Choosing a Dividend ETF

Rob Carrick’s column in The Globe and Mail this Saturday looked at the three dividend ETFs listed on the TSX. Rob asked three bloggers to share their picks: Canadian Capitalist, Million Dollar Journey, and yours truly. I’d like to explain my choice in more detail.

Let’s begin with a review of the three ETFs in question:

Horizons AlphaPro Dividend (HAL) is an actively managed ETF that “invests primarily in equity securities of major North American companies with above average dividend yields.”

Claymore S&P/TSX Canadian Dividend (CDZ) tracks the S&P/TSX Canadian Dividend Aristocrats Index, which focuses on dividend growth. Companies in the index must have raised their dividends in each of the last five years.

iShares Dow Jones Canada Select Dividend (XDV) holds the 30 highest-yielding stocks, though it also screens candidates based on dividend growth and average payout ratio.

I don’t think active management will add value after costs, so that rules out HAL. This ETF currently holds about 10% in cash, reserves the right to hold preferred shares and bonds, and its commentary talks about waiting for the market to reach its targets before deploying that cash. This kind of forecasting is worthless, in my opinion, and doesn’t justify the higher management fee (it’s the most expensive of the three at 0.70%), the inevitably higher turnover, and the perpetual cash drag.

Why not hold two dividend ETFs?

That means the decision comes down to the Claymore and iShares ETFs. My fellow bloggers both chose Claymore’s fund, but I suggested that investors consider splitting their investment between CDZ and XDV. This isn’t because I’m being wishy-washy — it’s because they actually have very different holdings.

Of the 30 stocks in XDV, Claymore’s ETF holds 16 of them, which seems like a lot of overlap at first glance. But the duplication is largely in stocks that make up a small part of each fund. When you look at the top holdings, some big differences emerge.

The iShares ETF is very heavy in banks: overall it’s 60% financials, including 33% in the Big Six banks, which are all in the top eight holdings. That’s a very large concentration in one sector.

Claymore’s ETF holds a more diversified portfolio of 56 stocks, with a much higher weighting in the energy and consumer sectors. While more than a third of its holdings are classified as financials, many are real estate investment trusts (REITs) and income trusts. Banks are a negligble part of CDZ: Scotiabank and TD are the only Big Six names, and together they make up a mere 4% of the fund.

The main reason for this discrepancy is that most banks — despite their high current yields — have not raised their payouts over the last five years and therefore aren’t eligible for the Aristocrats index. While dividend growth is important, does it really make sense for a Canadian income investor to avoid the banks for several more years because they didn’t raise their dividends during the worst financial crisis of our lifetime? If you were assembling a portfolio of dividend payers today, would you ignore the yields of CIBC (5%) and BMO (4.8%) simply because they haven’t raised their dividends every year since 2005?

In my opinion, both of these ETFs have their problems, but they mesh together nicely. The table below shows their average sector weightings. If you held a 50-50 mix, you’d have a nicely diversified dividend portfolio:

One important note: several of CDZ’s top holdings are income trusts. When the new rules take effect next year, the Aristocrats index will boot out any income trust that doesn’t raise its distribution after converting to a corporation. That will change its top holdings considerably, though it won’t change the fact the ETF has very little bank exposure. It will likely just raise the percentage of REITs, utilities and telecoms in the fund. The index is reconstituted every December.