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Dependable Dividends
Scotia Canadian Dividend Fund

Dividend funds are usually viewed as the more conservative and less risky cousins of equity funds. Traditionally, dividend funds reduce risk by investing mainly in dividend-paying preferred shares, which have many of the characteristics of bonds. However, it has become common for dividend funds to focus their attention on dividend-paying common stocks, which provide greater potential for capital gains than do preferred shares.

Is the perception of lower risk borne out by reality? According to GlobeFund, the volatility of the average dividend fund has indeed been about one half that of equity funds over the last three years. What did investors get in return for lower volatility? Over the same three years, dividend funds gained an average of 6.4% annually, while equity funds managed gains of only 0.7%. Over the longer term, Canadian dividend funds yielded an average annual return of 9.9% over the ten years ending November 30th. In contrast, equity funds yielded only 7.2% annually over the same period while the S&P/TSX 60, which is a possible benchmark for dividend funds, had an average annual return of 7.5%.

There are sixty-three dividend funds listed on GlobeFund. Of these, only twenty-eight have at least a five year track record. With only fourty-three of the 223 stocks in the S&P/TSX Composite yielding more than 2% (and only eighteen members of the S&P/TSX 60) it is inevitable that there will be great similarities in the makeup of Canadian dividend funds. A Frugal Funds survey of dividend funds in 2002 found that the two main points of differentiation among dividend funds are the fraction of preferred shares held, and the fraction of bonds held. Some funds held as much as 50% of their portfolio in preferred shares while others had none at all, and the fraction of bonds ran from zero to about 10%. Bond holdings were generally corporate issues.

The survey also revealed a value bias in dividend funds, which is not surprising given that they invest only in dividend-paying stocks. Generally, the approaches used were a blend of value and growth-at-a-reasonable-price (GARP), with a handful of managers fully in the value camp. Another appealing feature of dividend funds is that they usually charge a lower management expense ratio (MER) than their equity counterparts. The median MER for dividend funds stands at a comparatively modest 2%, while equity funds have a median MER of about 2.5%. As always, frugal investors should keep fund MERs to a minimum since these fees have a negative impact on returns and add up over the long term.

Dividend funds with MERs of less than 1.8% include offerings from Phillips, Hager & North, ScotiaBank, Bank of Montreal, and Royal Bank. The big banks' mutual funds aren't usually prominent among low-MER funds, but they are well represented in the dividend fund category. The rest of this article focuses on the Scotia Canadian Dividend fund, which charges a very modest 1.21% MER. In the interest of full disclosure you should know that I currently own units of this fund.

Scotia Canadian Dividend

Over the past five years, as equity markets went through a severe contraction, the $988 million Scotia Canadian Dividend fund gained an average of 9.2% annually. In contrast the S&P/TSX 60 index gained only 3.5% over the same period. Over ten years, the fund yielded average annual returns that exceeded the index's performance by four percent and that of the average dividend fund by almost one percent. As of December 12th the fund was up 19.6% since the start of 2003.

The fund is managed by a team of ten analysts at Scotia Cassels, but Britt Doherty has held primary responsibility for the fund since May of 2003. Mr. Doherty describes his investment style as bottom-up GARP with a value bias. The fund invests primarily in dividend-paying, large-cap common stocks of companies with a market capitalization in excess of $750 million. Total return (yield plus capital growth) is emphasised, with preference being given to companies that show strong potential for dividend payments. The fund's low 18% turnover ratio attests to Mr. Doherty's long-term approach.

Mr. Doherty does not favour preferred shares for the fund because they are interest rate sensitive, and so behave too much like bonds. He also considers the liquidity risk associated with preferred shares to be too great. Recently, the fund has been substituting income trust units as a proxy for preferred shares. At mid-year preferred shares and income trusts made up about 7.5% of the portfolio. Furthermore, the fund will not invest in bonds, except for short-term money-market instruments.

At the end of November, the fund held about seventy stocks, of which six were U.S.-based and represented 3% of assets. The top three sectors were Financial Services, Utilities, and Materials. Top stocks included the major banks, BCE (BCE), TransCanada (TRP), and Terasen (TER). Overall, the portfolio's dividend yield was 2.5%, and the trailing twelve month total income distribution (as of September 30th) was $0.39 per unit, or 1.6% of the unit price.

Faced with a slow economy, talk of deflation, and a looming war in Iraq, the fund started 2003 defensively, being overweight in financial stocks and underweight in utilities and materials. Later in the year the fund increased its exposure to the industrial sector, with BCE being brought up to nearly market weight. The gold sector also saw increased representation with the addition of Placer Dome (PDG) and Barrick (ABX). A large weighting in utilities was very good for the fund, as that sector saw near 20% returns during 2003. However, the mid-year decision to reduce the fund's exposure to mining, and to sell Noranda (NRD) in particular, turned out to be a costly case of bad timing. Indeed, in the second half of the year commodity prices rallied strongly, and the price of Noranda's stock jumped by about 60%.

The fund currently holds about 7% of its assets in cash. Mr. Doherty has already identified stocks he wishes to buy, but he is waiting for a market pullback before deploying his cash. Going forward, he expects continued growth in corporate profits in 2004, albeit at a substantially reduced pace. He also expects to see interest rates start to inch up. As this happens the fund's exposure to the rate-sensitive financial and utilities sectors will be lowered, and industrial and materials stocks will fill the gap.

With a $500 minimum investment and purchase available through bank branches, the Scotia Canadian Dividend fund is easily accessible to all investors. Its enviable long-term track record and a near rock-bottom 1.21% MER makes the fund an excellent choice for small and not-so-small cost-conscious conservative investors. The fund should be held as part of the equity portion of a well-structured portfolio.

Always keep in mind that fees, such as the MER, act to lower your returns and will add up over the long term. Seeking out quality funds that charge lower fees helps to ensure that more of your investment keeps on working for you.

Carl Wolfe, PhD

February 2004

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