Linda: One thing is avoiding yield traps. So sometimes you come across this big, juicy yield.
Isabela: Exactly.
Linda: But it's not always a gift, especially if you look under the hood.
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Isabela: Welcome back to The ETF Experience podcast. If you've scrolled through social media lately, you've probably seen that dividends are the ultimate passive income cheat code. But what's the catch? Well, today we'll be answering some of your most-asked questions around how do you compare dividend ETFs, and do millennials and Gen Z really need dividend income?
To help me answer these questions today, I'm joined by Linda Otamendi from TD Asset Management. Welcome to the podcast, Linda. How are you doing today?
Linda: Thanks, Isabela. Doing well. It's nice getting out of my typical research scope to chat about dividends today.
Isabela: Absolutely. Well, we're very excited to have you on. And I thought we could just jump right into it, because one of the most common questions we get is, how do you compare dividend ETFs? And it is a very broad question. And before we jump into that question, we actually have to set a few definitions first and answer other questions. So let's start off with, what is dividend income?
Linda: Yeah, sure. Well, if you own dividend-paying assets it would be the portion of profits that the entity has agreed to pay out to its shareholders. And so that might be monthly, quarterly, semi-annually or annually. And some investors appreciate this steady stream of income, especially if they have upcoming liabilities that match at a similar cadence. Or maybe they just like the flexibility of the cash that they can use to fund their lifestyle, their next trip, or maybe reinvest for future gains.
Isabela: Exactly. I mean, who doesn't like to see some extra cash show up in their account every quarter or month, whatever it may be?
Linda: Yeah, I know. Somehow you always don't expect as well.
Isabela: Right? So what is the difference between distribution versus yield versus dividends?
Linda: Sure. The way I think about distribution is kind of your total compensation package from an ETF because it can include dividends, interest, capital gains, or a return on capital. Whereas dividends is kind of like your steady paycheck. And then yields can be an income return metric because it's your dividends over your price.
But actually, a return metric that I like to pay attention to more is your total shareholder return because it takes your dividend yields plus price appreciation. And so I find that a lot better because what good is an asset yielding 12% if it might depreciate 15% in price? You'd be better off owning an asset yielding 2% that has potential 10% price appreciation.
Isabela: Exactly. So that total return number is very much key when even looking at dividend ETFs.
Linda: Yeah, for sure.
Isabela: Awesome. So Linda, you mentioned Return On Capital, sometimes called ROC. And that's basically just when the ETF gives you back a portion of your own investment, almost like a financial boomerang. Could you maybe talk a bit more about the details of return on capital, like the pros and cons related to it?
Linda: So when I think about the pros, it's non-taxable upfront because, like you mentioned, it does return part of your original investment. So it's not actually considered income. So that can be nice if you're looking to defer that. And then in terms of cons, I would say that you can't escape taxes forever, obviously. And so you actually will incur greater capital gains when you do choose to sell that asset, given that it's decreased your adjusted cost base.
Isabela: Exactly. That makes sense. OK, so we've set some important definitions. Now we can answer how do you compare dividend ETFs. So we actually did talk about this beforehand, and we've identified three factors to look into. And these factors are number 1, looking at the underlying holdings; number 2, understanding if the dividend ETF is active or passive; and number 3, understanding the distribution frequency of the dividend ETF. So maybe, Linda, you can start us off and talk a bit about the underlying holdings of a dividend ETF.
Linda: Yeah, sure. I like this one because this is what I typically look at in my day to day when I'm evaluating dividend paying stocks. And so there's usually four things I like to look at. First is the sustainability of the dividend. And so one metric that you can use here is the payout ratio, which would be the dividends over free cash flow. And ideally, you want it below 100% because if it's over it means that they're paying out more cash than the business is actually generating. And so you don't want them to be funding it from debt or equity issuance, which is usually a red flag.
The second one I would look at is growth potential. And so there you can evaluate the denominator of that being free cash flow. And is that growing over time? Because usually, if it is and the business is quite healthy and growing cash, then it can also increase its dividend over time. And then while still staying within that payout ratio that I talked about.
Then the third I like to look at is management capital allocation track record. Are they committed to paying and growing the dividend, especially if that's something that you care about. Whereas maybe some businesses prioritize buybacks or reinvestments into the business instead, which is still fine and great for a total shareholder return perspective. But if you do rely on that income, then maybe not what you're looking for.
And then finally, one thing is avoiding yield traps. So sometimes you come across this big juicy yield, right? But it's not always a gift, especially if you look under the hood and it's actually just been the result of the price depreciating significantly, maybe due to some fundamental reasons that will limit their free cash flow going forward and could actually put the dividend at risk of being cut. So you kind of want to avoid running into a burning building at that point.
Isabela: Exactly So keep your eye out on those juicy yields and see whether or not that actually makes sense.
Linda: For sure. Yeah, but maybe I'll pass it to you and you can talk about the other two we identified.
Isabela: Yeah, of course. So when taking a look at passive versus active ETFs, dividend-paying ETFs. So on the passive side, we can start off with that. The way it works is a passive dividend ETF takes a look at the whole universe. And usually, we'll include all those companies that pay a dividend. And then sometimes the way it works is it's weighted based on the highest-paying dividend stock.
So, for example, like you mentioned, if there's those double-digit yields, that could be weighted the most heavily in the ETF. Now is that always the best? Well--
Linda: Yeah, not always.
Isabela: --it depends. Exactly. So, on the other hand, when you take a look at active dividend ETFs, the way that works is the portfolio manager is going to take a look at the whole universe, set certain factors in place, and then use their expertise to add value when picking the individual companies that are going to be part of that dividend ETF.
