How to add dividend ETFs to a Couch Potato portfolio

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

— Mike

A: The traditional Couch Potato portfolios use plain-vanilla index funds and ETFs that cover the broad market, without specifically focusing on dividend-paying stocks. Many investors wonder about modifying this approach by using specialized ETFs that focus on yield. This is an especially common question for retired investors who rely on their portfolio to generate income.

Whether a dividend strategy can be expected to deliver higher returns than the traditional Couch Potato is debatable, but I recognize the intuitive appeal of investing for income. If you decide to modify the strategy to focus on dividends, I’ll make a couple of recommendations.

The first is to make sure you stay well diversified. The broad-market index funds in the Couch Potato lineup include hundreds, even thousands of stocks. ETFs that screen for companies paying higher-than-average dividends will inevitably include fewer names, and some include just 30 or so. Moreover, the stocks may be concentrated in a small number of sectors. Some Canadian dividend ETFs have more than 60% of their holdings in banks and financials, for example. It’s certainly possible to build a diversified portfolio with dividend ETFs, but it’s harder, and you may have to use several funds with different strategies to avoid overlap.

The second key issue is to keep an eye on taxes. While eligible dividends from Canadian companies are tax-favoured (especially if you’re in a low tax bracket), not all high-yield ETFs have that advantage. Dividends from U.S. and international stocks are fully taxable as income and may be subject to additional foreign withholding taxes. Real-estate investment trusts (REITs) are popular with yield-oriented investors, but the income from these stocks are generally not characterized as dividends and are also fully taxable.

Even if you are using your portfolio to generate cash flow in retirement, it’s not necessary to modify the Couch Potato strategy to focus on dividends. For more on how to use a “total return” approach, see A better way to generate retirement income.

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

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