Dividend investing remains one of the most popular strategies among Canadian investors thanks to the concentration of high-yielding stocks in our domestic stock market.
Many of the dividend payers in Canada tend to come from large-cap players in a few select industries: banking, insurance, pipelines, telecoms, railways, and utilities. These "blue-chip" holdings often make up the top ranks of leading Canadian market indices as well.
For example, the U.S.-listed Vanguard Total Stock Market Index Fund ETF (VTI) currently yields 1.53%. In comparison, the Canadian-listed Vanguard FTSE Canada All Cap Index ETF (VCN) offers a 12-month trailing yield of 2.95%, nearly double that of VTI.
In addition, dividends from most publicly traded Canadian corporations are subject to favorable taxation when held outside of a tax-advantaged account like an RRSP or TFSA. Investors holding ETFs that spit out eligible dividends are able to claim federal and provincial tax credits.
Canadian ETF providers have taken advantage of this interest, releasing dozens of dividend ETFs with varying strategies and styles. Today, we'll be focusing on domestic equity dividend ETFs, which largely come in two forms: passive indexing and factor-based (also known as "smart beta").
Keeping it passive
Passive Canadian dividend ETFs achieve exposure to dividend stocks by tracking an external benchmark index. These indexes set out the rules for which stocks can or cannot be included, and usually include restrictions based on yield, market cap, sector, and liquidity. In general, passive index dividend ETFs can be separated into two categories based on their strategies.
The first strategy focuses on Canadian stocks with higher-than-average yields. This involves screening for stocks that have recently paid or are forecasted to pay above-average yields. This can be done in comparison to a broad-market index or a sector index of peer companies. ETFs in this category include:
- Vanguard FTSE Canadian High Dividend Yield Index ETF (VDY)
- iShares Core S&P/TSX Composite High Dividend Index ETF (XEI)
The second strategy identifies Canadian stocks with a history of increasing dividend payments consecutively. This approach is known as "dividend growth". ETFs that implement these strategies tend to have lower present yields, but a potentially higher rate of growth.
- iShares S&P/TSX Canadian Dividend Aristocrats Index ETF (CDZ)
- Invesco Canadian Dividend Index ETF (PDC)
Screening for factors
"Smart beta" ETFs represent a hybrid between traditional passive indexing and true active management. These ETFs attempt to isolate attributes predicted to influence excess returns, called "factors" by implementing systematic, rules-based, quantitative methodologies.
A smart-beta dividend ETF is therefore one that screens potential dividend stock holdings for additional factors. A common one seen in Canadian ETFs is the "quality" factor, which is actually comprised of two separate Fama-French factors:
- Investment: Screens for companies that make conservative investments
- Profitability: Screens for companies with strong operating profitability.
Historically, both of these factors, and especially profitability, have contributed to the outperformance of "quality" stocks over their peers. Take a look at this article from the CFA Institute, which notes:
"Over all economic cycles since 1963, going long high quality stocks, or profitable firms, and shorting their low quality, unprofitable counterparts has been a great investment strategy. And the power of the factor has not diminished."
Interestingly enough, Vanguard found that both its U.S. high dividend yield and dividend growth ETFs had exposures to multiple factors:
"The performance of these strategies has been time-period dependent and largely explained by their exposure to a handful of equity factors: value and lower volatility for high-dividend-yielding equities and lower volatility and quality for dividend growth equities."
To me, this makes sense intuitively. In order to pay a sustainable and growing dividend, a company must be profitable and have strong financial ratios. These companies tend to be better long-term investments. In a roundabout way, investing in dividend ETFs could help investors build more robust equity holdings, especially with additional factor screens.
However, before you draw the conclusion that "dividends = good", I'd like to reiterate something I noted in an earlier article on dividend ETFs:
"Dividend investing doesn't perform well because of the dividends paid – it's because dividend stocks tend to be more profitable, undervalued, and higher quality on average. Dividend growth (consecutive payouts and increases) just tends to be an incidentally correlated criteria for screening these factors. Investors could arguably achieve the same results by tilting their portfolios using smart-beta funds that screen for value, profitability, and quality. A dividend growth portfolio is basically a bunch of large-cap value stocks with good profitability and sustainable investments, but you could achieve the same results without focusing on dividends, which tends to exclude otherwise fantastic stocks that do not pay them."
That being said, if you're still keen on investing in dividend ETFs that utilize a factor screen, the following funds may be suitable:
- BMO (TSX:BMO) Canadian Dividend ETF (ZDV) – rules-based strategy that considers a three-year dividend growth rate, yield, liquidity, and payout ratio.
- iShares Canadian Select Dividend Index ETF (XDV) – rules-based methodology that screens for dividend growth, yield and payout ratio
- iShares Core MSCI Canadian Quality Dividend Index ETF (XDIV) - selects stocks with strong overall financials, solid balance sheets and less volatile earnings.
- CI WisdomTree Canada Quality Dividend Growth Index ETF (DGRC) – fundamentally-weighted index of dividend stocks based on 3–5-year earnings growth estimates, low debt, and stable earnings.
This content was originally published by our partners at the Canadian ETF Marketplace.