The Tyranny of the Aristocrats

Last August, Rob Carrick of The Globe and Mail wrote a piece about Canadian dividend ETFs and he invited three bloggers — me, Canadian Capitalist and Million Dollar Journey — to offer our picks. My colleagues both chose the Claymore S&P/TSX Canadian Dividend ETF (CDZ), one of the more popular ETFs in Canada, with almost half a billion dollars in assets. I took a different view, suggesting that investors consider buying equal amounts of CDZ and the iShares Dow Jones Canada Select Dividend Index Fund (XDV).

My reason for that recommendation — explained in this August 2010 post — was that the ETFs track two very different indexes, and there was surprisingly little overlap in their holdings. Well, that’s even more true today. The S&P/TSX Canadian Dividend Aristocrats Index, the benchmark for CDZ, was reconstituted in December, and the changes were dramatic: the Claymore ETF now has zero exposure to banks and insurance companies. Its iShares competitor, meanwhile, is more than 51% financials: the Big Six banks alone make up almost 30% of XDV.

How to become an Aristocrat

To understand what’s going on here, it’s important to know S&P’s methodology. The Aristocrats index was originally created in the US, and its most important rule was that a company had to have increased its dividend for 25 years in a row. That’s a very select list—of the thousands of publicly traded companies in the US, only about 50 can claim that track record. If you applied the rule in this country, you wouldn’t have much of an index—actually, you’d probably just have Fortis. So when the Canadian version of the Aristocrats index was launched, it set the bar at seven consecutive years of dividend increases, and it has since dropped that to five. (Companies must also have a market cap of at least $300 million.)

Think about that for a moment. If a company fails to raise its dividend in any year, it will get booted out of the Aristocrats index and be sentenced to five years with no chance of parole. Remember, we’re not talking about eliminating a dividend, or even reducing it: even if a company pays the same dividend two years in a row, that’s grounds for getting expelled from the aristocracy. They’re a tough crowd over at S&P.

During the financial crisis of 2008–09, many companies had a rough time and did not raise their dividends. So when the index was reviewed in 2009, 14 companies were shown the door. Scotiabank and TD were the only banks left in 2010, and both were banished from the index this past December, along with Encana, Great-West Life, Canadian Tire, RioCan and 18 others. Only five new companies were added, including Enbridge, Rogers and Tim Hortons.

Showing no mercy

I have to question the wisdom of the Aristocrats methodology. While failing to raise dividends may have frustrated investors, it may have been the right thing for those companies to do. Sometimes it makes more sense for a business to use its free cash to get through a temporary crisis rather than to raise its dividend. In the long run, that should benefit all shareholders. But the Aristocrats index is merciless and short-sighted. Not only has it kicked out dozens of financially sound companies, it has forced CDZ to liquidate these holdings and stick investors with a hefty capital gains distribution at the end of 2011.

The upshot of all this is that CDZ now holds 39 stocks, none of which are banks or insurance companies. That’s why I think it makes sense for dividend-focused investors to also look at the bank-heavy XDV. The two ETFs actually complement each other nicely, and holding equal amounts of both offers much better diversification than either one on its own. That’s the strategy I recommend in my Yield-Hungry Couch Potato portfolio.

For investors who do not need current income (that includes anyone investing in an RRSP), I continue to recommend broad-based index funds and ETFs that do not screen stocks for dividend yield.

18 Responses to The Tyranny of the Aristocrats

  1. Money Smarts Blog January 14, 2011 at 8:49 am #

    Great article. I think dividend investing is a reasonable way to invest, but I never understood the reliance on history when picking stocks.

    Basing stock picks on the number of consecutive years of a dividend increase is just looking back in time. It’s kind of like buying growth stocks that have the most years of consecutive stock price increases. Bear Sterns was a very profitable company for a long, long time – until one day it wasn’t. 🙂

    Another issue, which I’m not sure is a factor or not – is that it’s possible that companies will change their behaviour because of these lists. If I’m CEO of ABC inc which has increased the dividend for 25 years and things are tight this year – do I increase it anyway (at the risk of company growth) or do I do the financial responsible thing and leave the div alone (or cut it) and face a lot of bad publicity? As you point out – increasing the dividend each year isn’t always the best thing.

    Mike

  2. Greg January 14, 2011 at 9:35 am #

    Whether the Aristocrats methodology is a good or bad methodolofy or a good or bad thing for CDZ is not relevant to me. This is the way the index was created. If you are going to follow it, you need to do so without exception or else you risk transforming from a passively managed fund to an actively managed one.

  3. Canadian Couch Potato January 14, 2011 at 9:54 am #

    @Mike: I don’t think there’s any question that many companies feel pressure from shareholders to raise their dividends, even when this may not be the best decision in the long-term. There are cases where companies have even issued more stock in order to pay dividends, which of course dilutes every investor’s stake, but makes them feel better. I’m not suggesting that a long record of dividend growth is bad, of course, only that striving to maintain that record at all costs is not necessarily good for investors.

