research

When I was a student working on the trading floor, I noticed my colleagues still held on to bond basis books, which provided tables of yield, coupon and price information for bond traders before we could rely on calculators or Bloomberg.

These particular volumes covered interest rates up to 4%. Interest rates were at 6% in the early 1970s, but one trader said they kept the books around “just in case rates fall.”

They didn’t for thirty years (yields only fell intermittently from 1941 to 1981). In fact, some traders never saw a sustained rally in the bond market for their entire careers. Contrast that with the last 32 years of falling interest rates, and you can understand why a generation of investors has a skewed view of history.

That generation was the baby boomers, who are today’s retirees. Those folks are fuelling today’s growing appetite for income, making dividends and dividend ETFs popular. The fact that dividend yields exceed bond yields seems unusual to many. But, from 1872 to 1956, the dividend yield of the S&P 500 stock index (or equivalent) generally exceeded the 10-year U.S. Treasury bond. This makes sense because stocks are riskier than bonds, and higher dividends help attract capital.

In 1938, Harvard economist John Burr Williams proffered discounted cash flow as a way to value securities. University of Toronto professor Myron Gordon and his colleague Eli Shapiro introduced a form of dividend discount model (DDM) in 1956, building on Williams’ work.

Table 1: Broad Canadian passive ETFs ranked by factor

Cost

Diversification

Liquidity

Tax efficiency

Tied 1st VDY

1st ZDV

Tied 1st CDZ

1st HAL

Tied 1st XEI

Tied 2nd FDY

Tied 1st XDV

2nd FDV

3rd ZDV

Tied 2nd ZCN

3rd VDY

3rd CDZ

4th RCD

4th HAL

4th XEI

4th VDY

Tied 5th FDV

Tied 5th FDV

5th DXM

5th RCD

Tied 5th PDC

Tied 5th PDC

6th ZDV

6th FDY

The DDM suggests that a stock was worth the discounted present value of the future stream of its dividends. The period of sustained economic growth in the 1960s, and afterwards, made forecasting future dividends more difficult, as many corporations chose capital reinvestment over dividend payout.

However, the principle remains important. Several dividend ETFs follow the idea that the ability to grow dividends, not just current yield, is an integral part of selecting securities.

So, look to dividend ETF mandates to understand how dividend growth is incorporated if you’re building a long-term portfolio.

We evaluated Canadian dividend ETFs using our ETF Screener as the arbiter for cost, liquidity, diversification and tax efficiency, supplemented by researching current holdings and data from ETF sponsor websites.

Cost

Not surprisingly, dividend ETFs are more expensive than passive broad market ones (see “Canadian equity ETFs” AER November 2015). The indices are more customized; they have quantitative drivers, like cash flow coverage, and can be weighted in a variety of ways.

Different criteria lead to different exposures and results. Further, rebalancing by weighting schemes or changing data can lead to higher transaction expenses than with their cap-weighted cousins. Using management cost, VDY and XEI are tied for lowest cost at 0.20%. Then comes ZDV at 0.35%, and RCD at 0.39%. But cost should not be the only consideration. Year to date, higher-cost FDV, HAL and RCD performed better than lower-cost alternatives (see Table 2). (Disclosure: the author’s firm sub-advises for Horizons ETFs.)

Liquidity

ETF traders know that liquidity is an increasingly important factor, particularly with hybrid strategies that may include smaller companies. We found liquidity was good for Canadian dividend ETFs because banks, which are highly liquid, are an important component. This has consequences for diversification and concentration (see Table 1).

XDV and CDZ were highest ranked using daily trading volume and bid-asked spread sampled every ten minutes for the last 21 days (as of October 31, 2015). They happen to be the two largest ETFs in terms of outstanding market value. VDY and XEI followed in the third and fourth spots.

Diversification

The purpose of diversification is to minimize risk. Diversification is a function of the number of holdings, and the uncorrelated nature of those holdings. In Canada, it’s difficult to escape the looming shadow of financial and energy companies. The Screener calculates the stock-specific risk for each ETF. Lower residual stock-specific risk means better diversification. XDV, with its 57.8% financials weight (9.2% energy) and VDY, with 63.7% financials (14.9% energy), showed poorly in this category.

TABLE 2: Canadian dividend ETFs by descending market value

 

Symbol

Mgt Fee

Dividend

Yield

Financial

Energy

Performance YTD, Oct 31

Performance,
1 year*

Performance,
3 year*

iShares Canada Select Dividend

XDV

0.50%

4.55%

52.8%

9.2%

-7.88%

-8.26%

6.20%

iShares S&P/TSX Canadian Dividend Aristocrats

CDZ

0.60%

3.71%

27.5%

16.8%

-6.11%

-3.80%

6.85%

BMO Canadian Dividend

ZDV

0.35%

4.60%

34.5%

23.0%

-7.81%

-8.42%

4.10%

iShares Core S&P/TSX Comp. High Div.

XEI

0.20%

5.42%

31.3%

27.9%

-9.19%

-12.06%

3.37%

Vanguard FTSE Canadian High Dividend Yield

VDY

0.20%

3.90%

63.7%

14.9%

-6.81%

-7.65%

8.12%

RBC Quant Canadian Dividend Leaders

RCD

0.39%

4.27%

54.6%

20.6%

-5.05%

-7.34%

N/A

Powershares Canadian Dividend

PDC

0.55%

4.91%

60.2%

13.0%

-6.95%

-3.04%

10.07%

First Asset Morningstar Canada Div. Target 30

DXM

0.60%

4.49%

27.3%

26.7%

-8.55%

-11.09%

3.87%

Horizons Active Canadian Dividend

HAL

0.70%

3.01%

17.7%

16.6%

-3.05%

1.32%

9.54%

First Trust AlphaDEX Cdn. Dividend Plus

FDY

0.60%

4.35%

33.5%

24.1%

-7.23%

-11.43%

N/A

First Asset Active Canadian Dividend

FDV

0.55%

3.22%

47.0%

3.2%

-0.57%

0.69%

N/A

First place is ZDV, and FDY is tied for second with CDZ. HAL comes in fourth.

Tax efficiency

The Screener defines tax efficiency as the percentage of total return retained after taxes are paid and before liquidation. It’s calculated as the ratio of total return after tax to total return before tax, assuming that 35% tax is paid on dividends and the position is not liquidated.

See Table 1 for full rankings by factor.

Summary

ETFs offer diversified exposure to dividends, but understanding industry and sector concentration, and balancing cost with other factors, are important considerations. We rarely use past performance as a criteria because there’s no guarantee it will be repeated. But, note that FDV with only 3.2% in energy, and HAL with only 17.7% in financials enjoyed better price performance over the past year than others in this category. So, check sector exposures.

Source: PÜR Investing. Performance for periods ending October 31, 2015. *Annualized performance.

Mark Yamada is President of PÜR Investing Inc., a registered portfolio manager and software development firm. Disclosure: PÜR Investing Inc. sub-advises for, and provides risk-based model portfolios to, Horizons ETFs.

Originally published in Advisor's Edge Report

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