Investing with Dividend Funds (by David Stanley)

Here’s another guest post by the original Beating the TSX author, David Stanley.  In his last post, he laid out the case for dividend investing in general.  Here he offers his thoughts on investing with dividend funds: mutual funds vs. ETFs . . . How do they stack up against each other?  Against the BTSX strategy?

This blog is founded on the premise that over the long run investing in dividends is the best decision a Canadian investor can make, but is it true? Sure, my column in the Canadian MoneySaver providing 28-year returns for the Beating The TSX portfolio showed a significant increase over the index, but maybe the sharp rise in ETFs (exchange traded funds), particularly dividend-based ETFs has rendered our strategy obsolescent.

ETFs should be taking over . . . right?

You might think that ETFs have completely taken over the investment market in Canada given all the attention they have attracted. I was surprised to find how little penetration ETFs have made here. The Investment Funds Institute of Canada <https://www.ific.ca/en/stats/> tells us that in March, 2019 total mutual fund assets equaled 1,534 billion$, while total ETF assets stood at 173 billion$, just around 10% of the mutual fund total.

Why am I surprised? Two major reasons:

Reason #1

First, the average MER (management expense ratio) for Canadian mutual funds ranges from 2.1 to 2.4% depending on the fund company, while the average MER for Canadian ETFs is much less, varying from 0.22 to 0.44%. Over a lifetime of investing this can make a very big difference to your net wealth.

Reason #2

I can hear you saying “Yes, but ETFs are designed to just match an index while mutual funds can beat them”. Certainly, that is the theory but does it work out that way? The second factor is explained by SPIVA, an acronym for ‘S&P Indices Versus Active’. It is a division of the S&P/Dow Jones Indices that measures the performance of actively managed mutual funds versus the performance of their benchmarks. The most recent Canadian report <https://us.spindices.com/documents/spiva/spiva-canada-scorecard-mid-year-2018.pdf> tells us how well Canadian mutual funds have done (Tables 1, 2).

Table 1. % of Cdn. funds underperforming the index
CategoryIndex5 Yr. (%)10 Yr. (%)
Cdn. Eq.TSX Composite89.788.9
Cdn. Div.Div. Aristocrats60.5100
Ref. SPIVA 2018
Table 2. Survivorship of Cdn. funds
Category# At startSurvivorship (%)
5 Yr.10 Yr.5 Yr.10 Yr.
Cdn. Eq.78904937
Cdn. Div.43647045
Ref. SPIVA 2018

These are some quite revealing data. They tell us that mutual fund investors have to pay a higher MER in order to have a big chance of underperforming the index. Of course, in theory, ALL ETFs underperform the index, but the degree of underperformance should be equal to the MER, less than half a percent.

And don’t forget survivorship bias

Survivorship is often ignored when viewing mutual fund results. We tend to look at the universe of mutual funds and think that the currently active funds are a true representative of fund managers ability when, in fact, the data don’t include those managers who have tried in the past and failed and, as Table 2 shows, a large percentage do not succeed.

To summarize, two major factors, high MERs and underperformance, make ETFs more attractive to investors than mutual funds.

What about dividend ETFs? XIU vs VDY

Now, let’s take a look at two popular Canadian ETFs, one that mirrors the S&P/TSX 60 Index (XIU) and one that emphasizes dividend-paying companies (VDY). Table 3 gives the characteristics of each fund.

Table 3. Characteristics of XIU and VDY as of 4/26/19
FactorXIUVDY
IndexTSX 60Hi Div. Index
Total Return (%) YTD16.716.2
5-Yr.6.155.17
10-Yr.9.09N/A
MER (%)0.180.22
Yield (%)2.93.8
AUM* (million$)8,606517
DRIP**?
*Assets Under Management
**Dividend Reinvestment Plan

XIU is an ETF designed to duplicate the performance of the S&P/TSX 60 Index, Canada’s version of a blue-chip index; it holds 60 Canadian large-cap companies and has been around since Sep 28, 1999.

