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portfolio strategy

Dividend aristocrats? Please.

Nothing against Exchange Income Corp. and AGF Management Ltd., but the two top holdings in the S&P/TSX Canadian dividend aristocrats index are not premium dividend stocks. A dividend aristocrat raises its dividend every year, and can afford to do it because the underlying business spews cash.

AGF had a dividend yield of 10.8 per cent late this week, which tells you investors wonder whether the annualized cash payout of $1.08 a share is safe. Exchange – formerly an income trust – is in the aviation, manufacturing and infrastructure businesses that has just increased its monthly dividend for the first time since fall, 2012.

Enbridge Inc., Metro Inc., Telus Corp. and Toronto-Dominion Bank – those are true dividend aristocrats.

This distinction is important because it highlights a problem with exchange-traded funds that allow investors to buy a basket of dividend stocks with a single purchase. The indexes these ETFs track aren't all that attractive. In limited cases, dividend mutual funds are worth some thought as an alternative.

It's not just the iShares S&P/TSX Canadian Dividend Aristocrats Index ETF (CDZ) that is based on a less-than-ideal index. The iShares Canadian Select Dividend Index ETF (XDV) tracks the Dow Jones Canada Select Dividend Index, which is about 55-per-cent weighted to financial stocks. The Vanguard FTSE Canadian High Dividend Yield Index ETF (VDY) has almost 58 per cent of its assets in financials and the PowerShares Canadian Dividend Index ETF (PDC) has almost a 59-per-cent financial weighting.

Dividend mutual funds also hold a lot of banks and insurance company stocks, but the largest of them have capped their exposure to this sector at 45 per cent or so. Also, these funds tend to go very lightly on the non-blue chip dividend stocks that figure prominently in the S&P/TSX Canadian dividend aristocrats index.

Judged by performance, dividend ETFs look good. CDZ and XDV returned an average 12.9 and 12.1 per cent annually, respectively, in the past five years on a total return basis (dividends plus changes in the share price), while the S&P/TSX composite total return index made 8 per cent.

Looking at past returns is an unreliable indicator of what the future will bring. Arguably, it's even less useful with dividend ETFs. Dividend stocks are one of the biggest success stories in investing in the past five years, so it's no surprise that dividend ETFs have done well. But what happens if the market trends that have sustained dividend stocks shift?

A more negative tone in the markets might work against the so-called aristocrats that are part of CDZ (to be fair, there are blue chip dividend stocks in it as well). Weakness in bank stocks could work against VDY, PDC and XDV. All of these ETFs are built on imperfect indexes, and this may have negative consequences in the future.

The appeal of index investing is that many actively managed funds can't match the returns from major indexes minus the small cost of owning an ETF. Some active funds will surely beat the index, but predicting which ones is a challenge that is beyond many investors and advisers. Billions of dollars sit in junk mutual funds that have proved inferior to long-term index investments.

But dismissing all mutual funds is foolish because some do good work. Dividend funds are an example. A list of big and notable dividend funds was assembled for this column and, while there are quite a few duds, several have done similarly to dividend ETFs over the past five years. More recent results from these funds beat ETFs in several cases.

Two of the best long-term performers have a common trait – comparatively low fees. The series D version of RBC Canadian Dividend has a management expense ratio of 1.21 per cent, while Beutel Goodman Canadian Dividend D is at 1.50 per cent. Two other lower-fee options would be the Series D versions of Trimark Canadian Plus Dividend Class and BMO Dividend, both of which are new and don't have a track record yet. Series D mutual funds are designed for do-it-yourself investors who don't want to pay the advice fees built into the cost of owing most mutual funds.

Beutel Goodman Canadian Dividend is an example of how a dividend mutual fund can offer superior diversification to a dividend ETF. Its weighting in financials was 37 per cent as of Sept. 30, and energy, information technology, telecom services and health care were all at roughly 10 per cent.

However, this fund isn't an ideal example of what dividend funds can do because it had a weighting of almost 26 per cent in U.S. dividend stocks as of Sept. 30. U.S. dividend stocks, which have outperformed lately, are not in the indexes tracked by most Canadian dividend ETFs. So let's look at RBC Canadian Dividend D, which has only a trace level of U.S. content.

Financials were the top holding of this fund at 45 per cent as of the most recent portfolio update, followed by energy, industrials and consumer discretionary stocks. Top holdings are a who's who of blue chip Canada, including the Big Five banks, Suncor, Enbridge, Canadian National Railway and BCE.

RBC Canadian Dividend D's returns over the past five years lag the two dividend ETFs that have been around that long (CDZ and XDV). If we go beyond five years using the example of the older, higher-fee A series of RBC Canadian Dividend, we see returns that have beaten the S&P/TSX composite total return index over every time frame measured in the database. Funds like this will have their ups and downs, and the successful managers running them can leave at any time. Yet, in this case, there's clearly some institutional know-how when it comes to running a portfolio of dividend stocks.

A practical benefit of owning dividend mutual funds like this is that investors can buy and sell them with no commissions from most any online broker. This makes them ideal for automatic monthly or quarterly investment plans. Most brokers charge commissions of up to $10 to trade ETFs.

Another path for investors seeking a fund approach to dividend investing is the actively managed ETF, which is basically an exchange-traded fund that uses active management instead of passively following an index. A few of these ETFs in the dividend category are listed in the accompanying chart. These are new products; let's see more from them before passing judgment.

Canadian dividend fund smackdown: ETFs vs. mutual funds

How a selection of exchange-traded funds and mutual funds holding all or mainly Canadian dividend stocks have performed in the past five years.