    @Greg: I appreciate the willingness to stick to a strategy, but it’s important to recognize that the Aristocrats index is not truly passive. All of these “strategy indexes” are a grey area between active management and true index investing. They are designed to provide rules-based methodologies for picking market-beating stocks. That doesn’t make them bad, necessarily, but it is worth questioning whether the index is well designed. It’s worth noting that CDZ tracked a different index during its first few years and only switched to the Aristocrats in 2009. The Aristocrats index has also changed over the years, from requiring seven years of dividend growth to only five. So there is already an admission that these indexes are works in progress.

  4. Echo January 14, 2011 at 10:09 am #

    As a dividend growth investor I agree that it can be dangerous for companies to continue to raise dividends at any cost just to stay on a list to satisfy investors. That’s why instead of owning CDZ I own individual securities and make my own decision on whether or not to continue to hold them. The Canadian banks were handcuffed to raise dividends over the past two years, but there is little doubt they will make up for that this year and any patient investor will be rewarded.

    Instead of an annual track record of increasing dividends I look for 5 and 10 year growth records, which makes more sense to me.

  5. Value Indexer January 14, 2011 at 10:48 am #

    To take the other side, maybe that’s the whole point. Just like having a dividend is a sign that your earnings are real, increasing it every year is a sign that the business is really profitable. Of course a bad manager can cripple a business by trying to look stronger, but that’s no secret to anyone. With all the investor expectations that cause careful review of the reported statements and even dumb strategic moves, I don’t think getting in the dividend aristocrats list is the biggest pressure on most companies.

    When it comes to the banks, maybe expecting dividend increases every year is too much. After all they’ve moved away from the plain, boring, stable profits of retail banking which lead to increased growth for a while but the higher the growth rate the less stable it is. Under the current model having them on the dividend aristocrats list almost seems like a temporary accident. Only looking at the last 5 years would contribute to this of course.

    As an investor you have a choice – do you want to go with the companies that have an unblemished history (for 5 years) and hope that conditions are mostly the same, or do you want to start doing a full analysis on individual stock and try to pick the ones with the best future dividend prospects? There are other indexes too but – not having done enough research to own them – it looks like they either own all/most dividend-paying stocks or follow some selection rules that aren’t that different from a dividend aristocrats index. In the end it comes down to three choices – follow rules to get the historically strong businesses, buy everything with a dividend, or do some stock picking.

  6. DM January 14, 2011 at 10:55 am #

    Thanks Dan, I was hoping you’d weigh in on this. I have held CDZ for the past 2 years and have been very happy with it. I liked the fact that it had reduced exposure to banks, as I also own XIC which has a healthy allocation to financials. At this point, I’m wondering if it makes sense to own CDZ at all. When I compared the total return of CDZ and XIC from the launch date of CDZ onward (2006 or so I believe…) I found that the two were in fact highly correlated. It is common to hear that blue chip dividend stocks outperform in bear markets but this doesn’t seem to show up with CDZ. I didn’t compare XDV and XIC but I expect a similar finding. In absence of any negative correlation between XIC and either CDZ or XDV, I’m left wondering why I should not get all of my exposure to Canadian equities through XIC. It would be simpler and easier to manage.

  7. Sustainable PF January 14, 2011 at 11:01 am #

    Couldn’t agree more. To exclude some of the financial giants due to a massive market drop affecting their ability to raise dividends is folly. The aristocrat strategy is flawed.

  8. Canadian Capitalist January 14, 2011 at 11:51 am #

    It is important to keep in mind that both dividend indexes could potentially see significant turnover. That’s because even if index constituents remain the same, the constituents are weighted on dividend yield and rebalanced on a quarterly basis for XDV and yearly basis for CDZ.

    But the index constituents are not likely to be the same. You’ve pointed out the pitfalls of the Aristocrats index. But the XDV index isn’t without its own flaws either. Recall that XDV’s constituents are selected based on a sort of dividend yields and the top 30 stocks are included in the index. XDV could see just as much turnover and I’d caution against comparing XDV and CDZ and concluding one is better than the other.

    This goes back to who should own a dividend fund. Those in asset accumulation years should hold broad-based indices, especially in taxable accounts. Those in their withdrawal phase own dividend ETFs to provide income. As such owning both is a very good idea with the caveat that they could see relatively high turnover in these funds.

  9. DRM January 14, 2011 at 12:32 pm #

    I’m not sure that I fully understand the implications with respect to reconfiguring CDZ. The article indicates to expect a capital gain at the end of 2011. I must have previously misunderstood that capital gains with ETF’s were based on the appreciation of the ETF, and not the appreciation of the stocks that they hold. In any event, I have two specific questions relating to CDZ.
    1) Will the capital gain be applicable only to unit holders of CDZ that purchased before the reconfiguration or will anybody that purchases CDZ in 2011 also be hit with the capital gain at the end of the year?
    2) By removing over 20 companies including majors like BNS & TD and only adding 5 new ones, why isn’t there a significant adjustment to the share vale of the ETF? Seems to me the value of CDZ is considerably less today than it was before liquidating the holdings in question.

