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ETFs and Funds Investing

Ignore Your Canadian Fund Manager’s Historical Performance

The number one gimmick investment fund marketers use to sell their products is a strong performance track record. Historical performance is considered a staple piece of information by fund marketers and unitholders, as it makes the product appear more tangible.

Unfortunately, historical performance is useless when evaluating a fund.

You’ve probably seen the following disclaimer along in most investment funds marketing:

“Historical performance are not indicative of expected future returns and may not be repeated.”

This disclaimer is there for a reason. It is added to marketing materials because the regulators know that funds are sold based on historical returns, so they want it to be clear that past performance has nothing to do with future performance.

Even if all aspects of the fund – the manager, the style, the investment policy guidelines – remain the same, the vast majority of strong performance is fleeting in nature and cannot be repeated. Managers can get lucky streaks that result in periods of outperformance. However, few have genuine skill and are unable to repeat this outperformance consistently.

The empirical evidence supports this.

In its report called “Persistence Scorecard”, Standard and Poors regularly provides data on the persistence of investment manager outperformance. On July 15, 2020, for the first time, S&P has calculated this for the Canadian market.

The Persistence Scorecard attempts to distinguish luck from skill by measuring the consistency of active managers’ success. The inaugural Canada Persistence Scorecard shows that, regardless of asset class or style focus, few Canadian fund managers have consistently outperformed their peers.

For example, across all seven categories we track, none of the equity funds in their category’s top quartile in 2015 maintained that status annually through 2019. If we consider funds in the top half of 2015’s performance distribution, in six of the seven categories fewer than 5% of funds maintained their performance over the next four years. Coin flippers had higher odds of success.

In general, very few Canadian investment managers have demonstrated that periods of outperformance were due to skill and could be repeated.

Lengthening the horizon to consider performance over two consecutive five-year periods, the top-quartile domestic equity funds of 2010-2014 had little luck maintaining their top-quartile status during the 2015-2019 period. Only 30% of them managed to beat the median while 23% ended up in liquidation or had a style change.

While there may be a handful of investment managers that possess the skill to consistently outperform the market, it is impossible to identify these people in advance. The evidence shows that the vast majority of investment managers cannot repeat periods of outperformance. Yet these active investment managers charge 2.5% for the pleasure of their underperformance.

Consequently, investors would do much better by using low cost index funds and instead focusing on managing their investing behaviour, savings rate, debt, taxes and asset allocation.

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Categories
ETFs and Funds Income Investing Investing

Review: iShares S&P/TSX Composite High Dividend Index ETF (XEI)

A reader recently asked me about the TSX-listed iShares S&P/TSX Composite High Dividend ETF (XEI). XEI invests in a range of dividend paying Canadian companies and features a 6.26% distribution yield (June 30, 2020). The ETF pays roughly $0.075 to $0.091 per share on a monthly basis providing an attractive income stream. XEI’s management fee is 20bps.

Is XEI too good to be true? Or is it a great income provider?

Currently, XEI remains about 26% below its February 20, 2020 peak before the Covid-19 market crash. In comparison, the S&P/TSX Composite Index only remains about 13% below it’s February 20th level. This divergence can mainly be explained by differences in the holdings. The S&P/TSX Composite Index, for example, holds gold miners and Shopify which have been performing very well since the March 23rd bottom. In contrast, XEI is heavy into financials and energy, both of which have lagged. As a dividend fund this makes sense.

XEI seeks to replicate the S&P/TSX Composite High Dividend Index. For this reason, the growth and momentum names that don’t pay dividends are excluded from the portfolio.

Effective June 13 2017, the fund’s name was changed from iShares Core S&P/TSX Composite High Dividend Index ETF to iShares S&P/TSX Composite High Dividend Index ETF.

XEI Construction

To understand how XEI operates, one must look at the methodology of the underlying index. The S&P/TSX Composite High Dividend Index consists of 50 to 75 stocks selected from the S&P/TSX Composite focusing on dividend income. The index is market-capitalization weighted, with stocks capped at 5% and each sector capped at 30%. The index rebalances quarterly.

