Dividend Investing Part 2: The Fallacies of Dividend Investing

Last week, I wrote a blog post arguing that one should be indifferent to dividends when it comes to security selection. A good friend responded with a few questions, inviting me to write a second post on the subject. Here you are, Mike … and anyone else who is interested.


First, a few observations

The negative impact of a desire for dividends

A desire for income, especially among seniors, tends to result in the overpricing of dividend stocks relative to their low- or non-dividend-paying peers. This is Economics 101. Demand pushes up the price, and since dividend yield is based on the ratio of the dividend to the price of the stock, the yield tends to decline, undermining the perceived advantage.


Dividend investors receive taxable income whether they need it or not

Because dividends are paid at the discretion of the board of directors, it gets paid out to investors whether they need the money or not. When held in a non-registered account, which is taxable, you wind up having to pay tax regardless of whether you need the income.


If you had two identical companies, one paying dividends, while the other one does not, the stock price of the dividend payer should eventually decline relative to the non-payer since the paid-out dividends are no longer a part of the company’s capital.


Dividends and stock buybacks are functionally equivalent; stock buybacks are more tax-efficient

In the U.S., there was an argument, championed by Senator Elizabeth Warren, that stock buybacks are a greedy choice that somehow benefitted corporations over shareholders. This buys into the fallacy that a dividend-paying company is somehow better for the investor than a non-dividend-paying company, or that share buybacks somehow benefit company executives over retail shareholders. Dividends and buybacks are functionally equivalent actions. Both spend the earnings of the company and are suitable if the company does not have a more effective use for its earnings.


Mature companies often pay dividends because they are not in a growth phase. They generate more income than is needed to fund existing operations or management does not see reasonably profitable investment opportunities, so they will pay it out in dividends.


Stock buybacks are done by dividend payers and non-dividend payers alike. One reason that companies might engage in stock buybacks is because of the stock purchase plans that they offer their employees. They don’t want to dilute the value of the stock by issuing more shares, which will increase the number of shares outstanding relative to the total value of the company, so instead, they buy back some shares to keep the share count more or less the same.


Other companies may choose to do stock buybacks because even though they may not have an investment opportunity now, they think they will later, and they would rather not increase their regular dividend now only to decrease it again.


Dividends are not a guaranteed source of income

In the previous paragraph, I indicated that a company’s board of directors prefers to avoid cutting its dividend payments. A dividend cut is perceived as a tangible indication that the company is having issues with the business, and the board fears it will undermine the public’s confidence in the company. However, dividends are not guaranteed. They are issued at the discretion of the company’s board. When the “Great Financial Crisis” (GFC) hit in 2008-2009, many companies reduced or eliminated their dividends. Other companies merged or were taken over, while still more companies went under altogether. The dividends of common shares are at the bottom of the capital structure of a company, behind preferred shares and various types of bonds. A dividend is not a guarantee of a company’s financial solvency.


The Efficient Market Hypothesis undermines dividend investing

The Efficient Market Hypothesis is another challenge to the idea that a focus on dividends is superior to other forms of investing. While you will hear arguments that the stock market cannot possibly be efficient, it is efficient enough that the average investor is unlikely to beat the market. There are simply too many professional investors out there with advanced credentials in Finance and the latest in sophisticated programming who are seeking that last little edge over the other professionals against whom they are competing. If there is a theoretical advantage to dividend investing, it has already been fully exploited by professionals.


Now, on to the three questions raised by my friend, Mike.


The relative volatility of dividend stocks versus non-dividend payers

To address this question, I chose two ETFs in the Canadian Dividend and Income category and compared them against an ETF that follows the TSX. The Dividend ETFs are CDZ, the iShares S&P/TSX Canadian Dividend Aristocrats Index ETF, and VDY, the Vanguard FTSE Canadian High Dividend Yield Index ETF. The broad-based index fund that I am using as a benchmark is XIC, the iShares Core S&P/TSX Capped Composite Index ETF. Although it is not a non-dividend payer, it simply holds the index of constituent stocks, without filtering them for dividends.


