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investor clinic

Dear ETF Industry:

First of all, I want to thank you for the eight billion or so exchange-traded funds that you've created over the past 10 years. I'm not really in the market for a two times daily bear natural gas ETF or currency-hedged emerging markets bond index fund, but it's good to know these products are there if I ever change my mind.

But I do have a small issue I'd like to raise. It's about the dividend ETFs you've been creating. Kudos for giving people so many options – there are now more than a dozen Canadian dividend ETFs. But how come I still can't find a product that gives me everything I want in one convenient package – namely rising dividends, low costs and great diversification?

Consider the latest dividend ETF to hit the scene. When I heard that the iShares Core MSCI Canadian Quality Dividend Index ETF (ticker: XDIV) has a management fee of just 0.1 per cent, I headed to the iShares website to learn more. Maybe this would be the ETF I was waiting for.

Nope. XDIV is definitely cheap – the management fee is one-fifth of what many other dividend ETFs charge – but diversification is terrible. The top four holdings are all banks and they account for about 41 per cent of the ETF's assets. All told, financials make up a staggering 57 per cent. (Note: Because XDIV is new, it doesn't yet have a management expense ratio, or MER).

The Vanguard FTSE Canadian High Dividend Yield Index ETF (VDY) suffers from the same problem. The MER is a very reasonable 0.22 per cent, but financials accounted for 61.8 per cent of the fund as of May 31. Utilities and telecoms – two sectors known for high and growing dividends – together accounted for just 12 per cent. Why can't an ETF be cheap and well-diversified?

Some dividend ETFs do provide decent diversification. The PowerShares Canadian Dividend Index ETF (PDC), for instance, has less than 30 per cent of its assets in financials and about 15 per cent (give or take) in each of utilities, telecoms and real estate. But the MER of 0.55 per cent is a bit high for my liking. (In fairness, PDC had the top return in my recent survey of Canadian dividend ETFs.)

And another thing: The way some dividend ETFs weight their individual constituents is a bit nuts. Take the iShares S&P/TSX Canadian Dividend Aristocrats Index ETF (CDZ). Choosing stocks that have raised their dividends regularly, as this ETF does, is a great strategy, but assigning the largest weightings to stocks with the highest yields is a problem. Why? Because a high yield is often a sign of a struggling company whose dividend is unsustainable.

Case in point: At the end of April, CDZ's largest holding was Aimia (AIM), which at the time yielded 8.8 per cent. But the loyalty plan operator's shares collapsed in May after Air Canada said it would be parting ways with Aeroplan, and Aimia recently suspended all dividends. CDZ's top holding now? Corus Entertainment (CJR.B), another struggling company that yields about 8.7 per cent and hasn't raised its dividend since January, 2015.

But I'm not here just to complain. I also want to help. I know the industry has the chops to create a dividend ETF that checks off all of the boxes. And I'm going to offer a few general suggestions as to what you should put in this ETF to make it the best dividend ETF ever.

Step No. 1: Put about 20 per cent of the ETF's assets into big banks, insurers and asset managers (I said 20 per cent, not 50 per cent or 60 per cent). Oh, and weight all the stocks in the ETF more or less equally.

Step No. 2: Put another 20 per cent in utilities and pipelines that raise their dividends regularly. A few names to get you started: Fortis (FTS), Emera (EMA), Canadian Utilities (CU), Algonquin Power & Utilities (AQN), TransCanada (TRP) and Enbridge (ENB).

Step No. 3: Allocate 15 per cent to telecom and cable stocks such as Telus (T), BCE (BCE) and Rogers Communications (RCI.B).

Step No. 4: Allocate another 15 per cent to dividend-growing consumer stocks such as Loblaw Cos. (L), Metro (MRU), Restaurant Brands International (QSR) and Dollarama (DOL).

Step No. 5: Put 10 per cent in railways, infrastructure stocks and other industrials; 10 per cent in real estate investment trusts; and the remaining 10 per cent in U.S. dividend stocks. No need to include energy producers: As we've seen, their dividends aren't reliable.

There you have it: A nicely diversified ETF stuffed with dividend-growing stocks.

As for the cost, if you can match XDIV's management fee of 0.1 per cent – or even come close – I'll be thrilled. So will a lot of other people, who will be handing you so much money you won't know what to do with it. Just don't use it to develop another triple-bull, covered-call, currency-hedged high-yield debt ETF, okay?

A look at Why active investors are jumping on the exchange-traded fund bandwagon

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