Dangers of Dividend Funds

Dividend funds are currently very popular with investors.

In many parts of the world, interest rate yields are quite low on a historical basis. To enhance returns, fixed income investors have turned to riskier investments that may offer higher yields. Such as dividends on preferred shares or dividend paying common shares.

As well, general equity investors are turning to perceived “safer” equity investments. Common shares in large, dividend paying companies. Shares that provide capital gains potential over time, but are back-stopped by a (hopefully) steady stream of dividend income.

Sounds like a good strategy to me. But there are always risks when investing.

Here are a few things to consider when assessing dividend funds (or dividend paying shares). 

A Flight to Dividend Funds

The Wall Street Journal’s, “The Dangers of Dividend Funds”, looks at a few perils with dividend investments.

The first thing though that interested me was the flight of investors to dividend funds.

This year through May 1, investors have taken about $2.65 billion out of U.S. stock funds overall—while placing a net $12.72 billion in mutual funds and exchange-traded funds that focus on dividend-paying stocks, according to EPFR Global.

That is a lot of money, just in the U.S. alone. Given what is going on in the world right now – low interest rates, economic uncertainty, potentially higher inflation, volatility in the equity markets, etc. – I have no problem with investors shifting assets to dividend paying stocks.

If you are someone who wants to increase your asset allocation in dividend stocks, make sure you consider the following points.

Do Not Simply Chase Performance

Past performance is no guarantee of future results.

You will see that in every mutual fund prospectus you read.

Evaluate your needs going forward. What investments make the most sense in light of your objectives, constraints, and personal situation (i.e., Investor Profile).

Investing based on prior performance is usually not a recipe for long-term investment success.

Concentrate on Your Optimal Asset Allocation

Your Investor Profile will lead to an Investment Policy Statement with a target asset allocation for your unique needs.

Part of your optimal asset allocation will include fixed income and dividend producing investments. But the amount will reflect your individual circumstances.

Focus your investment portfolio on your asset allocation and not on chasing the flavour of the day. In the long run, I believe this will be the more successful approach.

Remember the Risk-Return Concept

I think that the major financial markets are relatively efficient. That means that the price of an asset should reflect its future. And the price of the asset is what drives the dividend yield.

Perhaps a one year Treasury bill (i.e., the risk-free asset) yields 4%. You can invest in that or you could invest in common shares of ABC company with a dividend yield of 7%. 4& versus 7%. A fairly easy choice.

But why is ABC yielding 7%? It could be because ABC is a forgotten stock or has been poorly analyzed, so that it is under-valued. And that could be true for small companies, companies in ignored markets, etc. Areas where a single, informed investor might gain a competitive advantage. But for larger companies in established markets, these companies tend to be analyzed to death.

So (again) why the 7% yield? Because ABC is significantly riskier than the Treasury bill. And that greater risk is reflected in the higher offered dividend yield.

Perhaps the company’s cash flow may not allow ABC to continue paying out the same dividend amount. That may cause future yields to fall. Or perhaps ABC’s business prospects are in question. That may hurt the future share price. While you maintain a 7% yield on the dividend, you may just find your capital slipping away as the share price falls. So you earn 7% annually in dividends, but perhaps you lose 25% on your initial capital investment. That may make your annualized total return much less attractive.

Bottom line: when seeing an investment that offers a very generous return, always ask yourself why? It could be an under-valued gem that you have found. Or the relatively high yield could indicate investment difficulties down the road.

Diversification

If investing in dividend stocks, make sure that you diversify within this category.

Some dividend funds concentrate in very narrow ranges and that can cause problems.

For example, bank stocks often pay good dividends. So you go out and buy a dividend fund that focusses on Canadian bank stocks. However, Canadian banks are highly correlated (they tend to move in lock-step). If you own a fund with 10 Canadian bank stocks, your diversification is poor. If you do want bank stocks, consider global banks to reduce some of the geographic issues. Better still, consider dividend paying companies from a variety of industries and countries.

Always watch the diversification within any one fund. If the fund’s holdings are too concentrated, the inter-asset correlations will be high, resulting in poor diversification.

Taxes May Be Your Biggest Expense

Always consider tax consequences.

Your investment focus must be on after-tax returns. Never focus on gross returns.

For example, in Canada, dividends receive preferential tax treatment versus interest income. Say you earn $10,000 in dividend income from shares in Royal Bank and $10,000 in interest income on Royal Bank bonds. You will pay less tax on the dividend income than on the interest. So your net return will be higher with the dividends.

But not all dividends. Only dividends sourced from an eligible Canadian corporation receive the dividend tax credit. Your $10,000 in dividends from Bank of America will receive the same tax treatment as your interest income.

And not all portfolios. Investment income earned inside a tax-deferred investment account is obviously treated differently than income earned in a non-tax-deferred account.

When assessing dividend funds, never consider the publicized rates of return. Understand your personal tax situation and then invest to optimize your net returns.

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