“Canadian Dividend Aristocrats” is a rather intriguing name for CDZ, isn’t it? According to dividendearner.com, membership in the aristocrat club has the following criteria:


  • The company’s security is a common stock or income trust listed on the Toronto Stock Exchange and a constituent of the S&P Canada BMI (Broad Market Index).
  • The security has increased ordinary cash dividends every year for five years but can maintain the same dividend for a maximum of two consecutive years within that five-year period.
  • The float-adjusted market capitalization of the security, at the time of the review, must be at least C$ 300 million.
  • For index additions, the company must have increased its dividend in the first year of the prior five years of review for dividend growth. This rule does not apply for current index constituents.


Vanguard describes the index for VDY as follows:


  • The FTSE Canada High Dividend Yield Index is a market-capitalization-weighted index that is focused on dividend income.
  • Index constituents are selected from the FTSE Canada All Cap Domestic Index.


Volatility is generally measured by the use of standard deviation. The larger the number, the wider the range of “deviation” from the fund’s average return. Most investors, especially those approaching or in retirement, would like to see a nice steady return that they can rely on. For that reason, 2022 has been a bit of a shock. Have indices that emphasize dividends softened the shock?



Apparently not. As a reminder, XIC, the broad market index tracker, is in the middle, with CDZ, the dividend aristocrat ETF on the left, while Vanguard’s high dividend yield ETF is on the right. VDY has not existed for 10 years, so its figure for volatility over 10 years is unavailable. Nevertheless, we see that XIC is less volatile whether the standard deviation is measured over 3, 5, or 10 years.


Frankly, this is as it should be. An index that tracks a broader range of securities should be less volatile. The fewer stocks you hold in your portfolio, whether chosen by yourself individually or selected by a fund manager, the greater the likely volatility. And remember, the constituents that make up dividend ETFs are chosen based on dividends, not on volatility. A focus on dividends does not automatically decrease volatility.


Another factor to consider is the relative allocation to the various sectors. The following chart shows a dramatic difference between the three ETFs.



You will note that the top two sectors which hold the same relative positions across all three funds are nevertheless allocated dramatically differently. VDY puts over half into Financial Services, and when Energy is added, the two sectors make up over 80% of this fund. Another fascinating difference is the heavy weighting in Real Estate for CDZ compared to VDY or the benchmark fund, XIC.


Finally, I will note the 12-month dividend yields of the three ETFs. The dividend-focused ETFs do have a higher yield:



The role of non-Canadian dividend payers in a portfolio

Because of the perceived tax advantages, the Canadian government provides to domestic dividend payers, there tends to be relatively little interest among dividend-oriented investors for dividends from foreign corporations. In fact, there can be tax disadvantages to foreign dividends depending on the account type.


Foreign dividends in non-registered accounts

Whether you hold a U.S.-domiciled fund like VIG, the Vanguard Dividend Appreciation ETF, or the Canadian-listed equivalent, VGG, the U.S. Dividend Appreciation ETF, the U.S. Internal Revenue Service (IRS) is going to withhold 15% of the dividend. If you hold VIG, you will likely see the withholding transaction in your account. If you hold VGG, 15% of the dividend will already be withheld before it is posted to your account. Either way, you will get a T slip that will show the foreign tax that had been withheld so that tax can be offset on your tax return.


Foreign dividends in RRSPs or RRIFs

Using the same ETFs above but inside a registered account, there is a tax advantage to VIG. Thanks to a tax treaty between the U.S. and Canada, the IRS will not withhold 15% from the dividends paid from VIG. However, since VGG is Canadian-domiciled, the IRS withholds the 15% by default, and since the dividends, or indeed any income earned within an RRSP or RRIF, are not taxed until withdrawn, the investor cannot claim a foreign tax credit.


But really, why would an investor want to emphasize income in an RRSP? The goal is to grow the investment assets until income is required. Ignoring the Home Buyers Plan (HBP) or the Lifelong Learning Plan (LLP), the RRSP is intended as an accumulation account for retirement. Some might argue, though, that dividend-paying stocks or funds, including those from foreign sources, are appropriate in a RRIF because income needs to be withdrawn. Dividends can certainly be used to provide part of the income that needs to be withdrawn from a RRIF, but eventually, the capital will need to be drawn down, too. In my opinion, the advantages are illusory.


Foreign dividends in a TFSA

Unlike the RRSP or RRIF, the TFSA is not recognized as a retirement account by the IRS. Therefore, 15% of the dividend will be withheld. However, since the TFSA does not generate a T-slip of any sort, there is no opportunity to claim the foreign tax that was paid. This makes the TFSA the least favoured account for dividend investors who seek to diversify into stocks where a significant part of the return is made up of dividends.


