Dividend investing has long been a favourite strategy for Canadian investors who are attracted by the prospect of earning a large stream of income, especially in an era of declining interest rates.
However, the poor performance of dividend stocks during the pandemic-induced market decline and subsequent recovery highlights some of the risks associated with this strategy.
A recent article in the Globe and Mail noted that the S&P/TSX Composite Index had recouped nearly two-thirds of what it lost during the pandemic downturn, but the Dow Jones Canada Select Dividend Index recovered just 43% of its losses. Similar underperformance is occurring south of the border when comparing the returns on the S&P 500 to US high-dividend indexes.
The article suggests the blame for this underperformance may lie in the high debt loads carried by many high dividend paying companies. This leverage has built up as companies focused on raising their payouts to attract investors and keep their place in dividend focused exchange traded funds (ETFs). High debt levels can ultimately endanger a company’s ability to pay dividends and eventually its survival in a recession.
This is but one of many possible explanations for why high dividend paying companies are struggling relative to the overall stock market. However, there are other reasons to be wary of pursuing a dividend investing strategy versus buying the whole market through an index ETF.
While high dividend paying stocks don’t have higher expected returns than the market, focusing on them does reduce your portfolio diversification. Only a small percentage of the stocks available on the market have high dividend yields. For example, the S&P/TSX Composite High Dividend Index holds 75 stocks compared to 250 for the broad composite index.
Therefore, you’re exposing yourself to the risk that comes from holding a concentrated portfolio to capture the same long-term returns.
As well, if you’re in a higher marginal tax bracket, pursuing a dividend strategy ultimately means paying more tax. While Canadian dividends are treated more favourably than interest income in non-registered accounts, foreign dividends are taxed at the same rate as interest income and twice the rate of foreign capital gains. And in contrast with capital gains, dividends can’t be deferred to a later date.
Now, this is not to say dividends aren’t important. They make up a substantial part of your total return and have been a reliable source of income during past recessions, as discussed in this article. In this context, it’s important to remember that a total market portfolio produces a substantial dividend yield. Currently, that yield is 3.3% for S&P/TSX Composite Index, 1.8% for the Russell 3000 (a close proxy for the total U.S. market) and 2.3% for MSCI EAFE index.
Dividend stocks in Canada have had a good run. The Globe article observes that over the last 20 years dividend indexes have outperformed the Canadian market as a whole, with less volatility and less severe selloffs. (For a thorough discussion of the reasons behind this historical performance, have a look at this article from Vanguard.)
However, as the regulators rightly require us to remind everyone, past performance does not predict future returns. When it comes to dividends, too much of a good thing can be bad for your financial health.