October 9, 2005

A dividend fund with a twist

A reader wrote to me in May asking about the ING Canadian Dividend Income fund, which is now the AGF Dividend Income fund. He said, in part:

"I am interested in your opinion on this rather unique fund. Last year's yield was over 5.5%. Sounds too good to be true. Would appreciate your opinion."

As I wrote my response, I thought the topic worthy of a short article for other readers.

Although I didn't confirm the fund's current dividend yield, its 2004 audited financial statements indicate a gross dividend yield of 5.1%. The gross yield is that paid before deducting the fund's management expense ratio (MER). The fund's MER was 2.1% as of its latest financials (2.4% excluding waived expenses), which equates to a net yield of 3%.

The fund holds dividend stocks and a dose of income trusts (16% as of the end of May), which boast high cash distribution rates. This helps boost the fund's overall yield. But dividends accounted for a fraction of the fund's 2004 total return with capital gains accounting for the lion's share of its 23% total return. It appears that significant capital gains have been contributed by banks, energy stocks (mostly trusts), and selected small cap stocks (some of which are very illiquid). But management expects that its strategy is itself a source of value added.

The fund employs a strategy called Dividend Capture or Dividend Rollover. The idea is to buy a stock shortly before its ex-dividend date and sell it shortly after it ceases trading ex-dividend. (At the ex-dividend date, the stock trades at a price that is reduced by the amount of the declared dividend per share.) It is based in part on the theory or expectation that the stock price will rise back up to its pre-ex-dividend level - or possibly higher. If all goes according to plan, the manager can pocket the dividend payment and, possibly, a capital gain. Scattered dividend payment dates of the portfolio's stocks are also used in an attempt to collect 'extra' dividend payments to further enhance yield.

If this sounds like a strategy that involves frequent trading, that would be a very big understatement. The fund's turnover in 2003 was 765% - equivalent to an average holding period of less than seven weeks. In 2004, turnover tipped into four-digit territory, at 1,045% - or an average holding period of just over a month. This type of strategy doesn't mix well in Canada's thin equity market.

The fund's assets are growing quickly - having risen from $17 million at the end of 2003 to $140 million as of June 2005. While it's still a manageable size, turning over an all-Canadian portfolio 8 to 10 times annually will become increasingly difficult. While the fund seems to focus on big, liquid dividend payers, I estimate that the fund could start running into some difficulty as it approaches the $1 billion asset level. Well before that, it will be precluded from participating in the smaller illiquid names included in the portfolio at December 31, 2004.

Direct brokerage costs, a cash cost, increase in lockstep with portfolio turnover. The less obvious cost is the 'market impact' cost of frequently trading large blocks of stocks. One example of market impact is illustrated when placing an order to sell shares. The market price of those shares may fall before the order can be filled. Buy orders can have the same effect - i.e. pushing up the price before the shares are purchased. This only occurs where the order size is large relative to a stock's liquidity or trading volume.

Admittedly, this is not a current problem since assets are just a fraction of the $1 billion mark. However, it's worth noting today so that investors can set appropriate future expectations. Besides, now with AGF's marketing dollars and a strong couple of years behind it, the fund may start to gather assets more quickly from new money and, more significantly, from switches out of unpopular AGF funds where exit fees would otherwise apply if the money left AGF's coffers.

I have no official opinion of the fund. While I'm doubtful of this strategy's ability to consistently extract sufficiently high profits out of the market, it seems to have worked well so far. But investors should understand that it has only existed in a very favourable environment for dividend stocks and trusts. I would like to see how the strategy works in an environment like 1998, where high yield securities were pummelled - or in an environment where dividend stocks are not the subject of the market's infatuation. Plus, the fund has achieved great success by frequently trading a very small asset base.

For now, enjoy the excess profits generated by this fund - assuming they continue in the near future. But eventually, either the market's sentiment will shift or the assets will rise to the extent that the strategy will be challenged. I expect the fund to disappoint to the extent that it won't be able to match its early numbers.