The tendency to buy high-dividend stocks and underestimating the investment risks rarely ends well in the mid-term.
Investors seeking income for retirement should know that dividend yields are a starting point, not an ending point.
The financial companies who sell mutual funds and exchange-traded funds certainly do: There are dozens of dividend-dominated funds in Canada and the United States that deploy myriad formulas, screening criteria or judgment to provide a specialized slice of the yield-paying pie.
Some of the concepts are as simple as geographic or industry limitations. Other funds attempt to sort out the dividend payers by strength of dividend, quality of the company, track record, or a combination of all three. (In last week's retirement section, we examined the index behind the iShares S&P/TSX Canadian Dividend Aristocrats Index ETF, which chooses its membership by number of consecutive years of increased dividends.)
"Investors, when they hear dividend, may think stability, but that's not necessarily the case," says Christopher Davis, director of research at Morningstar Canada. "If the strategy is focused on really high-yielding stocks, the odds are it's also going to be investing in riskier stocks. These stocks have high yields for a reason, and it's because investors fear these stocks in the funds won't be able to sustain their dividends."
To give you a sense of some of the options, here's a sampling of Canadian funds and U.S. ETFs that have dividend strategies with a twist. These are not recommendations for all investors; what may be suitable for some may not be for others.
The iShares Dow Jones Select Dividend Index Fund, with more than $1.2-billion in assets, is Canada's largest dividend-based ETF. What helps make it "select" is that it requires stocks to have a positive or flat five-year dividend growth rate, which means any reduction during that time must be offset by increases. Companies must also have been profitable over the previous 12 months, and have average earnings per share (EPS) over the prior five years of at least 125 per cent of its dividend. (This is a "dividend coverage ratio," designed to measure whether the company is generating enough profit to cover its payouts.)
Interestingly, the index it's based on is perhaps less "select" than the Canada High Dividend 50 Index, another Dow Jones product that brings in dividend yield, three-year dividend growth, three-year EPS growth and the company's debt load as qualitative factors. The mutual fund from Marquest Asset Management Inc. that tracked the index was wound down last October, however.
Funds in Canada and the United States based on Standard & Poor's various Dividend Aristocrats indexes own stocks with a long track record of dividend increases. Other funds take a similar approach and layer on additional qualitative factors.
Vanguard's Dividend Appreciation ETF (VIG) uses Nasdaq's Dividend Achievers indexes, which combine annual dividend increases with other financial metrics that Nasdaq says are proprietary. There's a Canadian-domiciled version of this ETF that trades under VGG.
For a bit more transparency, investors can look to the Schwab U.S. Dividend Equity ETF, which uses the Dow Jones U.S. Dividend 100 Index. The Dow Jones index starts with longevity of dividend payments (at least 10 years) and then considers achievement in four metrics that it's happy to disclose: cash flow to total debt, return on equity, dividend yield and five-year dividend growth rate. Its expense ratio is a microscopic 0.07 per cent, and it gets five stars from Morningstar.
BMO Nesbitt Burns Inc.'s family of dividend ETFs incorporate rules that, in the firm's view, mean its ETFs "will not be subject to buying into deteriorating companies based solely on yield screening." The funds, which come in Canadian, U.S. and international versions, require a positive or flat three-year dividend growth rate. Then, BMO grades stocks on their payout ratios, comparing dividends paid to operating cash flow and assigning the best grades to companies with payout rates of less than 50 per cent.
Once stocks make the cut, they're weighted in the fund by yield, with the highest yielders receiving the greatest weighting. Over the past three years, however, that's left the BMO Canadian Dividend ETF exposed to the energy sector, and the fund's performance has underwhelmed, says Mr. Davis. It gets one star from Morningstar.
RBC Global Asset Management introduced a series of dividend ETFs in 2014 with perhaps even more unusual criteria. The RBC Quant Canadian Dividend Leaders ETF (RCD) , like its U.S. and international brethren, use uses a number of proprietary formulas for choosing its members, and then also uses a proprietary method for weighting stocks that de-emphasizes the most valuable companies in the fund. The funds are too new to receive Morningstar ratings, says Mr. Davis, who likens them to actively-managed ETFs.
Two of the top actively-managed Canadian dividend-oriented mutual funds are the Dynamic Dividend and Dynamic Equity Income funds, which receive four and five stars, respectively, from Morningstar. As with most mutual funds, the fees are higher than for ETFs – the management expense ratios are 1.31 per cent and 1.1 per cent for the adviser-sold Series F shares.
While the extra cost is a downside, Mr. Davis says, "active managers can avoid the potential potholes that a rules-based approach will have a more difficult time avoiding. There aren't many, though, we can find who do this particularly well."
David Milstead