  10. Michel January 14, 2011 at 1:18 pm #

    Sorry guys, it doesn’t really matter. If you look at a 3 year chart of both CDZ and XDV, their performance is relatively the same. Owning both will only overdiversify your portfolio with mostly large cap canadian stocks.

  11. Canadian Couch Potato January 14, 2011 at 2:04 pm #

    @DRM: 1) The capital gains distribution will be the result of selling a number of stocks at a profit. It is passed along to shareholders at the end of the year, so anyone who owns CDZ this coming December will be on the hook, regardless of when they purchased the ETF. See this post for more details:
    http://canadiancouchpotato.com/2010/12/10/how-to-avoid-paying-other-peoples-taxes/

    2) As each holding is sold, it is replaced by new stocks, including additional shares of companies that have remained in the index from last year. So there is no net outflow from the fund, and therefore no drop in the fund’s NAV.

  12. Canadian Couch Potato January 14, 2011 at 5:29 pm #

    @DM: I would tend to agree with you that there is no significant benefit to holding both CDZ and a broad-based index fund like XIC, unless you specifically need current income. I should also note (@Michel here as well) that there seems to be a misunderstanding that CDZ is a fund of large-cap blue-chip companies. It is not. The minimum market cap to qualify for the Aristocrats index is $300 million, which by most definitions is well into small-cap territory. Many of the companies in CDZ are REITs, income trusts and smallish corporations.

    @Michel: It should not be surprising that XDV and CDZ are highly correlated, as they are both Canadian equity funds. But both funds hold just 30 and 40 companies, with quite a different mix of sectors. Holding both would in no way qualify as “overdiversified.” And as I mention above, CDZ is not a large-cap fund.

  13. Canadian Couch Potato January 14, 2011 at 5:38 pm #

    @CC: Thanks for your comment. Excellent point about XDV: I have not looked closely into this ETF in terms of the amount of turnover in the index. This is a good reminder that, where possible, total-market indexes are often preferable because of their extremely low cost and negligible turnover.

  14. JS January 15, 2011 at 4:12 pm #

    Why is it a “bad thing” to own XDV even if you are in your accumulation years? I am probably 30 years away from retirement but still, i’d rather own for the long run XDV than GIC since I can expect 3.5% from XDV (plus the appreciation of the ETF) and around 3.1% for a 1-5 years GIC laddering strategy. Granted, it is more volatile (I have a loooong runway ), but I love the compound effect of dividends through the years.

  15. Canadian Couch Potato January 15, 2011 at 5:31 pm #

    @JS: It’s not a bad thing to own XDV or some other dividend-focused ETF in your accumulation years, but it’s probably not optimal. There is always a tradeoff between dividend payouts and earnings that get reinvested in the company (which raises the company’s value and share price). If you don’t need the dividend income now, it is usually better to simply buy a broad-market index fund, which will have lower cost, lower turnover and better diversification. This is especially true in a taxable account, since capital gains taxes can be deferred, but tax on dividends cannot.

  16. The Dividend Ninja January 16, 2011 at 12:04 pm #

    Hi Dan, excellent article! I see I’m last to get to the list of commenters 🙂

    I was actually going to write up on the CDZ ETF last month. One thing that investors should note, is CDZ until recently held a lot of income trusts, with high dividend yields. But since these trusts have now converted to corporations, they will have no option but to lower their dividends since they are now corporations (in a different tax structure). So the 4% yield may not be sustainable, and may actually be lower come February and March.

    Basically you may be better off just buying a couple of banks and a couple of other big Canadian blue chips with 4% yields, than buying this ETF. Anyway, great article and well researched!

  17. SoloSailor January 18, 2011 at 8:07 pm #

    @Dividend Ninja … I agree with you completely. In the last quarter of 2010, I increased my holdings of CDZ. But once I saw the wholesale changes made to it’s holdings, I questioned whether it wouldn’t be better to sell and buy 5-6 good blue chips stocks with dividends > 4% with the potential of yearly, or almost yearly, dividend increases. I’ve started my research.

  18. Biff Dow February 13, 2013 at 1:10 pm #

    Excellent article. I used to hold both a dividend mutual fund and CDZ to play one off against the other performance-wise. Of late I was noticing how much better the mutual fund was doing despite the higher MER. Explains a lot. I dumped CDZ.

    Honestly, though, I don’t like the American-heavy XDV as I’ve found it lacks a lot performance-wise. It’s weird because given the advantages of ETFs, the dividend ETFs are poor performers vs. mutual funds across the board unlike their income trust counterparts.

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