Why Don’t Couch Potato Portfolios Use Dividend ETFs?
A reader, L.P., asks the following question (edited for length and clarity):
Dividend stocks tend to be value stocks. An ETF like VDY will tend to perform similarly to a value stock index, although VDY is a little less well diversified because it omits value stocks with lower dividends. The total return, consisting of capital gain plus dividend, of dividend stocks will tend to be similar to the total return of value stocks. This means that dividend stocks with their higher dividend will tend to have lower capital gains than other value stocks.
If value stocks perform well over a given period of time, they could outperform a broad index ETF like XIU. Historically, there has been a value premium, but having a value tilt has performed better than focusing more narrowly on just dividend stocks.
You might see some analyses that seem to show that “solid” dividend stocks outperform the broader index by a wide margin. This is typically a result of survivorship bias. If we look at just companies that have paid increasing dividends for decades, it’s obvious that they have been great investments that have outperformed in the past. But there is no guarantee that this outperformance will continue into the future. Solid long-term dividend payers sometimes cut their dividend or go bankrupt. Think of GM and Kodak. If you don’t include the performance of GM and Kodak among other long-term dividend-payers, your analysis has survivorship bias.
As for dividend payers performing better in downturns, I think it is more likely that dividend investors perform better in downturns. This biggest risk during a downturn is that investors will lose their nerve and sell low. Some dividend investors ride out the temporary drop in stock prices by keeping their focus on the steady dividends.
In summary, while well-diversified dividend investing can work well for investors, it is not the path to outperformance that many think it is. The flip-side of higher dividend payments is typically lower capital gains. It is the total return of stocks that matters most in the long run.
“Why don’t sample couch potato portfolios in books and blogs use dividend ETFs for the equity portion? Wouldn't an ETF like VDY outperform XIU over the long haul? Long-term dividend investing has good historical returns. Higher dividends can accumulate over the long run. I'd imagine that a dividend ETF full of solid dividend payers would correlate closely with the general market performance if not slightly better in downturns? Is my thinking off?”Thanks for the thoughtful question. First off, let me say that dividend investing can be a reasonable approach as long as investors are well diversified. Certainly, an ETF like Vanguard’s VDY is reasonably well diversified within Canada. However, some dividend investors go off the rails when they convince themselves that dividend-paying companies are much better than other companies.
Dividend stocks tend to be value stocks. An ETF like VDY will tend to perform similarly to a value stock index, although VDY is a little less well diversified because it omits value stocks with lower dividends. The total return, consisting of capital gain plus dividend, of dividend stocks will tend to be similar to the total return of value stocks. This means that dividend stocks with their higher dividend will tend to have lower capital gains than other value stocks.
If value stocks perform well over a given period of time, they could outperform a broad index ETF like XIU. Historically, there has been a value premium, but having a value tilt has performed better than focusing more narrowly on just dividend stocks.
You might see some analyses that seem to show that “solid” dividend stocks outperform the broader index by a wide margin. This is typically a result of survivorship bias. If we look at just companies that have paid increasing dividends for decades, it’s obvious that they have been great investments that have outperformed in the past. But there is no guarantee that this outperformance will continue into the future. Solid long-term dividend payers sometimes cut their dividend or go bankrupt. Think of GM and Kodak. If you don’t include the performance of GM and Kodak among other long-term dividend-payers, your analysis has survivorship bias.
As for dividend payers performing better in downturns, I think it is more likely that dividend investors perform better in downturns. This biggest risk during a downturn is that investors will lose their nerve and sell low. Some dividend investors ride out the temporary drop in stock prices by keeping their focus on the steady dividends.
In summary, while well-diversified dividend investing can work well for investors, it is not the path to outperformance that many think it is. The flip-side of higher dividend payments is typically lower capital gains. It is the total return of stocks that matters most in the long run.
I guess the reason that I am not looking at Dividend ETFs, is most of this is inside already tax sheltered accounts (RDSP, RESP, RRSP) so dividend income and it's tax benefits are not as important (in that instance). I guess if I had more money in external accounts that have more Tax implications, I guess I might.
ReplyDelete@Alan: You're right that the distinction among interest, dividends, and capital gains is only important in taxable accounts. Even then, for people in higher tax brackets, taxes on capital gains are lower than taxes on dividends. Another advantage of capital gains taxes is that they can be deferred.
ReplyDeleteHere's a comment from John that he wasn't able to post directly on the blog himself:
ReplyDeleteHi Michael,
Further to your post about dividend ETFs, one drawback to Canadian dividend ETFs might be additional tax drag. Dan Bortolotti and Justin Binder of PWL Capital demonstrate this with the after-tax comparison of XDV and XIC on p. 10 of their white paper, After-Tax Returns. https://www.pwlcapital.com/pwl/media/pwl-media/PDF-files/White-Papers/2014_Bender-Bortolotti_After-Tax-Returns_Hyperlinked.pdf?ext=.pdf
BTW, I tried to post this in the comments section of your blog, but as the instructions were in Japanese, I was unable to execute. (I'm in Tokyo, using a Japanese-language browser).
