These funds are screaming ‘buy me’

As you wait for time to tell which camp is right, one investment category is screaming “buy me.” I am referring to dividend mutual funds. Right now, you can’t go wrong with them. That is, as long as you can prevent the fund companies from clawing back your gains in the form of high fees.

My reasoning is very simple. Compared to bond yields, dividend yields have rarely been more attractive. How so? Just think about which you would rather buy: a stock that offers a 3% yield right now, plus the possibility of capital gains and yield increase; or a 10-year bond that offers a 3% yield, and… Well, that’s pretty much it. With stocks, you expect corporate earnings to grow. You also expect the dividend payout to improve with higher earnings, leading to share price appreciation. With the bond, you have to be content with the 3% return for the whole 10-year period.

Because of the potential upside with stocks, investors have historically bought equities even when their dividend yields were lower than bond yields. Since the 1950s, the dividend yield on common stocks has averaged just half that of bond yields. When 10-year bonds paid 4%, investors were still happy to buy stocks that paid just 2%.

Right now, however, that yield gap is much narrower. Canadian banks, utilities, and telecommunications stocks are distributing dividends at yields ranging between 3.5% and 5%, while government bonds are offering up 3% or less. In the U.S., even defensive stocks for world-class companies such as Coca-Cola and McDonald’s are now offering amazing yields exceeding 3%&#8212compared to the 1% or so they offered in the past. Why so high? It’s mainly because many investors, stung by their losses in 2008, fear another setback. Therefore, they are demanding higher yields to compensate them for the risk of staying in the market.

Even if our worst fears come true, and we enter phase two of a double-dip recession, I believe that high-yield equities will be fine over the long run. If the recession deepens, interest rates will stay low, keeping dividend yields attractive. On the other hand, if our alternate disaster scenario of out-of-control inflation comes riding into town on the back of a strong economic recovery, corporate earnings will improve. When they do, dividend payouts will increase, paving the way for higher share prices. With dividend funds, you’ll win either way&#8212and collecting a 3% annual dividend while you wait for things to unfold is not a bad proposition.

Of course there is still the risk of dividends being cut, and that’s not a risk to be casually dismissed. Even the best companies have done it (Manulife, how could you?), and often in good times. However, I would say that in the vast majority of cases, corporate balance sheets are strong and dividend payouts fairly safe. You will get the odd case where an individual company slashes dividends. However, if you hold a diversified mutual fund, a few isolated cases of dividend cuts will have minimal impact.

Unfortunately, there’s a bigger problem with funds in the dividend category, and that’s their high average management expense ratio (MER) of 2.2%. If you’re not careful, such high fees could snatch back more than half of the dividend income that you would otherwise expect to collect.

Those high fees lead us directly to a second problem, which you could call mandate drift. By definition, mutual funds in the dividend category should be investing only in high-yield equities. But many managers try to compensate for the high fees by chasing performance&#8212in the form of higher capital gains&#8212even if that means buying equities with lower yields.

Because of this drift away from the dividend mandate, you’ll find that the actual dividend yields of most funds in the category are in the disappointing 0.5% to 1% range. To camouflage this issue, fund companies engage in a somewhat misleading practice: they give you back some of your original investment in the form of a cash distribution referred to as “return of capital.” For example, a fund that is yielding 1% from dividends alone will often distribute 2% to investors&#8212but the additional 1% that you receive is not income. It’s your principal investment returned back to you, to make you feel good.

In the Dividend delight table below, I have listed eight funds with management expense ratios (MER) of 2% or less. All of the funds have a real dividend yield of 2% or more, and a minimum 10-year average annual return of 5%&#8212not bad, considering the recent stock market crash. When calculating the estimated dividend yield of each fund, I ignored the distributions that consist of your own returned capital, and just took the actual dividends into account. Within the “Canadian Dividend Funds” category proper, I only found two candidates that met my requirements. So to compile the list, I had to dig into other categories, such as “Canadian Equity Balanced” and “Balanced.” That said, all the chosen funds have at least two thirds of their portfolio invested in equities.

In addition to the funds listed in the table, there are a couple of exchange-traded funds (ETFs) worthy of your consideration. The iShares Dow Jones Canada Select Dividend Fund (XDV) currently offers a yield of 4% with a cheap management expense ratio of 0.5%. The Claymore S&P/TSX Canadian Dividend ETF has a higher estimated yield of 4.5%, with a 0.6% MER.

The Claymore S&P/TSX Canadian Preferred Share ETF (CPD), which invests solely in preferred shares, currently offers a net yield of nearly 5%. The difference between common and preferred shares is that when it comes to dividend distribution, the preferreds take priority. In other words, if a company has both common and preferred shares, and not enough money to pay out all the dividend cash it promised, it will pay the dividends on the preferred shares first. This makes preferred dividends safer, but the downside is that preferreds offer no significant long-term potential for capital appreciation.

I find the Claymore Preferred Share ETF especially attractive because it strikes a good balance between different types of exposures. In one portfolio, it combines floating-yield issues (50%), perpetual issues (30%) and convertible bonds (20%). The floating-yield preferreds protect you from inflation, and the yield on the perpetual issues becomes attractive when interest rates fall, which tends to happen in recessions. The convertible bonds component rounds out the ETF by offering an opportunity to participate (moderately) in the next bull market.