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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
Investing Wealth

17 Investing Guru Quotes

“There is only one side of the market and it is not the bull side or the bear side, but the right side.” — Jesse Livermore

“The trick is not to learn to trust your gut feelings, but rather to discipline yourself to ignore them. Stand by your stocks as long as the fundamental story of the company hasn’t changed.” — Peter Lynch

“The way I figure out the economy is literally from the bottom up and from company anecdotal information, knowing that housing leads retail and retail leads capital spending. From listening to the guys on the ground. When you talk to companies and to guys who run companies, you get a whole additional perspective on the economy.” — Stan Druckenmiller

“The whole world is simply nothing more than a flow chart for capital.” — Paul Tudor Jones

“Bull-markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” — John Templeton

“The sucker has always tried to get something for nothing, and the appeal in all booms is always frankly to the gambling instinct aroused by cupidity and spurred by a pervasive prosperity. People who look for easy money invariably pay for the privilege of proving conclusively that it cannot be found on this sordid earth.” — Jessie Livermore

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” — Peter Lynch

“The nature of the game as it is played is such that the public should realize that the truth cannot be told by the few who know.” — Jesse Livermore

“If you want to become really wealthy, you must have your money work for you.” — John Templeton

“Remember, things are never clear until it’s too late.” — Peter Lynch

“Every serious deflation I have looked at is preceded by an asset bubble, and then it bursts.” — Stan Druckenmiller

“The four most expensive word in the English language are ‘This time it’s different.” — John Templeton

“Don’t be a hero. Don’t have an ego. Always question yourself and your ability. Don’t ever feel that you are very good. The second you do, you are dead.” — Paul Tudor Jones

“Never invest in any idea you can’t illustrate with a crayon.” — Peter Lynch

“Looking at the great bull markets of this century, the best environment for stocks is a very dull, slow economy.” — Stan Druckenmiller

“At the end of the day, the most important thing is how good are you at risk control.” — Paul Tudor Jones

“Go for a business that any idiot can run – because sooner or later any idiot probably is going to be running it.” — Peter Lynch

Categories
Real Estate

1989-1996 Canadian Housing Collapse Looks Eerily Similar to Today

I recently wrote a couple articles proposing that Canadian real estate might be on a downward spiral. So far it has declined 10% on average since February. Some parts of the GTA have already experienced declines of up to 18%.

Hundreds of thousands of Canadians have deferred their mortgages. While some may have done so fraudulently most were in genuine financial distress, as millions of Canadians suddenly lost their jobs.

Unfortunately, these deferrals simply kick the can down the road – payments are piling up as is the interest on the deferred interest. Many of these mortgages will enter default. Many people who can no longer afford their homes will sell. Overall, the supply-demand dynamic is changing for the worse.

CMHC recently issued a report saying Canadian home prices could decline by up to 25% by the end of 2020. Others researchers have argued for larger declines.

As expected, those with a vested interest have cast the CMHC report as inflammatory. Many Canadians simply are in denial that a significant housing decline could happen.

Very smart people are sometimes unable to see breaks from normality. Remember when Federal Reserve Chairman Ben Bernanke was in denial about the US housing collapse?

“Housing markets are cooling a bit. Our expectation is that the decline in activity or the slowing in activity will be moderate, that house prices will probably continue to rise.”

Ben Bernanke, February 15 2006.

Bernanke said this (and many other similar quotes suggesting housing market stability) right when the US housing market was collapsing.

Nobody has a crystal ball, but frankly I find it appalling – but not surprising – that people are so quick to dismiss the possibility of a similar significant decline in Canada. Especially given the weak economic and consumer fundamentals. The fact is it is very difficult for people to accept discontinuous breaks in their reality, just as many couldn’t in February when it was clear that Covid-19 was growing into a global pandemic.

None of this is new. Canada experienced a very similar situation 30 years ago when home prices declined between 1989 and 1996, taking 13 years to recover. At that time immigration didn’t help, falling rates didn’t help and reduced housing inventory didn’t help.

Today, I came across a great thread on Twitter by @ExtraGuac4Me. The thread showed that the same denials were happening in 1989 – right before housing fell by 28% on average.

I’ve pasted the thread in its entirety below:

Before dismissing CMHC’s report, consider this: in 1989, pre-recession, Wood Gundy suggested Toronto home prices would drop by 25%. TREB called the report “inflammatory” & OREA stated “a large price decline is unlikely because the real-estate market doesn’t work like that”

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Mortgage rates then fell dramatically by over 500bps (5%!!) over the next few years. This was a significant drop in borrowing costs that cannot be understated.

And no, immigration did not fall in 1989. It went from about 191k in 1989 to 256k by 1993. Also, more immigrants chose major city centres in the 1990s compared to the 1980s. Yes, more immigrants came to Canada and even more went to the Toronto area.

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In the end, despite increased immigration to Canada with more people moving to the Toronto area and a substantial reduction in interest rates, prices fell 25% with many condos facing 35%+ declines.

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