Everybody loves a good dividend payment – the feeling of seeing a cash balance land in your account every quarter from holding high-quality, long-term stock picks is hard to beat.
In bull markets, reinvesting the dividends and letting them compound plays a huge role in boosting total returns. In bear markets, the green from the dividend payment can be a much-needed psychological boost for investors on the brink of capitulating.
Thankfully, Canada's stock market is full of top-notch dividend stocks, mostly from the financial, energy, and utilities sectors. These are mostly large or mega-cap blue-chip stocks that represent the top holdings in the S&P/TSX 60. Some of these stocks have paid dividends consecutively and increased payouts for 20+ years, qualifying them as "dividend aristocrats".
Does dividend growth investing work?
The short answer here is "yes, but not for the reasons you may imagine". To sum it up, dividend investing works not because stocks pay dividends, but because dividend paying stocks also tend to provide excess exposure to alpha-generating Fama-French risk factors, such as value, profitability, and quality.
To understand, we have to examine a paper from 1961 from Merton Miller and Franco Modigliani titled "Dividend Policy, Growth, and the Valuation of Shares". In this paper, Miller and Modigilani advanced their "dividend irrelevance theory", which argued that investors should be indifferent between a $1 dividend (which causes the stock price to drop by $1, all else being equal) versus receiving $1 by selling shares.
This makes sense. Dividends are not "magical money printers", that's a common mental accounting fallacy used by dividend investors. They are paid out of the after-tax retained earnings of the company. A company pays dividends when it has no better use for the cash (i.e., they cannot use it for further growth), and thus elects to return excess profits to shareholders.
However, dividend paying stocks tend to be from higher quality, lower-valuation, more profitable companies. That is, aside from a few with unsustainably high payout ratios, dividend generating companies tend to be good business. After all, they must have done something right to have a surplus of cash to give back to shareholders, right?
And that is the revelation here. Dividend growth 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.
Canadian dividend ETFs
This is just my opinion, but if I was a Canadian dividend growth investor, I would select funds not based on their total return or dividend yield, but on their exposure to the value, profitability, and quality risk factors. This can be done via a simple Five-Factor Fama-French Regression Analysis.
Of course, I could gain exposure via smart beta funds, but from what I've seen, these funds tend to be hit-or-miss based on their methodology and rules, with poor factor loadings in many cases. In my experience, for factor investing, U.S. ETFs from Dimensional Fund Advisors or Avantis Investors are the gold standard. Ironically, existing passive Canadian dividend ETFs tend to also provide good exposure incidentally at a much lower cost.
I've selected a few Canadian equity dividend ETFs using the NEO ETF screener below. Pay attention to their underlying indexes. Some of these ETFs target dividend growth while others target high present yields. The former is preferable for total returns, while the latter is best for passive income needs.
1. Vanguard FTSE Canadian High Dividend Yield Index ETF (VDY)
- Assets under management: $1.7 billion.
- Management expense ratio: 0.21%.
- Index: FTSE Canadian High Dividend Yield Index.
- Total holdings: 47.
- Yield: 3.46%.
- YTD return: -2.67%.
2. BMO (TSX:BMO) Canadian Dividend ETF (ZDV)
- Assets under management: $869 million.
- Management expense ratio: 0.39%.
- Index: N/A, actively managed.
- Total holdings: 50.
- Yield: 4.37%.
- YTD return: -4.40%.
3. iShares S&P/TSX Canadian Dividend Aristocrats Index ETF (CDZ)
- Assets under management: $966 million.
- Management expense ratio: 0.366%.
- Index: S&P/TSX Canadian Dividend Aristocrats Total Return Index.
- Total holdings: 94.
- Yield: 3.60%.
- YTD return: -7.17%.
The following article was originally published by our partners at the Canadian ETF Market.