Be clear on what you want from dividend fund investingBy Kate McCaffery | September 27 2011 03:16PM
If you exclude money market fund sales, year-to-date gross sales of Canadian Dividend and Fixed Income Equity funds came in fourth overall as of June 30, behind the Canadian fixed income categories and the Canadian Equity Balanced category.A typical dividend fund’s investment in blue-chip, dividend-paying companies is enough for many people to make the products a core investment holding. The tax treatment makes Canadian dividend funds good for non-registered holdings too. Primarily, though, people are invested in the funds because of the income stream they sometimes provide and because there is evidence that dividend-paying stocks outperform over the longer term.
Unfortunately, they are also popular because a lot of investors are willing to invest in any product that has the words income or dividend in the title. This element of trendiness is also supported by demographics as a rather large segment of the population moves into their retirement years and begins to look for income-generating investments.
“There’s nothing wrong with wanting income,” says Alastair Kellett, senior fund analyst at Morningstar Canada. “The problem is when everyone wants it at the same time. It tends to get more expensive. If everyone is doing the same thing at the same time, it tends to push prices higher.”
The second problem is that a lot of people are interested in dividend products because of the widely-held notion that such investments are more secure, but also because of the oft-quoted and repeated research that says dividend paying stocks generally outperform in the long run.
“It’s a notion that has some research support,” but Dan Hallett, vice president and director of asset management at Highview Financial Group, also warns that clients and advisors need to be careful about taking theoretical works and assuming the same results will apply to different products. “Those studies on stocks in general, weren’t done on funds or other investment structures,” he says. “The studies were based on the market (how much dividends contributed to total returns), there hasn’t been a study that I know of which takes returns and subtracts fees, for instance.”
As for the security of such investments, it’s true that companies which pay dividends do tend to be more solid, but they’re not immune to market and regulatory pressures or public perception. Banks, for example, are a staple for dividend fund managers but a lot of banks today still have significant pressures to contend with.
John Shaw, vice president and portfolio manager at CI Investments, points out that banks are the biggest issuers of preferred shares. The quality is high but availability is declining, thanks to new Basel Committee requirements and new OSFI (Office of the Superintendent of Financial Institutions) rules about capitalization.
“The European and U.S. banks have all faced these issues. As a result, very few of them are paying decent dividends today.” Although he says Canadian banks are fairly valued, he adds that investor concerns are depressing share prices elsewhere. “I find valuations outside of Canada to be extremely compelling,” he says. “They’re not paying much in dividends. A lot of investors are waiting for that to come back before they buy.”
“A lot of global financials aren’t paying a dividend,” he adds. “That doesn’t mean they’re not dividend stocks – it’s completely natural for them to pay the dividends, and they will, but if you ran a screen for dividends, a lot of financials wouldn’t be in there today. They’ll all be (paying) in a year and a half but they’re a lot cheaper today.”
Still, even if the stocks are completely stable, the investments will still need to weather the moments (or months) when the broad market corrects itself. “If the broad market falls 40-60 per cent and dividend funds maybe fall 30-40 per cent, it’s a material difference but does it put the shares in a different risk category? I don’t think so,” says Mr. Hallett.
Companies are obviously making an effort to meet the demand for dividend products, sometimes spinning out dividend versions of their equity funds and sometimes by putting dividend in the fund’s name, even when the bulk of the fund’s portfolio is invested in non-dividend paying stocks.
Firms are deflecting criticism for this practice by saying they invest in certain companies in the hope that management will start paying dividends down the road. Many were caught holding Research in Motion shares for this reason.
Among those which can legitimately call themselves dividend funds too, there is a diverse and widely divergent range of mandates to choose from. One fund can favour preferred shares while the next manager invests primarily in common shares, for example. A manager’s use of preferred shares alone can impact investment suitability considerations – some managers use preferred shares as a balanced strategy alternative to bonds; others use them as a way to lock-in a predictable stream of income. Foreign content and distribution policies (which affect frequency, not to mention how distributions, if any, are classified for tax purposes) vary widely as well.
Then there is a question about fund size. Several dividend funds top Morningstar’s list of “giant” funds by asset size, which typically inspires questions about a fund’s ability to be responsive.
Mr. Kellett says that although they do give up some flexibility, size is less of a pressing concern with a lot of dividend funds because they invest in very large companies for a long time. “You’re not actively trading them which does allow you to get quite big without necessarily having a problem.”
In fact, Stuart Kedwell, senior vice president, portfolio manager and co-head of the Canadian equity committee at RBC Global Asset Management says size has its distinct advantages that are often overlooked. “There is a lot of information that comes to a large fund,” he says. “If we wanted to buy 50,000 or 100,000 shares and someone sold it to us quite quickly, we’ve learned a tremendous amount about what’s taking place in the market and about where we might buy our next 50-10,000.”
Like Mr. Shaw, Mr. Kedwell also says bullish sentiment in the market has moderated and valuations have improved recently.
When choosing the right dividend fund for investors, there is the usual list of recommendations – look at fees, the sponsoring firm, the management’s track record, their process and their consistency or adherence to it – with a few product-specific considerations to measure as well: For a client needing consistent distributions to fund living expenses, an income fund that invests in preferred shares could be the way to go. For a younger client who simply likes dividend paying investments, a broader, more flexible equity mandate might be more suitable.
“Do you want to generate some tax-preferred income or is a theme to latch onto in pursuit of your total return objectives?” There are trade-offs, says Mr. Hallett. A stock which pays more now will likely have less opportunity to grow in the future.
“I think the starting point is to be clear on why you’re interested in a dividend fund in the first place.”