Choose dividend funds with care

Many retired investors who are seeking regular income want to have some dividend mutual funds in their portfolios because of the combination of good yield and tax advantages they are perceived to offer.

In fact, some of them do provide exactly those benefits. But a majority do not. Unless you choose very carefully, you can easily end up with an unsuitable fund in your portfolio.

What I call Type A dividend funds are the ones you will most often encounter. These are actually blue-chip equity funds in disguise. The portfolio consists mainly of common stocks such as banks, utilities, and the like. They have decent growth potential but anyone looking for above-average cash flow is likely to be disappointed if they put money into one of these.

This type of dividend fund fares best in rising stock markets, where the portfolio can benefit from higher share prices. When markets sag, so do the fortunes of Type A funds. 

For example, the Scotia Canadian Dividend Fund fits the Type A definition perfectly. The portfolio is mainly in common stocks with banks, Molson, BCE, and TransCanada Corp. among the largest holdings. This fund produced gains for invesrs every year from 1996 to the end of 2000, some of them substantial (30 per cent in 2000). But it lost money in 2001-02 when the markets tanked. As for distributions, they’re very low. The fund has paid out only 39c per unit in the past 12 months, which works out to a yield of 1.8 per cent based on the unit value at the beginning of October 2002.

Type B dividend funds are the ones I consider to be “pure” examples of what this type of fund should be. In this case, the emphasis is genuinely on tax-advantaged income. To achieve this, a large portion of the portfolio is invested in preferred shares and some of these funds now include a sprinkling of income trusts.

Because of this different approach to portfolio-building, the performance patterns of Type B dividend funds are very different from those of Type A. In fact, the two types should not even be lumped together in the same category since this makes performance comparisons meaningless.

One of the best examples of a Type B dividend fund is the GGOF Monthly Dividend Fund. If you judge it only on the basis of total return, you’re unlikely to be impressed. While Type A dividend funds were scoring big gains in the late 1990s, this one actually registered small losses. But through the bear market, the GGOF entry generated steady profits while Type A dividend funds sank. As for cash flow, this one yields about 5 per cent, all of which was eligible for the dividend tax credit in 2002 if received outside a registered plan.

In my view, this is the best of the Type B dividend funds currently available. Manager John Priestman is a veteran who understands how to put together an income portfolio to maximize cash flow and minimize risk. The three-year risk level of this fund is less than half that of the average for the Canadian Dividend category, according to Globefund.

Remember, if you are seeking income from a dividend fund, look for a Type B. It will provide the cash flow you want and the risk level is much less than that of a Type A fund.