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If the fund records a large capital gain one year and no gain the next year, it will make the fund’s distribution look more volatile than it otherwise would be.

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The iShares S&P/TSX Canadian Dividend Aristocrats Index ETF (CDZ) is supposed to contain stocks that raise their dividends regularly. But if that's the case, why does the distribution bounce around so dramatically from one year to the next? Sometimes it rises, sometimes it falls. I'm confused.

You're right. If you look on the iShares website, you'll see that CDZ's "total distribution per unit for tax purposes" has indeed been volatile in recent years. In 2012, for instance, the exchange-traded fund distributed $1.43906. The distribution dropped to 85.348 cents in 2013 and then jumped to $2.08962 in 2014.

That's hardly the sort of pattern you would expect from an ETF that's based on a rising-dividend methodology.

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So what gives?

Well, the first thing you need to understand is that the "total distribution for tax purposes" isn't always the same as the cash the investor actually receives. The former often includes a chunk of capital gains (which was the case in 2012 and 2014), which are usually reinvested in the fund and not paid out in cash. Capital gains can arise when an ETF rebalances the stock weightings in its portfolio, for example, or when a company is removed from the index on which the ETF is based because the stock no longer meets the criteria for inclusion.

Capital gains are realized when a stock is sold; they aren't generated by the underlying dividend flow of the portfolio. So if the fund records a large capital gain one year and no gain the next year, it will make the fund's distribution look more volatile than it otherwise would be. If you want to get a more accurate picture of the ETF's distribution growth, you need to strip out the capital gains and look at the actual cash the ETF paid out.

You can find this information by going to the main page for CDZ and clicking on "distributions." If you then click on "recent" and choose the "table" view, you'll see a column with the heading "cash amount" (right next to a column that shows the "reinvested" amount, if any). The iShares website lists CDZ's monthly cash distributions going back to the start of 2007.

If you add up the actual cash distributions for each calendar year, you'll see the amount of cash paid out fell in 2011 from the previous year, rose in 2012 and 2013, then fell again in 2014.

But wait. That's not a rising trend, either. Why not? A key reason is that the composition of the index has changed from one year to the next as companies were added and deleted. For example, new tax rules in 2011 led many high-yielding income trusts to cut their dividends and convert to a corporate structure. These stocks would have been booted from the index because they no longer met the dividend-growth test for inclusion in the S&P/TSX Canadian Dividend Aristocrats Index.

Similarly, a number of big banks were dropped from the index for failing to raise their dividends during the financial crisis.

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To be included in the index, a company must have raised its dividend for at least five consecutive years (although it can maintain the same dividend for a maximum of two consecutive years within that five-year period.) The stock also has to meet certain requirements for market capitalization and average daily trading value. When stocks are added or deleted, it affects the ETF's distribution (which is paid from the cash the fund receives, less the ETF's expenses).

"If you have a company that was paying a 5-per-cent yield and you remove that company, and the company that's added to replace it pays 3 per cent, that is going to reduce the income to the portfolio," explained Steven Leong, director, iShares Product, at BlackRock Canada.

What about the increase in CDZ's cash distribution in 2013, and the subsequent drop in 2014?

"What happened in 2013 is that we had a couple of companies that paid special one-off dividends, and that raised the yield for the year, " Mr. Leong said. Because those special dividends weren't repeated in 2014, the amount of cash received by the fund dropped.

In an ideal world, a rising-dividend ETF would pay unitholders a steadily rising distribution. But with stocks frequently coming and going from the index, and capital gains and special dividends further affecting the payout, the distribution can often be quite volatile and may well continue to bounce around in the years ahead.

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