Are dividend ETFs a good investment for Couch Potato investors?

Q: I am a 63-year-old retired Couch Potato investor. I haven’t seen any unbiased (meaning unsponsored) information about dividend ETFs. Have you got any thoughts or recommendations on those?
—Mike

A: A rational investor should consider a dollar of dividends to be equivalent to a one-dollar increase in the value of a stock or fund—at least before considering taxes. But many investors show a strong preference for dividends: there’s something about a “bird in the hand” that makes those regular payments so attractive. As a result, fund providers offer a wide range of dividend ETFs for income-oriented investors.

I generally recommend sticking to “total market” ETFs that hold hundreds, even thousands of stocks, whether or not they pay dividends. These usually offer broader diversification and lower cost, and selecting companies that pay consistent dividends or have better-than-average yields should not be expected to boost returns over the long term.

Dividend investors may balk at that last statement, pointing out that (at least according to U.S. data) companies that paid steadily increasing dividends over the last 25 years did indeed outperform the broad market. But the problem with that finding is it suggests investors 25 years ago could have known which companies would go on to raise their dividends over the next 25 years, which of course is impossible. (This is a common error called look-ahead bias.)  Identifying companies that raised their dividends in the past does not help you predict which companies will outperform over the next 25 years.

Another common reason to favour dividend stocks and ETFs is their tax-advantaged income, thanks to the dividend tax credit. But here, too, one needs to be careful. This credit can be a boon to those with little other income: for example, in all provinces, you can receive about $55,000 in dividends from Canadian stocks without paying any federal income tax at all. If you’re in that situation, it’s easy to see the benefit of ETFs that focus on yield.

However, few people are able to generate all the income they need from Canadian dividends, especially in retirement. Mike, if you’re retired at age 63 you may already be receiving Canada Pension Plan benefits and payouts from an employer pension. In two years you’ll be eligible for Old Age Security, and by age 72 you’ll be required to make taxable withdrawals from your RRIF. All of these sources of income can edge you into the higher tax brackets, where the dividend tax credit becomes somewhat less valuable.

And remember, it’s only Canadian dividends that get preferential tax treatment. If you use dividend-focused ETFs for your U.S. and international equities, you are likely to pay more tax than you would if you held broad-market funds. That’s because capital gains are taxed at only half the rate of foreign dividends. So assuming two foreign equity ETFs return 7% overall, it is usually more tax-efficient to have a 5% capital gain and a 2% dividend, compared with a 3% capital gain plus a 4% dividend.

So, Mike, I don’t think investors should focus on dividend ETFs in their portfolio. Just stick to the most diversified, lowest-cost equity ETFs and focus on total return rather than income.

—Dan Bortolotti, CFP, CIM, associate portfolio manager with PWL Capital in Toronto

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