withholding taxes can consider EWU for foreign large-blend exposure. However, like most foreign large-blend funds, it has high exposure--20%--to financials, which could be negatively impacted by the ongoing European sovereign debt crisis.

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Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

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