By Miles Clyne
It has long been touted that investors who focus on traditional income-generating investments are taking the safer, more predictable way to secure wealth and assure themselves current and future income. Investment income typically comes from common and preferred stocks that pay dividends, or interest income from bonds and GICs.
These days, most individuals invest through vehicles like mutual funds and exchange traded funds (ETFs), which are a collection of individual securities. This makes sense, unless you can do the analysis on the individual securities to create a portfolio that you have confidence in owning. Pretty much the only analysis you need to do on a basket of investments like a mutual fund or ETF is compare the performance against its benchmark. If you are close to the benchmark over a reasonable time frame, (i.e. 5 years), you’ve got a decent investment – but not necessarily the right investment. Hang with me on that thought.
Let’s take a quick look at the dividend income space in Canada. Not all dividend-producing investments are equal. However, one thing that all Dividend Income funds in Canada have in common is that they ALL underperform their benchmark (source of data: S&P SPIVA report 2014). For the moment, ignore the blue line in the chart below. The white line is the S&P/TSX Canadian Dividend Aristocrat’s Index. This is the same index that Canadian Dividend Income funds are compared to. The index is down just over 10% year-to-date at the time of this writing. Given that not one dividend income fund has performed as well as the white line over the past 5 years does not say much for the management skill going into these products, nor the peace of mind you would hope to have from these investments. Additionally, the SPIVA report does not say how badly these managers underperformed, only that zero beat their benchmark over the past five years.
If you were fortunate enough to own investments associated with this index prior to mid-2014 you may have done well. Since 2014 you have been relying on the belief that now you are being paid to wait, and hoping that growth will resume. Trust me, you do not want to live off of dividends alone.
Moving on to the blue line: preferred shares.
The blue line is the benchmark for the S&P/TSX Preferred Share Index. Over the past 5 years it would be hard to image how anyone could be happy with this dividend income vehicle. Over this time period it has cost you more than it has benefited you. And preferred shares are considered safer than owning dividend paying stocks. Hmm, must be an anomaly? Not really; this was one of the more obvious train wrecks coming over the past several years.
I have one more interesting chart to show you. This is XLB, the long-term bond ETF that replicates the long term government bond index in Canada. The index is down since early in the New Year almost 9 percent. Based upon the income this index generates, it would take about 2.25 years of income to make up the losses experienced. Yep, get paid to wait, be happy!
These charts typically illustrate very good, if not the best-case, scenarios with these various assets. They are common assets that most Canadians will own in some fashion in their investment and retirement accounts. Given the interest rate environment and economic uncertainty we are in, they are taking it on the chin.
With interest rates marginally above zero both in Canada and the US, it is hard to imagine these investments can be buoyed along for the next 20 years like they have for the past 20 years as interest rates have fallen. All investments that are interest-rate sensitive (investments that produce income) have a much harder time generating growth when interest rates rise. With historic low interest rates, the best-case scenario may be very low levels of income for investors and no growth. The worst case – the level of losses these assets classes may encounter - will depend on how much and for how long interest rates rise.
Sadly, most investors are not being informed about the risks associated with the investments noted above. For two decades, ever lower interest rates added growth along with the income to these investments, making them very attractive. With interest rates at multi-decade lows, rates should ultimately rise, creating loses, not gains to capital. Income streams are getting near, if not at, historic lows for most of these assets. Offsetting any loses will be extremely difficult, and if you actually need the income to maintain your standard of living, you may have to spend your capital along with the income. This will challenge the sustainability of the investment portfolios of those that depend on their portfolio for income.
When the world changes and we don’t, is there is a price to pay? What was once safe and cozy may ultimately turn risky and uncomfortable. You may have a good product, but it may not be right product at the right time. The good news is there are solutions. Ask your advisor about your portfolio and if you need to make changes to your strategy.