Higher yields in the bond market have weighed very heavily on dividend-paying equities – after all, bonds are a clear competing investment for investors looking for income, and those bonds pay more now than before. This weakness in the dividend space has created a potential opportunity, given valuations and rather juicy dividend yields (before or after tax). However, higher yields, inflation, and growth gyrations have increased performance dispersion in the dividend space. We believe a more active or rotational approach to dividend investing has become more optimal.
But first, a bedtime story.
You hear the word Goldilocks a lot lately. It’s the phrase used to explain the perfect environment when markets just go up with no solid reason except that everything is “not too hot, not too cold, but just right.” We all remember the fairy tale. A girl wanders through the forest and into a bear house. She’s rather picky but tries all the food, the chairs, and the beds, looking for one that is ‘just right.’ The tale has been around for at least two centuries. The traditional story concludes with Goldilocks running away from the bears’ house after they discover her sleeping in Baby Bear’s bed. Goldilocks was a fussy home invader who would very likely meet her demise in the shadow of the bears’ wrath. In the true-to-life version, her actions lead her into a very serious situation. In every perfect Goldilocks environment, the situation can change in an instant when the bears return home and discover that someone has eaten their dinner.
In 2024, inflation is the big bad bear coming back home. Its steady easing has halted, even reversed somewhat, and this has reduced the odds and timing of global central banks cutting rates. Bond yields have risen considerably, approaching their 2023 highs. The current level of Canadian and U.S. bond yields is not crippling high but high enough for investors to reevaluate their options and expectations. The buy-anything period is likely over, at least for now, and markets are entering a more volatile period; perhaps by circumstance, the timing also aligns with weaker seasonality. While the round trip of rate expectations has only recently impacted broader equity markets, the dividend space has been feeling the impact of higher bond yields for some time. Higher for longer brings with it a unique set of risks to the dividend space. This has made the dividend space more challenging, and we believe it increases the
The dividend factor (aka dividend stocks) has lagged other factors all year. While unfortunate, this has also created a bit of an opportunity. Many companies now carry dividend yields of 6% or 7%, which are pretty safe dividends. The challenge has become not just whether to add to dividend strategies but how. Divergence in performance within the dividend space has increased, which means it’s no longer best just to add anything with a yield to a portfolio. Not all yields are created equal, and the winning or losing factors keep changing.
We believe the more flexible approach, or a more active management approach, can better adapt to these changing market conditions. Especially compared to a more passive or index-hugging strategy.
Index misallocations – Let’s face it: The TSX is concentrated on Financials and Energy. Passive funds screening on yield amplifies the concentration risks. One of the more popular dividend ETFs has 56% of the fund allocated to Financials. These misallocations expose investors to higher sector-specific risks. Active management done right improves diversification and can reduce this concentration risk.
Dispersion – Active managers are particularly challenged in periods when dispersion is low, and market leadership comes from extremely large stocks. When all the dividend stocks move together, who cares how you get exposure? But when the performance dispersion is high among dividend stocks, it matters how you are exposed. Dispersion across the dividend space is quite high, and variability among dividend strategies in Canada is also on the rise. In the chart below, we look back at the Dow Jones Canada Select Dividend universe and plot the monthly return difference between the 25th and 75th percentile. Outside of the crisis period in 2020, the average dispersion this year is near the highs.
Volatile periods – Higher rates tend to increase volatility. Passive indexing tends to struggle when markets get choppy, whereas active managers can be nimble. Raise cash or actively increase company exposure to more defensive sectors. This proactive approach allows managers to manage risks, especially when it’s the most rate-sensitive sectors that are under pressure.
Unusual macro forces – Higher rates create market tension, especially for high-duration assets and highly leveraged companies. Active managers can identify and avoid companies that may have a high dividend yield but are vulnerable to rising borrowing costs. When rates are high, market inefficiencies tend to arise.
Canadians love dividends, but most active funds aren’t very active
There are dozens of dividend and income-focused funds and ETFs in Canada. Within the Morningstar Canadian Dividend and Income Equity category, there is no shortage of options. Among them are the bank-owned behemoths, with the top four funds managing over $50 billion. When dissecting the universe, an important metric to look at is the active share, which establishes the percentage of holdings that differ from the benchmark index. A portfolio with an active share between 20% and 60% is considered a closet indexer. Among these behemoths, the active share is as low as 35%, and the highest is just 53%. The category average active share for funds over $200 million is just 50%. In effect, the category is rife with closet indexers, as seen in the chart below. Most ‘active’ managers tend to look very much like the index. Liquidity also plays a part. The bigger the fund, the more difficult it is to look very different than the index, but that’s not the only reason. Career risk for portfolio managers is also a consideration. Our view is that it’s impossible to beat the market if you look like the market. Managers must strive to earn the fee they charge. For example, the Purpose Core Equity Income Fund has an active share of 72%, the third highest in the category, along with a strong performance record.
Digging deeper, in the chart below we have the sector allocations across the category. The vertical bars represent the range from maximum to minimum allocation for the sector, with the category average as well as the sector weight of the Purpose Core Equity Income Fund. By and large, most sectors have a somewhat limited exposure range, with the real major differences coming largely from the Energy and Financial sectors. These two sectors are where active managers can make a meaningful distinction from both the index as well as peers.
Final Thoughts
Building a sustainable and high-performing dividend portfolio in Canada requires a keen eye and strategic selection. Active management empowers managers to go beyond the limitations of passive indexing, seeking out hidden gems, prioritizing quality over just high yields, and adapting to changing market conditions. Canadian dividend-paying companies make up the core of many advisor models and investor portfolios. Passive strategies play a key role in building robust portfolios to help reduce costs and provide broad market beta, but active management best suits the dividend-focused core, especially in present market conditions.
— Derek Benedet is a Portfolio Manager at Purpose Investments
Insights with Purpose
At Purpose, we are attempting to change the status quo within the investment industry – mainly the enigmatic standards by which the industry operates. We are an open book when it comes to portfolio design and discussions surrounding our outlook and strategies. We want to make managing portfolios simpler for advisors and act as a sounding board for ideas. We start by running portfolio comparisons between your portfolios and ours. Not to say ours is right and what you are doing is wrong, but to understand the differences and have discussions surrounding the rationales. We aim to keep this discussion going quarterly; this is not a one-and-done service. We want to build our relationships with advisors so that the end client has a satisfactory investment experience.
If you want to know what exposures your portfolio is tilted toward, feel free to reach out to our team. As the great Peter Lynch once said, “Know what you own and why you own it.”
Sources: Charts are sourced to Bloomberg L.P.
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