Are dividends magic? Some investors seem to think so. I get it, dividends are easy to love. It’s nice to think that you could live off dividend payments without ever needing to sell any of your stocks. But should your investment strategy focus on dividends?
Dividend investing strategies generally either target companies that have high dividend yields or companies that have a long history of increasing dividends. Proponents of these strategies typically argue at least one of two things: 1) these strategies produce higher returns than the broad market, and 2) dividend-paying stocks generate a low-risk stable source of income, like bonds.
It’s certainly possible to fund a comfortable retirement by focusing on dividends, but is this the best approach for you? I hope to provide an overview of what you need to know to answer this question.
What is a dividend?
When a company makes a profit, it can either reinvest it or give it to its shareholders. Paying out a portion of profits to shareholders is called a dividend.
The dividend is not free. Those profits could have been reinvested to grow the business or used to buy back shares. By paying a dividend, all else equal, the company will become less valuable. Stock prices are constantly influenced by other factors, but if you look at the graph below for Johnson & Johnson you can see that higher dividend payouts (bottom line) generally result in a lower stock price (top line):
In theory, aside from tax considerations, shareholders should be indifferent between a company’s decision to reinvest profits or to distribute it as a dividend.
Different risk profile than bonds
With interest rates at historic lows over the last decade, dividend-paying stocks have become a popular alternative to bonds for investors looking to generate a steady stream of income.
But it’s important to understand that dividend stocks behave very differently than bonds. The chart below shows the total returns of a popular dividend ETF (blue line) and a popular Canadian bond market ETF (red line):
As you can see, the dividend ETF has been much more volatile than the bond ETFs. The value of these can drop significantly during market downturns, while bonds generally hold their value.
You might not care about short-term fluctuations, only the stream of dividend income. But as we saw in the Great Recession and during the current crisis, companies do cut or suspend dividends. This is far less likely to happen with the interest payments from high-quality bonds. Additionally, low volatility does have value. You never know when you may need to sell a portion of your portfolio, and even the calmest investors can start to panic when markets dive.
Steady stream of income
While dividends can be used as a steady stream of income, there is no need to limit yourself to that. Many retirees successfully fund their retirement using total returns.
As long as the size and total return of your portfolio are large enough to meet your spending needs, it does not matter whether those returns are from dividends, interest or capital gains. In fact, unless you plan on saving much more than you need, it would be optimal to start drawing down your portfolio at some point.
Investors who argue that dividend investing strategies have produced higher returns than the broad market point to charts like the one below. The blue line is a popular dividend ETF (CDZ), while the red line represents the broad Canadian stock market (XIC).
One common rational for this performance is that dividend-paying companies have a different mindset that leads to above-average returns. But there are a lot of different variables in play here. To know whether otherwise similar companies that pay dividends perform better, you would need to control for these other variables.
A 2017 study by Vanguard did just that. It used regression analysis to control for well-understood factors attributed to above-average returns: value, size, low volatility, quality and momentum. The study found that the value, low volatility and quality factors explained virtually all of the historical returns of dividend investing strategies.
Okay, but why does this matter as long as dividend investing strategies have outperformed? Well, while focusing on dividends may give you some exposure to these factors, that doesn’t mean that it is the best way to do it. There are ETFs that directly screen for these factors. The three charts below compare three different factor-based ETFs to a popular Canadian dividend ETF (CDZ):
All three factor-based ETFs have outperformed the dividend ETF since their inception. This is consistent with the idea that while these factors explain the market-beating returns of dividend strategies, dividend strategies are not an optimal way to benefit from exposure to these factors.
Whether you choose a dividend strategy or focus on these factors directly, you are making a bet that these well-understood factors will continue to outperform. I’m not entirely comfortable making that bet for the next 70+ years of my investing life. But there is nothing wrong with it. Just realize that this is different than saying dividend-paying companies will continue to outperform because they have a different mindset.
The tax treatment of dividends differs from country to country. In Canada, dividends are taxed at a lower rate than ordinary income (e.g., wages, interest) at all income levels. In fact, if you earn less than a certain amount ($48,000/year in Ontario) the marginal tax rate on Canadian dividends is negative!
Dividends are also taxed at a lower rate than capital gains below a certain income level ($97,000/year in Ontario). Above this income level, capital gains are taxed at a lower marginal rate. The table below shows the marginal tax rates of capital gains, dividends and other incomes for different income levels (see rates for other provinces at TaxTips.ca).
Capital gains also have a big advantage in that the tax is only paid when you sell, which means that it can be deferred decades into the future. Taxes on dividends must be paid every year, reducing the amount that can be reinvested.
There are entire ETFs that have been created to turn dividends into capital gains in order to be more tax efficient. These total return ETFs recently had to restructure when certain tax loopholes were closed. But the new funds still avoid paying out dividends for the purpose of tax-efficiency.
To mitigate the lower tax efficiency of Canadian dividends at higher incomes, you could hold your Canadian dividend stocks in your TFSA/RRSP. But if you hold non-Canadian stocks outside of those accounts, any dividend payments would be taxed at the “other income” rates.
Because non-Canadian dividends are taxed at much higher rates than Canadian dividends, many dividend investors focus on Canadian companies.
This lack of diversification makes for a riskier portfolio. Canada represents only around 3% of global equity markets, and there are examples of individual countries underperforming global markets for decades (see Your Investments Should be Global).
If you choose to heavily weight your portfolio towards Canadian dividend stocks, then you shouldn’t really benchmark your performance against the Canadian stock market. You should compare it to the returns of a diversified global portfolio. Recently, the total returns of the US stock market (red line) have significantly outpaced those of Canadian dividend stocks (blue line):
The performance of the global stock market (red line) has not been as strong, but it has outperformed Canadian dividend stocks (blue line) since markets bottomed out during the Great Recession:
Temptation to pick stocks
One issue with pursuing a dividend investment strategy with ETFs is that the management fees are relatively high. The management expense ratio (MER) for the iShares S&P/TSX Canadian Dividend Aristocrats Index ETF (CDZ) is 0.66%, compared to 0.06% for iShares Core S&P/TSX Capped Composite Index ETF (XIC).
This encourages many dividend investors to purchase stocks directly. Unfortunately, stock picking is incredibly hard. Even hedge fund managers regularly underperform the market. And most DIY investors do not properly calculate their returns and compare them to an appropriate benchmark.
You can certainly fund your retirement goals with a dividend-focused investment strategy. Just make sure that you understand the implications in terms of tax efficiency and risk. You should also be comfortable with your rationale for why this strategy will outperform the broad market.