While I'm here, long overdue kudos to you for such a thoughtful and helpful blog!!
Regards,
John
@John: It's definitely true that investors with non-registered accounts who don't need any current income from their portfolios are better off with deferred capital gains instead of paying dividend taxes every year.
DeleteVery thoughtful blog has quickly made it to my A-LIST.
ReplyDeleteThanks for covering an area I've been pondering on personally.
Luciano.
I'm not sure I'd say this was A-LIST Material PAL! :-) I will continue to ponder on this as well... Doesn't Ponder play QB for the Vikings?!?
DeleteI can see that your main purpose in this article seems to be to promote
ReplyDeletethe Couch Potato Strategy. PWL Capital is shameless enough in its promotion.
@Anonymous: I have voted with my own money on an index strategy because I believe it is best for my savings. If you disagree, make an argument. You've hinted that I'm promoting indexing for some sort of payment. This isn't true. Instead of resorting to ad hominem attacks, make a case for the type of investing you believe is best.
DeleteAll businesses promote themselves, PWL included. However, they have far less to be ashamed of than the vast majority of the rest of the financial industry. Their promotion of indexing is a great benefit to most investors. I don't invest with them because I don't see the need to pay their fees; I believe I can achieve better results with my own choices and extremely low fees.
Over the last few years, now that I've watched (rather, paid attention to) my portfolio more...you either accept higher dividend payments (and lower gains) or higher capital gains and lower yields. Most broad market ETFs provide that latter, so it's more of a total return approach.
ReplyDeleteIt's hard to argue with the facts but because my registered accounts are nearly maxed out, I intend to keep my CDN dividend payers in a taxable account; for the reasons you already know.
I've avoided dividend ETFs in recent years for a few reasons, I find you get a few too many yield-chasing companies in there. AGF and EIF come to mind within some dividend ETFs. Also, I'd rather not pay fees when I can own these 20-30 companies they all own outright. Will I change my mind? We'll see :)
Mark
A very important aspect you fail to mention is that if you have no other income you can receive up to $49,289 for 2014 in eligible Canadian dividends in Ontario (amount differs by province) without incurring any tax whatsoever except for the $600 OHIP premium (which is $0 below $20,000 in dividends and increases from there). Furthermore, you can replicate Canadian dividend funds and save the approx 0.50% MER quite closely with as little as $400K, You'd need about $1.31M right now to receive $49,289 in dividends using a dividend ETF such as XDV (but you might as well buy the underlying holdings if you have that kind of money and save the MER). Any excess could be invested in funds that use a swap to turn dividends into capital gains, such as HXS (S&P/TSX 60), HXT (S&P500) and/or HBB (CDN bonds) to avoid further tax until you sell them.
ReplyDeleteAt age 65, if you delay your CPP until age 70 you can receive a maximum of $551.54 OAS + $747.86 GIS for a total of $1,309.40/mos or $15,712.80/yr virtually tax free as your total tax only increases from $600 to $3,627. FYI, receiving GIS does not reduce OAS but CPP does so that is why delaying it is beneficial, not to mention it grows each year it is deferred.
That brings you up to $65,002 per year income less $3,672 tax = $61,330. Furthermore, if you need to top up your after-tax income (either before age 65 or after) you can redeem some of your TSFA.
Before or after 65 you can also redeem any other investments for extra cash such as tax advantaged ETFs (HXS, HXT, HBB, etc) and you will only pay tax on the capital gain, not the return of capital, initially at the rate of only 11.5%,
After age 70, when you are required to turn your RRSP into a RRIF then the income you are required to receive from the RRIF will result in you likely losing all of your GIS, but not your OAS. You still benefit from the dividend tax credit on your dividends though. The bonus is your CPP kicks in at the maximum rate of $12,460/yr which would give you a total income of $49,289 (dividends) + $6,618 (OAS) + $12,460 (CPP) = $68,367 total income - $6,672 income tax = $61,605 after tax. After this any RRIF income you get will be taxed at about 47% in Ontario in 2014. Even if you had no RRSP to convert into a RRIF, $61,605 tax-free/yr is enough for most people to live on.
Anyway, I think this clarification is very important. I do know people who live off their dividends and pay almost no tax and the favourable treatment of Canadian eligible dividends is an important tax wrinkle to consider.
@Rosedale Dweller: There are many tax-efficient strategies involving both dividends and capital gains. Someone with no other income can earn significant capitals gains without paying taxes as well. To make a meaningful comparison, we need to start with a given person's financial position and devise one strategy around dividend stocks that average 4% dividends + 3% capital gains and make optimal use of RRSPs, TFSAs, and non-registered accounts. Then devise another optimized strategy around an index of stocks making 2.5% dividends + 4.5% capital gains.
DeleteExamples of not paying taxes on capital gains (other than for those with very low incomes such that they don't even get into the first tax bracket?)
Delete@Rosedale Dweller: I'm not sure what your point is. With the 50% capital gains exemption, you can make twice as much without having to pay any taxes. Overall, capital gains work out better than dividends for moderate to high incomes, and capital gains work out better for low incomes.
