Dividend funds take a hit

Dividend funds have long been a popular choice for investors looking for a combination of cash flow and modest growth. Historically, they have tended to be steady performers with minimal downside risk. But these days, conditions are anything but normal!

The final three months of 2007 were miserable ones for most of the funds in the recently renamed Canadian Dividend and Income Equity category. The average fund lost 3.2per cent over the period and in many cases the decline was much worse, exceeding 5per cent in a few cases. Only one fund in this category, out of the more than 100 listed on Globefund, showed a profit during that time frame: the tiny ($3.3 million in assets) imaxx Canadian Dividend Fund which managed to eke out a 0.53per cent gain. It’s secret? A below-average position in financial stocks (25per cent).

For most dividend funds, financials are the mainstay of their portfolios. Most usually commit at least one-third of their assets to the sector and it’s not unusual to find a weighting of more than 50per cent. The reasons for this are obvious. Once you get beyond financials and utilities, Canada does not offer a wide range of attractive high-dividend stocks, unlike the U.S. Of course, bank stocks are the foundation of this sector and until now they could be depended on for annual dividend increases and steady growth.

The U.S. subprime mortgage mess has changed all that. Although our tighter lending rules protected us from the widespread abuses that have led to the current crisis the United States, some of our financial institutions invested heavily in mortgage-backed collateralized securities and are taking big write-downs as a result. National Bank and CIBC have been the big losers so far and the share price of both companies has been hammered. On Jan. 21, CIBC stock was trading more than 40per cent below its 52-week high. That’s almost unheard-of among the major banks and dividend funds that held significant positions in CIBC shares were hurt accordingly.

But even banks such as Toronto Dominion, which has virtually no subprime exposure, have seen their share price fall. As this was written, TD shares were down 16per cent from their 52-week high. Scotiabank, considered to be the most conservative of Canada’s Big Five banks, was down by about the same percentage. Royal Bank was off almost 22per cent and Bank of Montreal by close to 26per cent.

When the funds release their performance numbers to Jan. 31, the picture is going to look even worse. Most of them were down more than 4per cent for the month and in some cases the losses exceeded 6per cent. Declines of that magnitude are virtually unheard-of among dividend funds.

That brings us to the obvious question – what should you do now? My advice is to hold on to your dividend funds. Unless there are some unexpected surprises lurking (always a possibility) it appears most of the Canadian banks have been oversold (CIBC and National are the obvious exceptions). We have already started to see a price rebound, which will benefit the dividend funds.

However, I would not advise putting any new money into dividend mutual funds right now. If you have cash that you plan to commit, hold on to it until the situation stabilizes. Then begin gradually building positions.