To be included in the index, a stock must be a member of the S&P/TSX Composite and have a non-zero indicated annual dividend yield. Selection is done step by step, as follows:

  1. As of the reference date for the Composite rebalancing, S&P Dow Jones Indices determines the median indicated annual dividend yield of all stocks in the S&P/TSX Composite with non-zero indicated annual dividend yields.
  2. The 75 stocks with the largest indicated annual dividend yield, from those stocks which have indicated annual dividend yields above the median calculated in step 1, are selected to form the index. Current index constituents are not removed unless their indicated annual dividend yield falls below the 85th position. Stocks that are not current index constituents with an indicated annual dividend yield ranking above the 65th position are automatically added to the index.
  3. If step 2 yields fewer than 75 stocks but more than 50, stocks with indicated annual dividend yields greater than or equal to the median form the index. The buffer thresholds given in step 2 continue to be 10 ranking positions above and below the number of constituents.
  4. If there are fewer than 50 stocks with indicated annual dividend yields above the median, stocks are added in descending order of indicated annual dividend yield below the median until a total of
    50 stocks are included.

The index is market-capitalization weighted subject to a maximum weight of 5% for each stock and 30% for each GICS Sector. The caps are established at the quarterly rebalancing and are not revised until the next quarterly rebalancing.

Based on this methodology, the portfolio will provide exposure to the highest-yielding dividend stocks in the S&P/TSX Composite Index, regardless of quality. Unlike some other dividend ETFs, XEI doesn’t factor in dividend growth or longevity.

Performance

Since its April 2011 inception, on an annualized basis XEI has returned 3.09% (ending June 30, 2020). If you held until January 31, 2020 (thus avoiding the Covid-19 mess), you would have received an annualized 6.27%.

Looking back 5 years (ending June 30, 2020), XEI returned 1.23% annualized vs. S&P/TSX Capped Composite Index’s 4.45%.

For the 5 years ending January 31, 2020, XEI returned 5.62% annualized vs. S&P/TSX Capped Composite Index’s 6.53%.

While fees can explain some of the difference vs the broad benchmark, it is clear that the lack of growth names has caused total returns to lag somewhat – especially recently.

Why is the distribution yield so high?

XEI sports a 6.26% distribution yield. While total returns matter, many investors are attracted to this yield. The yield is based on the underlying components of the ETF, 49.08% of which is concentrated in the top 10 holdings.

The top 10 stocks held by XEI have dividend yields ranging between 4.74% and 8% (as of June 26, 2020). These ten holdings contribute to about half of XEI’s overall distribution.

Many funds top up their distributions by returning capital to investors. In contrast, XEI is mostly distributing dividends the fund receives from underlying holdings. In 2019 about 8% of the distribution was considered return of capital, whereas in 2018 and 2017 there was none. Most of XEI’s distribution is organic as opposed to manufactured.

Exposure

While XEI imposes a 30% cap on sector weights the fund is still quite concentrated. I would expect this, given the nature of how the ETF is constructed (essentially a sort and rank of dividend paying stocks). Naturally, XEI will have higher exposure to areas of the market that have higher dividend yields – financials, energy, utilities. 73% of the ETF is concentrated in these three sectors.

Bonus concern

It is interesting to note XEI’s high portfolio turnover. Clearly this has to do with the construction and rebalancing methodology.

Compare XEI’s 2018 turnover of 49.86% to that of the FTSE Canadian High Dividend Yield Index ETF (VDY), which is just 22.90%. This may be a nothingburger, but higher turnover strategies tend to be indicative of higher costs. However, with XEI’s management fee of just 20bps this doesn’t appear to be much of a concern.

My verdict

XEI will never hold high-flyers like Shopify or junior gold miners. So investors need to recognize that it might underperform the broad market during periods in which momentum or growth are favoured.

Given the construction methodology, it is expected that many names within XEI might have historically been poor performers. (Dividend yields rise as stock prices fall.) There is no discretion applied to what names are in XEI, so there inevitably will be a mix that could includes dogs at risk of dividend cuts. Luckily exposure to any single company is limited to 5% at the time of rebalancing.

There may also be companies with well-supported dividends that have simply underperformed (driving up the yield) for other reasons.

Conclusion: don’t buy XEI for the yield. Buy it because you like most of the companies it holds. If you think most of the underlying holdings will continue to pay their dividends and are good long-term holdings, then XEI is a convenient way to invest in those companies.