DeleteYou are not sure what my point is? OMG, scroll back. It's quite evident. You are totally wrong in claiming that you can make twice as much without paying any taxes. Capital gains incur taxes on 1/2 of the capital gain at your marginal tax rate. That is a FAR CRY from the strategy I have enumerate which is ZERO tax on dividends under a $49,289 if one has no other income. I think you need to review the tax act. Sheesh!!!!
Delete@Rosedale Dweller: The 50% capital gains exemption allows you to earn twice as much when compared to regular income or interest income. The comparison to dividends is different because of the tax credit.
DeleteThe strategy you described isn't relevant to anyone I know. Most people who have substantial non-registered savings also have RRSP savings. Assuming an early retirement, the optimum strategy for spending by my calculations is to use RRSPs to some degree early on and defer capital gains in the non-registered account. The RRSP balance seems to have to be very low before it makes sense to prefer dividends. No doubt there are some people who end up with a million dollars in non-registered accounts, have no RRSP savings, and who don't earn any other income well before age 65.
It may not be relevant to people you know, but everyone's situation is different. I have 2 friends in their 60's who are employing exactly this strategy. Remember, you need not turn your RRSP into a RRIF and incur forced withdrawals until you are after age 70.
DeleteBut my point was more that you said you don't have to pay any taxes on capital gains. That is plain wrong.
@Rosedale Dweller: This is getting tedious. It is my contention that employing the strategy you describe is suboptimal in the cases I've analyzed when trying to maximize after-tax income for the rest of one's life. Having taxes lower for one year is not a complete analysis.
DeleteI didn't say there aren't any taxes on capital gains. I said they're only 50% taxes and that if you have no other income, the most regular income you can earn without paying taxes would be half of what you could earn with capital gains without paying taxes. I can understand that you didn't find my earlier comment clear, but continuing with this line is pointless.
One more thing: Yes dividend paying stocks will crash similar to the market when it does (but maybe not quite as much) and some dividends might be cut or reduced but if one has a diversified dividend portfolio one can take solace in the fact that 1) on average the yield on the entire portfolio will not decline appreciably; 2) one can continue to collect dividends while one waits until the market recovers; and 3) dividends increase about 1-3% on average per annum (around the rate of inflation).
ReplyDelete@Rosedale Dweller: If you start with the assumption that the total return of dividend stocks will outperform the total return of the index, then the conclusion is pre-determined. Most dividend investors just believe their stocks are better than other stocks. However, there is no evidence that dividend stocks outperform value stocks as a whole.
DeleteTrue, but the effect of paying zero tax on almost $50K in dividends in Ontario favours that kind of income even with lower returns.
Delete@Rosedale Dweller: I'm not sure how many people will have huge non-registered accounts without having RRSP assets as well -- perhaps those who don't work but inherit large sums. In any case, I don't doubt that there are people who can gain some advantage from maximizing dividend income, but you have to do a thorough analysis of a given person's situation taking into account the expected lower returns that come from either a concentrated dividend portfolio or using an ETF with a higher MER than broad index funds have. For those who've maxed out their RRSP and TFSAs, capital gains are better in their non-registered accounts because the taxes can be deferred.
DeleteWell of course you have to do an analysis and allocate investments to be the most tax efficient just like you have to do with any strategy. Also, it is not known whether a diversified Canadian dividend portfolio will produce lower returns than other alternatives over the long term, especially when one consider the tax free nature of the dividends in my example. One example: CDZ which is a Canadian Dividend ETF and which has an MER of 0.50% has actually done better than the S&P/TSX Composite Index since 2006 (with no MER)! I don't have any data going back any further . Do you?
DeleteLastly, if you want to do some planning and play around with various scenarios of taxable income, dividends, GIS, OAS, CPP, RRSP/RRIF income, this fantastic tax calculator will do it for any province.
ReplyDeletehttp://www.taxtips.ca/calculators/canadian-tax/canadian-tax-calculator.htm
One practical reason to stick with a total index for smaller investors: I have a small account (< $50k) and only buy ETFs once or twice a year when rebalancing. Any dividend I get throughout the year just sits in my trading account earning no interest. If that profit were represented by a stock price increase instead it would stay invested throughout the year. I already have a few hundred dollars always sitting there, uninvested, from bond and REIT funds, no need to exacerbate that with dividends too.
ReplyDelete@lew: Avoiding uninvested cash is part of the appeal of dividend reinvestment plans and total-swap ETFs. The way I deal with this is I treat the cash drabs in various accounts as my emergency fund.
DeleteMichael, I'm really impressed with the simplicity of your portfolio. It mirrors my thinking. I'm wondering why however, you chose VNC over XIC when XIC has a higher market capitalization.
ReplyDelete@Anonymous: There's nothing wrong with XIC. I just decided I trusted Vanguard more when it comes to looking out for investor interests. It's true that VCN has smaller assets under management, but I don't think this matters much.
Delete