Many Canadians regard dividend investing as gospel. If so, they might want to start investigating alternative faiths.
Over the past three years, investors who selected Canadian stocks on the basis of their dividend yields have received little in return for their trouble. Exchange-traded funds that followed dividend-investing strategies have generated essentially zero in payoffs for their long-suffering unit holders.
The pain has hit with particular intensity this year. Despite the widespread belief that dividend stocks can cushion downturns, many dividend ETFs have lagged the broad market. Stalwarts such as the iShares S&P/TSX Canadian Dividend Aristocrats Index ETF (CDZ) or the Vanguard FTSE Canadian High Dividend Yield Index ETF (VDY) have suffered stinging losses since January.
Perhaps this represents a temporary aberration. Dividend-investing strategies have historically produced market-beating results in Canada, so the current weakness could be just a passing lull.
Or maybe not. Anyone who wants to practise dividend investing in Canada today has to face an inconvenient truth: The two sectors that produce the bulk of Canadian dividends are confronting challenges.
For banks, the problem is low interest rates, which reduce the margins that banks can earn on loans and crimp bank profits. For energy producers, the challenge is the dimming outlook for fossil fuels – a trend that is hammering oil stocks in Canada and around the world.
Both problems seem likely to linger, perhaps for years. The Bank of Canada indicated on Wednesday that low rates will remain in place until at least 2023. As for fossil fuels, the fight against climate change is gathering pace at the same time as demand for oil is sputtering because of pandemic-weakened economies.
Canadian dividend investors should mull these trends. Financial-services companies and energy-related businesses generate more than 60 per cent of all the dividends from the S&P/TSX Composite Index. These two sectors also make up the bulk of most Canadian dividend ETFs. If they are in for an extended period of ho-hum performance, Canada’s dividend investors could face a long period of lacklustre returns.
If nothing else, dividend investors may want to hedge their bets by broadening their approaches to picking stocks. The current challenges demonstrate that there is nothing magical about dividend investing.
This should not come as a complete surprise: Finance professors have taught for decades that dividends are irrelevant to stock returns. Some companies, such as Warren Buffett’s Berkshire Hathaway Inc., have generated huge profits for investors without paying a dividend. Others, such as the pre-financial-crisis versions of General Motors Co. and Citigroup Inc., have run into trouble despite paying regular dividends.
A 2013 study by Stanley Black of Dimensional Fund Advisors found that global portfolios of dividend-paying companies and non-paying companies produced nearly identical average returns between 1991 and 2012. Larry Swedroe, a noted financial author and director of research for Buckingham Strategic Wealth, echoed that point last year. “There is nothing special about dividends,” he wrote.
He argued that when dividend investing works, it does so by steering investors to high quality companies, with strong balance sheets and sustainable earnings. When dividend investing flops, it does so because it lures yield-hungry investors into slowing industries that are maintaining high yields despite growing risks.
A better strategy, Mr. Swedroe suggested, is for investors to ignore dividends and simply look for high-quality businesses.
What does that mean for Canadian investors? One simple approach is to buy an index fund that tracks the broad market. With the S&P/TSX Composite now yielding close to 3 per cent, you will still enjoy a steady stream of dividends but with considerably more diversification than dividend funds offer.
Another approach would be to select any of several ETFs that focus on picking quality or low volatility stocks. Some candidates include the BMO Low Volatility Canadian Equity ETF (ZLB), CI First Asset MSCI Canada Quality Index Class ETF (FQC) and iShares MSCI Minimum Volatility Canada Index ETF (XMV). These funds typically offer a decent dividend yield but with more diversification than a typical dividend fund. Over the next couple of years, that diversification could be a definite plus.
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