The tyranny of the aristocrats

Last August, Rob Carrick of The Globe and Mail wrote a piece about Canadian dividend ETFs and he invited three bloggers — me, Canadian Capitalist and Million Dollar Journey — to offer our picks. My colleagues both chose the Claymore S&P/TSX Canadian Dividend ETF (CDZ), one of the more popular ETFs in Canada, with almost half a billion dollars in assets. I took a different view, suggesting that investors consider buying equal amounts of CDZ and the iShares Dow Jones Canada Select Dividend Index Fund (XDV).

My reason for that recommendation — explained in this August 2010 post — was that the ETFs track two very different indexes, and there was surprisingly little overlap in their holdings. Well, that’s even more true today. The S&P/TSX Canadian Dividend Aristocrats Index, the benchmark for CDZ, was reconstituted in December, and the changes were dramatic: the Claymore ETF now has zero exposure to banks and insurance companies. Its iShares competitor, meanwhile, is more than 51% financials: the Big Six banks alone make up almost 30% of XDV.

How to become an Aristocrat

To understand what’s going on here, it’s important to know S&P’s methodology. The Aristocrats index was originally created in the US, and its most important rule was that a company had to have increased its dividend for 25 years in a row. That’s a very select list—of the thousands of publicly traded companies in the US, only about 50 can claim that track record. If you applied the rule in this country, you wouldn’t have much of an index—actually, you’d probably just have Fortis. So when the Canadian version of the Aristocrats index was launched, it set the bar at seven consecutive years of dividend increases, and it has since dropped that to five. (Companies must also have a market cap of at least $300 million.)

Think about that for a moment. If a company fails to raise its dividend in any year, it will get booted out of the Aristocrats index and be sentenced to five years with no chance of parole. Remember, we’re not talking about eliminating a dividend, or even reducing it: even if a company pays the same dividend two years in a row, that’s grounds for getting expelled from the aristocracy. They’re a tough crowd over at S&P.

During the financial crisis of 2008–09, many companies had a rough time and did not raise their dividends. So when the index was reviewed in 2009, 14 companies were shown the door. Scotiabank and TD were the only banks left in 2010, and both were banished from the index this past December, along with Encana, Great-West Life, Canadian Tire, RioCan and 18 others. Only five new companies were added, including Enbridge, Rogers and Tim Hortons.

Showing no mercy

I have to question the wisdom of the Aristocrats methodology. While failing to raise dividends may have frustrated investors, it may have been the right thing for those companies to do. Sometimes it makes more sense for a business to use its free cash to get through a temporary crisis rather than to raise its dividend. In the long run, that should benefit all shareholders. But the Aristocrats index is merciless and short-sighted. Not only has it kicked out dozens of financially sound companies, it has forced CDZ to liquidate these holdings and stick investors with a hefty capital gains distribution at the end of 2011.

The upshot of all this is that CDZ now holds 39 stocks, none of which are banks or insurance companies. That’s why I think it makes sense for dividend-focused investors to also look at the bank-heavy XDV. The two ETFs actually complement each other nicely, and holding equal amounts of both offers much better diversification than either one on its own. That’s the strategy I recommend in my Yield-Hungry Couch Potato portfolio.

For investors who do not need current income (that includes anyone investing in an RRSP), I continue to recommend broad-based index funds and ETFs that do not screen stocks for dividend yield.