The label is a fable

Stocks that reliably pay high dividends are sometimes called widows-and-orphans stocks. At least in theory, they’re rock-solid investments that can provide a steady stream of income to feed a widow and orphans, no matter what happens. Given the ultra-safe reputation of these stocks, you would assume that dividend mutual funds, which invest in dividend-paying stocks, must also be ultra-safe and must also pay good dividends. However, that’s not the case. Canadian dividend funds are not that safe—and most pay negligible, if any, income from dividends.

Let’s start with the issue of safety. Dividend funds aren’t as safe as most people assume because they’re tightly tied to the ups and downs of the financial sector. Dividend funds bet a big chunk of their money on this single sector of the economy because most of the Canadian companies that pay healthy dividends happen to be either banks or insurance companies. As a result, most Canadian dividend funds have half or more of their assets riding on the stocks of a relative handful of financial-industry firms. If the financial sector hits a bump, dividend funds feel the pain, immediately and intensely.

Quite a few dividend funds combine this financial sector obsession with a willingness to venture far outside the small universe of dividend-paying stocks to complete their portfolios. In other words, they stash stocks with low or no dividends into what is supposed to be a dividend fund. To understand why, join me on a brief trip into the mind of a typical dividend fund manager.

“My fund is supposed to pay dividends, but my options are limited,” he or she thinks. “If I want to stick to steady dividend payers, my predominant choices are banks, insurance and utility companies, most of which pay dividends in the 2% to 3% range. But my fund charges annual expenses of more than 2%, so if I buy stocks in those companies, I’ll have hardly anything left to distribute to investors.

“If I can’t deliver the promised dividends, how can I keep my clients happy? I guess my best bet is to invest for capital gains instead. If I can make some capital gains, I can distribute those gains at yearend to compensate for the low dividend income. Right now, for instance, since commodity prices are soaring, I might as well ride the trend and allocate some 20% or 25% of my fund to energy and mining stocks. True, these stocks don’t pay much in the way of dividends, and they’re rather risky, but they hold the potential for some nice capital gains.”

You can probably see where all of this is going. The typical Canadian dividend fund winds up holding a bunch of dividend- paying financial stocks and a lot of other stocks that don’t pay dividends or pay very small ones. Once you pay the hefty 2%-plus management expense ratios (MERs) imposed by most dividend funds, not a lot of actual dividend income is left over to go into your pocket. Most investors in these funds end up with less than 1% a year in income that can be attributed to dividends. Investors in some funds get even less, because the high management expenses eat up all the scanty dividends.

It surprises people to learn that dividend funds aren’t actually great dispensers of dividend income, but it’s true. Most of these funds are really equity funds in disguise. The typical Canadian dividend fund and the typical Canadian equity fund display roughly similar volatility. Each generates much the same amount in terms of dividend income. “If it walks like a duck and quacks like a duck, you can be reasonably sure it’s a duck,” goes the old saying. So if you’re investing in a dividend fund because you think it’s somehow safer than an equity fund, you might want to think again. You probably own what is really an equity fund despite its dividend label.

At the very least, you should examine how you’re getting paid. Fund companies know that most investors don’t look too closely at how their income is generated. Thus, to offset the low dividends they receive, many dividend funds distribute a regular payout to their investors. But if this payout is larger than the fund’s net dividend income—and it usually is—a good chunk of the money that winds up in your wallet is really not dividend income.

In good years, the extra money may come from capital gains, but in years where there are no capital gains to distribute, your fund company may simply return part of your initial investment to you, to make you feel that you are getting regular income. If you hold a dividend fund, ask your adviser whether its distributions include return of capital. If so, your dividend fund is really just taking your money and paying it back to you — after extracting its fees, of course.

Does that mean that dividend funds are bad investments? Not at all. Some manage decent returns by picking stocks well. But so do some equity funds. My point is that adding a dividend fund to your portfolio doesn’t do as much as you think to diversify your investments or ensure you a steady stream of income.

There are better strategies. In fact, if you buy the right products, a well-diversified, dividend-paying portfolio can still be an excellent investment.

I like dividend-paying stocks for three reasons. First, they have a record of strong performance. The Dogs of the Dow strategy consists of investing in the Dow Jones Industrial Average stocks that have the highest dividend yields. This strategy has rewarded U.S. investors with superior returns over the long term.

A second reason to like dividend-paying stocks is their ability to cushion you from harm if the market tumbles. Sure, if the market falls 10%, it still hurts. But if you’re receiving a 3% dividend, you can console yourself with the thought that three years of those dividends will largely make up for your loss.

My final reason for liking dividend-paying companies is that they tend to be disciplined firms. Dividend-paying firms know that making a bad acquisition or fumbling a new product will jeopardize their dividend and antagonize investors for years. So these firms are less likely to take silly risks.

To buy a good selection of dividend-paying companies, you can choose from far better products than the expensive, low-paying and highly concentrated offerings of most Canadian fund companies. In my column in the October issue (Shooting for the stars) I suggested several cheap exchange-traded funds (ETFs). These are essentially mutual funds that trade like stocks. Chief among their virtues are low, low management expense ratios — most charge you only 0.4% and 0.6% a year, or less than a quarter of what an equivalent mutual fund would charge.

Any of the dividend ETFs that I mentioned in my October column would be a decent buy for income-seeking investors. Most deliver dividend income that exceeds 3% a year. In particular, Claymore Canadian Dividend & Income Achievers (TSX:CDZ), iShares Canadian Dividend Index (TSX:XDV) and iShares Dow Jones Select Dividend Index (NYSE: DVY) deserve a close look.

Another interesting choice is iShares Dow Jones EPAC Select Dividend Index (NYSE: IDV). This ETF tracks the top yielding 100 companies in Europe, Asia, Australia and Canada, which means you get the benefits of global diversification and are shielded from further deterioration in the U.S. dollar. The fund has a superb dividend yield of around 5% and charges a management expense ratio of only 0.5%. Those advantages more than compensate for its 40% concentration on financial stocks.

The only disadvantage is that the fund has been around for only a year. But I like its strategy for selecting its holdings. Among other things, it requires companies to have at least three years of uninterrupted dividend payments. I am reasonably confident that, over the long term, this strategy will provide superior results.