Dividend ETFs have been slammed by one of the country's top experts on income investing.
"I wouldn't even think of a dividend ETF," said Tom Connolly, publisher of the Connolly Report since 1981. His objections: "First of all, they have too many stocks. Second, they have the wrong kind of dividend stocks. They go for the high yield stuff."
Mr. Connolly's a big believer in dividend growth – the web address for his newsletter is DividendGrowth.ca. He finds the stocks that populate dividend ETFs to be excessively tilted towards delivering a high yield as opposed to dividend growth.
High yielding stocks offer payouts that stand above dividend growth stocks, so there is some appeal in owning them. But dividend growth stocks offer a better overall package for the long-term investor. You get regular increases in your quarterly dividend payments – typically one per year – and you also get the potential for share price appreciation.
High yield stocks tend to be based on weaker businesses that can't afford to boost their dividend payments. The high yield is a sign that investors are skeptical about the company's growth prospects and, sometimes, its ability to sustain its dividend.
Mr. Connolly said U.S. dividend ETFs are a better bet because there's a wide enough variety of dividend growth stocks in the U.S. market to fill up a portfolio with quality. In Canada, dividend ETFs tend to have a solid Top 10 and then deteriorating quality. "They start to dilute good stocks with bad ones because they want higher yields," he said.
Dividend ETFs offer instant diversification – expect to find between 30 and 70 stocks in many cases. Mr. Connolly prefers a more concentrated portfolio of individual dividend growth stocks. His sweet spot is dividend growers with a yield that typically lies in the 2 to 4 per cent range. "You've got a good initial yield and sustainable dividend growth -- that's the kind of stock I call a dividend stalwart."
Dividend payout ratios differ from sector to sector, but he likes his portfolio of dividend growers to average about 50 per cent overall. His thinking is that this level of dividend payout lets companies retain enough earnings to keep building the business. That paves the way for more dividend growth down the road.
Next: Mr. Connolly on how to start building a dividend portfolio and more.