Categories
ETFs and Funds

5 Top Dividend ETFs in Canada

Investing in Canadian dividend paying stocks has never been easier. To do this you can either buy one or two dozen individual stocks or you can buy an ETF that already owns a basket of dividend paying companies.

Of course, the convenience of buying an ETF comes with a small price. Between 10 and 60bps, the management expenses paid for simplified access do compound over time. Still, for many the ETF option makes the most sense.

Many people don’t have time to track many individual stocks. Some investors might have little to invest. Others might not even know what to look for when choosing an individual stock. For these people, an ETF might be the best way to invest in dividend stocks.

Personally, I like the way a broadly diversified dividend ETF can help me mitigate the risk of problems with any one individual company. An ETF also allows me to make asset allocation changes and new contributions with relatively few trades. Also, those who work in the investments industry know that ETFs remain off the compliance radar providing easier buy/sell execution.

I still bolt on a few individual dividend stocks here and there to enhance certain exposures. But ETFs remains the core to my dividend portfolio.

Below I list out five of the top dividend ETFs in Canada. I first provide high-level summary stats and then go deeper into each individual portfolio. Finally, I provide my conclusions at the end.

Summary Stats

BMO Canadian Dividend ETF (ZDV)

This ETF seeks to replicate the performance, net of expenses, of the Dow Jones Canada Select Dividend Index. The index is comprised of 30 of the highest yielding, dividend-paying companies in the Dow Jones Canada Total Market Index, as selected by Dow Jones using a rules-based methodology including an analysis of dividend growth, yield and average payout ratio.

Top 10 Holdings (30.00%)

iShares S&P/TSX Canadian Dividend Aristocrats Index ETF (CDZ)

This ETF seeks to replicate the performance, net of expenses, of the S&P/TSX Canadian Dividend Aristocrats index. The index consists of common stocks or income trusts listed on the Toronto Stock Exchange which are constituents of the S&P Canada Broad Market index (BMI). The security must have increased ordinary cash dividends every year for at least five consecutive years, and the float-adjusted market capitalization of the security, at the time of the review, must be at least C$ 300 million.

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Top 10 Holdings (19.95%)

iShares Canadian Select Dividend Index ETF (XDV)

This ETF seeks to replicate the performance, net of expenses, of the Dow Jones Canada Select Dividend Index. The index is comprised of 30 of the highest yielding, dividend-paying companies in the Dow Jones Canada Total Market Index, as selected by Dow Jones using a rules-based methodology including an analysis of dividend growth, yield and average payout ratio.

Top 10 Holdings (58.37%)

Vanguard FTSE Canadian High Dividend Yield Index ETF (VDY)

This ETF seeks to track, to the extent reasonably possible and before fees and expenses, the performance of a broad Canadian equity index that measures the investment return of common stocks of Canadian companies that are characterized by high dividend yield. Currently, this ETF seeks to track the FTSE Canada High Dividend Yield Index. It invests primarily in common stocks of Canadian companies that pay dividends.

Top 10 Holdings (73.68%)

iShares Core MSCI Canadian Quality Dividend Index ETF (XDIV)

This ETF seeks to replicate, net of expenses, the performance of the MSCI Canada High Dividend Yield 10% Security Capped Index. The MSCI Canada High Dividend Yield 10% Security Capped Index targets companies from the Parent Index (excluding REITs) with high dividend income and quality characteristics and includes companies that have higher than average dividend yields that are expected to be both sustainable and persistent.

Top 10 Holdings (77.75%)

Conclusions

For your convenience, I’ve re-displayed the summary stats below:

Judging by the sector exposures, XDV, VDY and XDIV provide more concentrated exposure to financials. VDY provides concentrated exposure to both financials and energy. If you desire an ETF more focused on financials and energy, VDY and XDIV are probably your best choice because of their exceptionally low fees.

The remaining dividend ETFs – ZDV and CDZ – provide a more diversified exposure to Canadian dividend paying stocks across a wider range of sectors. Although ZDV is a bit more concentrated in financials and energy, this provides it a yield boost. Finally, ZDV also charges a lower fee, making it my preferred ETF for broad exposure to a wide variety of Canadian dividend paying stocks.

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