Dividend ETFs are a great idea gone a little sour in real life.
Cheap access to a diversified portfolio of income-paying stocks is the promise of dividend exchange-traded funds. But having just finished a review of Canadian dividend ETFs for my multi-part ETF Buyers' Guide, I can report that there are two significant flaws with these products. They're not cheap in many cases, and neither are they diversified.
On the cost front, there has been some movement in the past year or so by a few ETF providers to bring down costs. The iShares Core S&P/TSX Composite High Dividend Index ETF (XEI) and Vanguard FTSE Canadian High Dividend Yield Index ETF (VDY) have now management expense ratios of about 0.22 per cent, which is more than three times the cost of owning a broad Canadian stock market ETF. Still, these two ETFs are, nevertheless, a bargain compared to their many competitors with MERs of 0.45 to 0.75 per cent.
Some of the more expensive dividend ETFs are actively managed, so there can be a rationale for high fees. A few actively managed dividend ETFs have done well in the past year, but it's way too soon for any judgements that active management is worth the extra cost in the dividend category. The rest of the pack in the dividend ETF pack are either track-trackers or quasi index funds that use a rules-based screening process. Why do these funds have MERs of 0.45 per cent or more when you can buy the broad Canadian market in ETF form for as little as 0.06 per cent?
Diversification is the worse problem. It's amazing how there can so many differently structured dividend ETFs, and yet such a consistent dominance by financial and energy stocks in their portfolios. With oil in decline for the past six months or so, energy seems about the last place to go find dividend stocks that can maintain or, better, increase their dividends. Yet if you look at the top holdings for dividend ETFs, you'll find energy listed first or second on the list of top-weighted sectors. Financials are much more promising from the point of view of dividend growth, but there are dividend ETFs with weightings in the sector of up to 50 per cent or so. Add energy and financials and you end up with as much as 70 to 80 per cent of the portfolio of some dividend ETFs.
Not all dividend ETFs present a diversification trap like this, but many do. That's a big reason why these products are a great idea gone a little sour.