Table 4: The top 10 holdings of XIU:
    
COMPANYSECTOR%
ROYAL BANK OF CANADAFinancials8.3
TORONTO DOMINIONFinancials7.6
ENBRIDGE INC.Energy5.7
CANADIAN NATIONAL RAILWAYIndustrials5.1
BANK OF NOVA SCOTIAFinancials4.9
SUNCOR ENERGY INC.Energy3.9
BANK OF MONTREALFinancials3.7
TRANSCANADA CORPEnergy3.3
BROOKFIELD ASSET MANG.Financials3.1
BCE INC.Communication3
Total holdings = 60 stocksTOTAL48.40%

VDY hasn’t been going for as long as XIU; the inception date is November 2, 2012. Both XIU and VDY have DRIP plans that allow investors to reinvest their dividends at no cost. The top 10 holdings of VDY are:

Table 5: The top 10 holdings of VDY:
  
COMPANYSECTOR%AGE
ROYAL BANK OF CANADAFinancials15.4
TORONTO DOMINIONFinancials14.2
ENBRIDGE INC.Energy10.2
BANK OF NOVA SCOTIAFinancials9.3
BANK OF MONTREALFinancials6.8
TRANSCANADA CORPEnergy5.8
CIBCFinancials5
MANULIFE FINANCIAL CORP.Financials4.8
SUN LIFE FINANCIALFinancials3.3
PEMBINA PIPELINE CORP.Energy2.6
FORTISUtility2.2
Total holdings =62 stocksTOTAL79.60%

Which of these 2 ETFs is the best investment based on the available data? I would have to pick XIU for a couple of reasons; perhaps the most important is better diversification. As you can see VDY is overloaded in financials (about 2/3 of the fund as compared to 1/3 for XIU). Even though VDY has a higher dividend yield, XIU has a better performance record because, I think, of its diversification.

TURF: a template for diversification

This is the first point about investing in Canadian dividend stocks; it is difficult to get a well-diversified portfolio. Financials and utilities/energy stocks usually outweigh the remaining sectors as we see with VDY. What to do? My approach has been that if you are going to invest in dividend stocks you should make a portfolio out of four sectors: Telecoms, Utilities, Real Estate (REITS), and Financials (TURF stocks), keeping as even a weighting among all sectors as possible. By doing this it can force some of your selections out of the TSX 60 Index since real estate is not represented in that index except as a part of the Brookfield Asset Management conglomerate.

If you’re going to choose an ETF, choose XIU

Overall, I would pick XIU as my favourite individual ETF. A low MER combined with good diversification (for Canada) and strong results make this a superior product. And, importantly, it has a DRIP program so that dividends can be reinvested in new shares at no cost to you. Do I think dividend ETFs will supplant dividend stock portfolio such as BTSX? No, I am of the opinion that our methodology will be around for a long time.

Beating the TSX has lived up to it’s name

XIU is the standard against which we measure the performance of our BTSX 10-stock portfolio. Our results of beating the XIU over the 28 years I was involved with the column resulted in beating the index 68% of the time with an average out-performance of about 25%. With just a little effort one can stand a good chance of outperforming the index with a stock portfolio that carries no MER and leaves decisions of buying, selling, and reinvestment up to you rather than an investment company. As long as BTSX continues to outperform it will be the best choice for dividend investors. Dave

Matt’s Summary
1.  Dividend mutual funds have high fees and a record of under-performance – ETFs are superior
2.  Comparing XIU and VDY, the former has greater diversification and better historical returns
3.  The BTSX strategy has outperformed XIU over the long term, but XIU is a solid alternative especially for those with less money to invest (under ~30k)
4.  BTSX may be used as a core strategy while diversifying using the “TURF” principle (telecoms, utilities, real-estate, financials)

5 Comments

  1. Great Article Dave and easy to understand – thank you and thank you Matt for facilitating. I am also super impressed with the current S&P 60 index values that can be copied to XL. I own at least 15 of the index including the “top ten” I have hesitated DRIP because of the complicated ACB calculations. My online broker account does not seem to track this accurately.

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