In our last blog post, we exposed the absolute failure of active Canadian dividend funds. It is frustrating to see investors pay so much in fees and, in return, get a close-to-zero chance of outperforming market indices. Investors paid close to $1 billion in fees to active Canadian dividend mutual funds in 2014. It‘s time to change strategies. Here’s what I would look for if I were a disillusioned active Canadian dividend mutual fund investor.

1- Stick to index ETFs

Active mutual fund returns are terrible. If you want to add value, don’t take any chances: stick to indexed ETFs. There are six of them on the Canadian landscape.

2- Tracking error: How closely does the ETF mimic its reference index?

Table 1 below shows the tracking error for all indexed Canadian dividend ETFs, based on their one-year returns compared to a benchmark, as of March 31, 2015. Please note that longer-period returns are often preferred to measure tracking error. However, some ETFs (namely, XEI and VDY) cut their fees last year, and as a result, longer-period data has become irrelevant. It is important to measure ETF returns based on the Net Asset Value (rather than market price), as NAV better reflects the ETF manager’s performance. As shown in Table 1 below, XEI has the best tracking error, followed by VDY. Differences in tracking error are mainly explainable by the fees: the lower the MER (Management Expense Ratio), the closer a fund tends to mimic its index. For that reason, VDY is most likely to catch up with XEI for tracking error: it cut its management fees six months ago to the same level (0.20%).

<<Insert Table One>>

3- Security diversification

One of the most important tools for risk management is making sure that the ETF is well diversified at the securities level. The simple way to look at this is to compare the number of stocks in each fund. But this measure of diversification is flawed: even if a portfolio holds a large number of securities, the overwhelming majority in dollar terms can be concentrated in just a few positions. This is why we suggest using the Diversity Index: the number of securities in the portfolio after accounting for large positions. As the chart below demonstrates, CDZ is by far the ETF that provides the most securities diversification among Canadian dividend ETFs.

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4- Sector diversification

Even a portfolio that is well diversified at the security level can be dangerous if it is concentrated in only one sector. In other words, an investor is better off holding three stocks in each of the ten stock market sectors than holding 30 oil and gas stocks. The Diversity Index can also be calculated at the sector level, providing a picture of how many sectors are actually represented in the ETF after accounting for concentrations.

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Chart 2 above demonstrates that CDZ clearly wins the sector diversification contest. It has six well-represented sectors, compared to five for its closest competitor, DXM.

Conclusion

In my view, the most important characteristics to look for in an indexed Canadian dividend ETF are a low tracking error and high diversification. It is important to notice that we excluded historical returns and dividend yields from our analysis, as they don’t provide any further insight into the portfolio’s risk and future returns. Nevertheless, this information is provided in the table below.

<<Insert Table two>>

While CDZ is by far the best-diversified ETF, it also has a very poor tracking error. On the other hand, XEI appears to be the best choice from a tracking perspective, but is in the middle of the pack for diversification. Your final choice should depend on what you value most. Personally, on the balance, I am most comfortable with XEI.

Sources: PWL Capital; Morningstar Direct; and websites for ETF firms iShares, Vanguard, Powershares and First Asset.