Are dividend ETFs redundant?

Numerous studies have found that the number of dividend paying stocks continue to decline. Not surprisingly, this has resulted in an increasing concentration of dividend paying stocks in large cap indexes as medium to small cap indexes tend to have members with characteristics not conducive to paying shareholder dividends: mainly lower profitability and less reliable earnings given relative immaturity in the business cycle.

The implication being that an overlap exists between broad based equity indexes and dividend paying stocks. But, just how large is the overlap?

The U.S. is considered one of the two countries (Japan being the other) where dividend concentration is less pronounced. However, if one purchased the Vanguard Large Cap ETF (VV) and the Vanguard High Dividend Yield ETF (VYM), of the top 50 holdings of each, there are 24 stock in common. This includes a staggering 19 of the top 20 holdings in VYM by weight.

Similarly, if one purchased iShare’s flagship Cdn. Large Cap 60 Index Fund (XIU) and iShare Cdn. Dividend Index Fund (XDV), one would find 15 of the 30 stocks compromising XDV are also found in XIU. This figure has more context if one considers that the overlap constitutes over 60% of XDV by weight.

The result is that one is not diversifying by investing in a large cap ETF and a dividend based ETF. Instead, an investor has merely created a redundancy in their portfolio and failed to mitigate against downside risk.

The issue becomes magnified if that same investor commits mutual fund-itis and begins purchasing niche ETFs which overlap the broader equity based ETFs. The ETF pairings to watch for in particular would be purchasing a broad based equity ETF and then a financial services industry ETF and/or preference share ETFs. Given the latter are typically issued by the same companies that pay dividends, if they can’t make a preference share dividends, which typically ranks in priority to common share dividends, they are not paying any class of shareholders a dividend.

The lesson being, and as a preview to a post next week, choice and selection are often not the best thing for the investor.