What ever happened to diversification?

The philosophy of our site is that individual investors should try to act and to invest as if they were institutional investors, choosing the same cost-effective products and using the same benchmarks as the latter; in general, see Our philosophy . Institutions use almost without exception the same benchmarks to measure their performance (in general, see Investment returns and indexes on our site):

• for North America, the Standard & Poor's composite indexes: the S & P / TSX in Canada, and  in the U.S., the S & P 500; and elsewhere.
• the MSCI Barra indexes : for developed countries,  the MSCI Barra EAFE, and for emerging markets the MSCI Barra EM.

 
The more an investor pursues an investment policy that does not seek to replicate, on a cost-effective basis, those market-wide indexes, the more he exposes himself to realizing results that deviate (and most likely under perform)  returns as measured by those indexes. This, plus the fact that there are more and more products that reproduce, on a cost-effective basis these indexes, and are traded actively, means that an index approach is increasingly popular. The bottom line: as a general rule, a policy of dividend investing necessarily means you are investing in a universe of shares that is less diversified than the markets in general.

To our knowledge few if any institutional investors follow a dividend investing approach. Some institutions seek additional returns using other techniques, such as writing covered call options; see Politics and economics discussion (or as PDF doc.1509).   Some authors actually recommend that retail investors consider this approach as an alternative to dividend investing; see Stock Investing Strategies (or as PDF doc.1510) . We ourselves are not big fans of option trading, a topic for another day.

Because we are based in Canada, we will look first at Canadian markets, where the Canadian tax system taxes dividends from Canadian companies very generously. But another reason is that the small size of the Canadian market on a global scale makes it a poster-child for how dividend-investing can lead to inadequate diversification.  We will then look at the much larger U.S. market. A note to our Canadian readers: in Canadian taxable accounts dividends from US shares are not as attractive as Canadian dividends since the Canadian tax system does not extend its favorable gross-up and credit treatment to foreign source income; in general, see Taxation and Investing  on our site.
 

In Canada

In Canada, the S & P / TSX 60 Index is popular with institutions perhaps because of the very actively traded ishares ETF XIU   which tracks it. It is composed of Canada's largest companies and behaves much like the TSX Composite Index. As of 21 01 2010:
 

• 19 companies in the S & P / TSX 60 index pay no dividend at all or a dividend with a modest  yield (less than 1.00%);
• 22 are high yielding (4.00% and above); and 
• 19 paying an average dividend yield (between 1.0% and 4.0%).

 
Thus, an investor who does not invest in companies in the S & P / TSX 60 which either pay no dividend or pay a dividend with a modest return is excluding nearly a third of all those 60 companies. And if an investor limits himself to companies that pay high dividends, he is excluding almost two-thirds of all those companies. And if an investor invests an equal amount in every share (rather than in proportion to  market capitalization), a common practice because it is simple to administer and does not require checking and monitoring changes in market capitalizations, the deviation from the index becomes even more important.In general, on how many shares is enough to diversify, see Diversification and equities on our site.
 
Dividend Aristocrats (Canada) - even less diversified
 
Many investors use the Dividend Aristocrats from Standard & Poors to help them in their dividend-investing approach; see the S & P document doc.1511 and Shenfield and Buchanan , p.3 (or as PDF doc.1512) .

An investor who invests only in companies classified as Dividend Aristocrats by S & P / TSX (criterion for inclusion: are part of the S & P Canada Broad Market Index (BMI), a little-known index, and have increased their dividends every year for the previous five years) would be limited to 56 companies as of January 20 2010; see the site for Standard & Poor’s on Canadian Dividend Aristocrats . In general on this approach, see: The Dividend Guy (or as PDF doc.1513); Dividends Matter (or as PDF doc.1514) ; encore Dividends Matter   (or as PDF doc.1515) ;  and CdnDrips.blogspot (or as PDF doc.1516) . The components of the Dividend Aristocrats change annually; for 2010, see Heinzl (or as PDF doc.1517). The Canadian Dividend Aristocrats are a weak equivalent to their much better known U.S. equivalent (see below),  where eligibility requires 25 years of dividend growth versus only 5 in Canada.
 
Here are some of the drawbacks of this approach:
 

• The BMI index differs significantly from the TSX.
• Of the 56 companies (see list at TMX Money Index & Constituents ) in BMI, most are not part of the S & P / TSX 60, either because they are smaller companies (typically more risky) that are part of the TSX Composite Index, or because they are affiliated with a company that is already in the S & P / TSX 60 (e.g. Power Financial, a subsidiary of Power corporation) and is therefore excluded from membership in the S & P / TSX 60. 
• Almost 50% of companies classified as Dividend Aristocrats are part of the financial services sector, an alarming concentration; see S&P doc.1511. For more on the concentration in financial services, see (in French) Bourget Finance & Investment (or as PDF doc.1518).

There is an ETF fund based on the Dividend Aristocrats in Canada: the Claymore S & P / TSX Canadian Dividend ETF fund . There is a competitor to the S & P / TSX Dividend Aristocrats, the Dividend Achievers, by Mergers , with which we are less familiar, and which seems less followed.
 
Conclusions for Canada

A policy of dividend investing in Canada typically involves investing an equal amount in a small number of companies, and so departing significantly from a portfolio index which is based on a greater number of companies and which is capitalization weighted. Blindly following dividend investing in Canada may be harmful to your financial health. The site of Keith Betty  that we much admire, and who advocates a dividend approach to investing, makes the following recommendations and gives the following warnings:

• Diversify effectively by selecting stocks from several different operating sectors such as: banks; non-bank financials; power generation; telecommunications; and pipelines.
• Each individual stock should generally make up at least 1%, and preferably 2-5%, of the portfolio. 
• Consider trimming individual stock holdings if they grow to more than 10% of the portfolio and either selling or adding more if they fall below 1%.
• Avoid overconcentration of stocks in a particular sector such as banking or telecommunications. Limit sector weights to 15-20% of the portfolio. 
• Remember that companies in "parent-daughter" relationships such as Atco - Canadian Utilities or Power - Power Financial - Investors Group/Great West Lifeco depend on cash flow from the daughters to the parent, and will not move independently.  Holding both parent and daughter is usually inadvisable. 
• Because the interests of the family may not coincide with those of the shareholders in family-controlled companies, and further difficulties may arise over matters of succession, limit your exposure to any family-controlled group. 
• Recall that holding subordinate-voting shares when a company has multiple share classes exposes you to all of the risk, while giving the controlling shareholder a 'free ride' with other people's money.  That's a much better deal for the controlling shareholder than for you. 
• Although the banks usually make a substantial profit, they will occasionally be hit with loan losses.  Some banks will usually be hit more than others, but it is impossible to tell which ones in advance.  Consider dividing the portfolio allocation amongst three or more bank stocks.  
• Recall that the regional banks, including the two Quebec-based banks, offer greater risk than do the five national banks. 
• Use "limit bids" when trading stocks in lightly-traded companies like Canadian Utilities. 
• Select stocks from the three different dividend paying cycles to even out cash flow. …..
• Note that Canadian equities should only form one part of a properly-diversified portfolio.  Also, because of the narrow breadth of the Canadian market, the dividend-growth investor will undoubtedly wind up being significantly weighted in Canadian banks.  This is all right as long as the investor realizes that the banks, by themselves, do not allow adequate diversification, even if they might form a significant part of the Canadian holdings.  For proper diversification, the investor should include equities from the US and international markets, as well as bonds.

 We doubt that many investors follow these guidelines which, properly applied, require considerable research and time.