So, in that case, the allocation might not even exist to a company that has a double-digit dividend yield, because they know based on their research that that's not going to be sustainable. So yes, with also active dividend ETFs, there is a higher fee. However you are getting that portfolio managers expertise there.
Linda: Yeah, it can help you avoid some of those yield traps.
Isabela: Exactly. And then you don't have to worry about doing the research. You can sit back, relax, and enjoy. And then we move on to the frequency of distributions. So as you mentioned, that can be monthly, quarterly, semiannually, annually. And the reason why it's important to understand this and look into this is because you need to determine if this aligns with your income needs.
So there's a couple options as to what you can do with these distributions. One of those options is actually setting up a Dividend Reinvestment Plan, also known as a DRIP. And the way that this works is every time that the ETF pays you a dividend, it automatically gets reinvested back into that ETF. And then the next time that you have a dividend payment, it might be a little bit more based on the fact that you've reinvested that dividend.
And also your initial investment, if that ETF appreciates, will also keep appreciating even more, so the power of compounding, right? So you can either choose to do a DRIP, you can simply leave that money in your account, but then you get to decide if you want to participate in the market or not. So maybe you want to use that dividend to buy other ETFs as an example. Or maybe you have those quarterly reoccurring income needs where you need to use that dividend for those needs. Ultimately, it's really up to the investor to decide, what their needs are and what's best suited for them.
Linda: Yeah, a lot of options.
Isabela: Exactly. There definitely is a lot. One question I had for you, Linda, also was, can you tell us what type of industries pay dividends versus what type of industries don't pay dividends?
Linda: Yeah, we tend to see more of the mature, stable, cash-generating sectors pay higher dividends. And so that can include telecom, banks, energy, consumer staples, utilities. So Canada is quite rich in those sectors, actually.
Isabela: Yes.
Linda: Whereas on the other hand, some higher growth sectors like technology, health care, consumer discretionary, they tend to reinvest more into growth. And that's why in the US we might see lower yielding or more non-dividend-paying companies.
Isabela: Exactly. And then that's when it's important to also understand the total return like you were talking about.
Linda: Right. Totally.
Isabela: Awesome. OK. So one other thing actually-- because we did also mention the frequency-- is, is there an ideal time to buy a dividend ETF? Maybe you can tell us a bit about the ex-dividend date.
Linda: Yeah. So it doesn't really matter in terms of the long term relative to your total shareholder return. But if you are trying to time getting in and receiving that dividend before the next one, you would want to buy the asset before the ex-dividend date, which is usually the cutoff date where they decide the allocation. But if you don't really care about the next one, you're in it for the long term, then you can actually get in after the ex-dividend date, and the price would have actually come down by the amount of the dividend in order to incentivize new buyers before the next distribution.
Isabela: Exactly. So it's always good just to understand whether or not you want that dividend and then know when the ex-dividend date is to know when is the appropriate time for you to buy that dividend ETF. Awesome. OK. So this brings us to our last topic, Linda. I wanted to get your thoughts on whether or not millennials and Gen Z, do they really need dividend income?
Linda: Yeah, I would say it really comes down to personal risk-based preferences. I'd say a lot of young adults, we have similar financial goals. We want to fund a house, maybe a kid, marriage, trip, et cetera. But the path to getting there can look quite different. Maybe one investor prioritizes more of the safe, high-dividend-paying assets where they just collect their dividends and they can reinvest and compound that over time until they're ready to make that large purchase.
Whereas someone else, they might choose the riskier route of trying to maximize the price appreciation. So maybe if it works out in their favor, they can get an even bigger house or whatever. But that one's definitely the riskier path because maybe the time comes where they want to make that purchase, but then their assets just depreciated significantly in value, and they don't have that income backstop.
So definitely things to consider. Maybe the sweet spot for you is somewhere between the two, but it really comes down to just personal preferences, what can help you achieve your long term financial goals within your risk tolerance.
Isabela: Exactly. And you mentioned the risks there. And one way to work around the risks is through diversification, which is the benefit of a dividend ETF. So, for example, surprisingly, dividends aren't always guaranteed. And we did see this during COVID even with the cruise lines.
Linda: Exactly. Yeah, I cover those stocks. And they all had to cut their dividends when their operations shut down.
Isabela: Yeah. So if you're reliant on this income, you just have to keep that in mind, where there could be an opportunity where that income won't reach your account. So if you're invested in individual stocks, that's a huge risk. Versus a dividend ETF, we're going to have that basket of stocks. If one of those companies pauses their dividends, you still have those other companies in that ETF that hopefully didn't pause their dividends because it's well diversified. So you're still going to get something. Just something for the audience to consider as well when making decisions.
Linda: It eliminates a lot of the options that we talked about earlier as well.
Isabela: Exactly. All right. So if there's one major takeaway from today's episode, it's this. Don't let high yield blind you to the bigger picture. Take a look under the hood of the ETF. Think about where you are in your investing journey. And remember that total return is what ultimately moves the needle.
Thank you for listening to this week's episode, and as always, stay curious, stay informed, and stay invested.
Disclosures
The statements and opinions contained herein are those of the participants and do not necessarily reflect the opinions of, and are not specifically endorsed by, TD Asset Management Inc. or its affiliates.
The information contained herein has been provided by TD Asset Management Inc. and is for information purposes only. The information has been drawn from sources believed to be reliable. The information does not provide financial, legal, tax or investment advice. Particular investment, tax, or trading strategies should be evaluated relative to each individual's objectives and risk tolerance. It is not an offer to buy or sell, or an endorsement, or recommendation or sponsorship of any entity or security discussed.
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