Canadian investors tend to view dividend investing and dividend stocks favorably, and it's understandable why. The North American stock market is rife with blue-chip, large-cap, lower volatility equities with a long history of consecutively growing and stable dividend payments. Dividend income from Canadian equities is also taxed rather favourably, making them great options for retirees.
Dividends pay an important role when it comes to valuation and a stock's intrinsic value. When reinvested, they are critical in contributing to a stock's total return over time. A long-standing, stable dividend payout ratio can be indicative of a profitable, cashflow positive, and well-managed company. When companies cut dividends, it is often a warning sign of trouble ahead.
The rundown on dividend indexes
A common alternative to picking individual dividend stocks is via the use of dividend index exchange-traded funds (ETFs). These funds consist of a basket of Canadian, U.S., or international dividend stocks, but their composition depends on their underlying screening criteria, which typically comes in several forms:
- Many dividend indexes screen for high yields by filtering for dividend stocks that currently have a large payout
- Other dividend indexes use a backwards-looking screen to select companies with a historical pattern of increasing dividends for a certain consecutive number of years
Beyond these two criteria, the construction of a dividend index can also vary depending on its weighting methodology, which are the rules governing the overall allocation of its underlying stocks. Common methods include:
- Weighting by dividend yield: Higher yielding dividend stocks are assigned a proportionately larger weight compared to lower yielding ones.
- Weighting by market capitalization: Large-cap stocks are assigned a proportionately larger weight compared to mid or small-cap stocks.
Not all dividend indexes are created equal
Dividend indexes constructed using variations of the above criteria and methodology can suffer from several deficiencies.
- Selecting and weighing stocks for high dividend payouts can lead to a "yield trap" situation, where the dividend yield is higher as a result of falling share prices or an unsustainable payout ratio. Energy and utilities stocks are common examples of this.
- Selecting and weighing stocks by historical dividend growth limits the ability of the index to capitalize on up-and-coming growth sectors, like technology, or younger dividend paying companies. A notable example of this is Apple, which is not eligible for inclusion in a variety of dividend indexes despite being one of the largest dividend-paying stocks (in terms of total dividend dollars) in the U.S. market.
- Selecting and weighing stocks by market capitalization also leads to a top-heavy index overly concentrated in certain sectors, such as energy and financials.
A better approach to dividends: future growth
CI WisdomTree Quality Dividend Growth Index ETFs seeks to avoid the limitations of the above-noted approaches by incorporating a forward-looking screen for dividend growth. The underlying index screens for 3–5-year earnings growth estimate which allows the index to target and select companies that are currently growing their dividends and are assessed to have future dividend growth potential.
As a result, CI WisdomTree Quality Dividend Growth Index ETFs are able to capture the performance of younger dividend-paying sectors and companies such as Apple. This offers exposure to different sources of return, higher potential returns, and enhances diversification.
In addition, CI WisdomTree Quality Dividend Growth Index ETFs target dividend stocks with excess exposure to the "quality" factor, which is defined by low debt, stable earnings, consistent asset growth, and strong corporate governance. This involves screening potential holdings for sufficient return-on-equity (ROE) and return-on-assets (ROA) metrics.
Screening for quality helps exclude unprofitable, risky companies that may have high dividend yields or historical consecutive dividend growth, but poor fundamentals.
Finally, CI WisdomTree Quality Dividend Growth Index ETFs eschew market-capitalization or yield-based weighting in favour of a "dividend stream" weighting. Each stock is allocated a weight based on the dividends paid by the company over the previous 12 months (dividend per share x # shares outstanding). This strategy helps the index avoid over-weighting potentially overpriced stocks and the lack of diversification due to overconcentration.
For more information, check out our strategy guide, or view CI WisdomTree's full list of dividend ETFs.