Retirement can be a hard transition for baby boomer investors, who have to give up their growth mentality and shift their portfolio priorities toward income and safety. Many have to replace – or at least reduce their weighting in – the Amazons and Shopifys that have furnished rich returns in favour of boring utilities, telecoms, financials and real estate investment trusts.
Fortunately, there are now several ways for investors to help increase their income exposure, including several dividend exchange-traded funds (ETFs). Over the last few years, numerous income-focused ETFs have come to market, which give investors an opportunity to buy a diversified basket of dividend payers. They’re often safer than owning individual stocks – the risk is spread over dozens of names in multiple sectors – they come with low management fees and many deploy innovative strategies that even allow you to keep a few big name growth companies that can continue benefiting from the market’s upside.
However, it’s worth shopping around, since not all income ETFs are created equal. Most equity income ETFs focus on one of two factors: either dividend growth or high yield, notes Jonathan Needham, vice-president of ETF Distribution for TD Asset Management Inc.. Dividend growers, also often called aristocrats, are stocks that consistently raise their payments every year. They are few in number and easy to identify, so the funds in this space are largely interchangeable.
High-yield focused funds – portfolios that hold companies that pay above 5% – can come with significant risks. In some cases, the companies in these ETFs are ones that have seen their stock price fall – yields can rise when shares decline and vice versa – and are at risk of cutting their payouts. A lot of these companies are also in sectors that are facing significant headwinds. For instance, many of the highest-yielding large-cap stocks on the Toronto Stock Exchange right now are pipeline companies that risk being stranded on the wrong side of the transition to emissions-free energy.
“There are dividend traps,” Needham says of high-yielding companies. “Chasing yield tends to hurt you, longer-term. Indeed, both of those strategies fall short.”
The quest for higher quality
To that end, TD has three dividend ETFs centred on increasing total returns, which is the return you get from the combination of income payments and share price growth.
The TD Q Canadian Dividend ETF (TQCD) and TD Q Global Dividend ETF (TQGD) use a quantitative strategy that factors in not only the company’s yield and history of dividend growth, but also the quality of its balance sheet. With strict limits on exposure to any one sector, these funds cover the entire dividend universe and come with competitive cash flows and reduced risk compared to dividend growth or yield-focused ETFs. For advisors, they represent a diversified, low-cost way for clients to enjoy higher-quality dividend exposure.
The TD Active U.S. Enhanced Dividend ETF (TUED) and TD Active Global Enhanced Dividend ETF (TGED) are more sophisticated still. Actively managed, these funds don’t only invest in dividend payers showing a high potential for total return. They can also invest up to 30% of their portfolio in secular growth companies like Amazon and Alphabet that wouldn’t qualify as dividend stocks. They then use derivatives to generate a synthetic cash income stream from these stocks by actively selling call options, creating a covered call position. In addition, they leverage the cash in the portfolio to sell cash-secured puts. (A future article will do a deep dive into how TD’s ETFs implement this strategy.)
With this approach, investors can have it both ways – they receive a competitive, steady income while also taking advantage of the market’s upside.
“You’re not leaving money on the table” for lack of long-term, secular growth stocks, says Needham, assuring boomers who are more habituated to capital gains. “We all need a little Amazon in our portfolio.” While his hunch is that markets will “normalize” in the coming years, with quality dividend payers advancing at least as much as growth leaders, investors can sleep well knowing they may benefit from either bias.
While the TGED and TUED ETFs management fees come with a slight premium to other index-replicating ETFs, the costs are more than justified by the strong returns attributable to their active management style. In the slightly more than two years it’s been around, TGED has generated a total return of 49% (18.6% annualized) as of Sept. 3, according to Bloomberg, outpacing the comparable MSCI World index by close to eight percentage points. Likewise, TUED, launched in June 2020, has produced a total return of 41% (30.5% annualized) to Sept. 3 this year, handily beating the S&P 500 over the same period.
How to use these ETFs in a portfolio
Both the quantitative and actively managed dividend ETFs make an appropriate core component of a portfolio for retirees, those approaching retirement and other income seekers, Needham adds. They can be complemented by ETFs invested in corporate and government bonds, preferred shares, real estate and infrastructure to create a portfolio that has steady income with lower volatility.
“The dividend strategy is a core equity strategy,” says Needham. "If you want a go-anywhere fund in an easy-to-access and cost-effective ETF structure, to be nimble and outsource your strategy to a professional, these are great options.”