In my view, non-Canadian equities, irrespective of whether they pay significant dividends, play the role of diversifying an investor’s portfolio and thereby reducing the risk of an unexpected return. However, focussing on dividend payers again narrows the range of available investments and diminishes the ability of the investor to reduce the idiosyncratic risk of this narrower selection.


Relative to professional investors, we retail investors have imperfect knowledge. It is fair to say that we also lack the perfect ability to act on the knowledge we do have. We can rely on the professional investment team, to the extent we can access such professionals, to do the stock selection, but the odds are that most of the benefit of that superior knowledge and ability will accrue to those professionals. Find a low-cost fund and you may do better. The alternative is to “buy the market” and give up trying to find some clue to outperformance that has surely been exploited already.


The pros and cons of dividend-paying stocks for income investors, particularly retirees


I think the pros are entirely psychological. From a behavioural finance perspective, dividend investing may help keep someone invested when markets hit a rough patch, as we have been seeing this year. This is the proverbial “being paid to wait” perspective. The investor wants growth as well as income, but when growth is not forthcoming at least there is some dividend income.



However, is “being paid to wait” an aphorism worth adopting for one’s investment philosophy? Certainly, a broad market fund is going to pay dividends, but to reduce the universe of available investments based on dividends is, in my view, mistaken. When accumulating assets, dividends are not necessary because investors want to grow their investments. When drawing down one’s assets, dividends are partially responsible for the return, but there is no particular advantage in receiving dividends over creating one’s own “dividend” by selling off a portion of the stock to generate the necessary cash.


Remember that the money that comes out of a RRIF is taxed at the investor’s marginal tax rate regardless of its source. The money that is withdrawn from a TFSA is tax-free, again regardless of its source.


Finally, for those who like to laud the tax advantages in non-registered accounts of eligible dividends from Canadian corporations, there is something called tax integration that might just change your mind. The credit for this insight goes to financial planner Jason Pereira, who dismantled this notion in a Twitter thread back in the early spring of this year (2022).


To fully appreciate the insight that Jason brings, you need to imagine two otherwise identical Canadian corporations, the only difference being that one pays a dividend and the other does not.


You may recall what seems like this odd gross-up and tax credit system for eligible Canadian dividends. The gross-up reflects that dividends are paid from after-tax earnings. You may argue that you do not care about corporate taxes or the fact that dividends are paid out of after-tax earnings, but even if you only see the after-tax amount, that doesn’t mean it hasn’t impacted your dividend. As Pereira illustrates, it is “like arguing it doesn’t matter that someone ate a quarter of your pizza before it was delivered to you. With pizza, you can see the difference. With a dividend, you don’t but that doesn’t mean a portion is not gone.”


The upshot of this is that dividends are not a particularly advantageous way to get money out of a corporation. The only true tax advantage comes from the 50% inclusion rate on capital gains.


Now, with the above paragraphs in mind, consider the retiree who is receiving Old Age Security and who is pleased to have built up a substantial portfolio of Canadian dividend payers in a non-registered account. Let’s suppose that with a combination of income sources from an employer pension plan, personal RRIF, CPP (QPP), and OAS, income has reached the OAS clawback threshold for 2022 of $81,761. Now, let’s suppose that this retiree received $10,000 in dividend income. For tax purposes, this has been grossed up to $13,800. Ignoring the regular income tax for a moment, consider if the $10,000 was just interest income. In that case, there would be a clawback of $1,500 (15%). However, thanks to the gross-up of dividends, OAS is clawed back to the tune of $2,070.



I reiterate my assertion that an investor should be indifferent to the presence or absence of dividends in one’s investment portfolio. The goal should be to build up a low-cost portfolio with a focus on total return. The lowest cost and broadest diversification are often obtained through a globally diversified index fund or a portfolio of such funds. Regardless of the above, if you are convinced that you can gain an advantage over the market, then find a low-cost managed fund or funds, that, again, has its focus on total return. Dividends are a component of total return, but they are not the key.


This is the 167th blog post for Russ Writes, first published on 2022-10-03.


Note: No blog will be published during the week of 2022-10-10. I will be on vacation.


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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.