Canadian dividend funds enjoyed another steady year in 2007, thanks to strong demand for dividend-yielding stocks and a general sense that the global growth story would continue. However, with bank stocks experiencing their worst decline in roughly 10 years, dividend-seekers are nervous. Where should they turn?

One recent laggard in the category is the $3-billion PH&N Dividend Income Fund, sponsored by Vancouver-based Phillips Hager & North Investment Management Ltd. The fund rose 13.6% in calendar 2005, when the benchmark — the S&P/TSX composite index — was up 24.1%. That trend continued; it delivered a further gain of 16.5% in 2006, while the index saw an increase of 17.3%. This past calendar year, however, the fund was down 4%, sharply trailing the index’s return of 9.8%. The result is an average annual compound return of 12.7% for the five years ended Dec. 31.

Contrast this with the $3.3-billion AGF Canadian Large Cap Dividend Fund, managed by Connor Clark & Lunn Financial Group under the auspices of Toronto-based AGF Funds Inc.The AGF fund rose 20.8% in calendar 2005, posted a 17.1% gain in 2006, then returned 7.1% this past year. As a result, its five-year average annual compound return is 16.1% — a first-quartile showing.

Interestingly, both funds earn a four-star ranking from Morningstar Canada, suggesting that their seemingly diverse paths may actually be somewhat similar.

Most dividend funds employ one of two strategies: they are either growth-oriented equity funds that lean toward higher-yielding blue-chip stocks; or they feature a mix of equities, income trusts and preferred shares aiming for high yield and income. Both of these offerings fall into the former category, holding less than 5% of their portfolios in income trusts or cash.

Dale Harrison heads up PH&N’s Canadian equities team and is lead manager for the PH&N fund. He joined the firm 10 years ago from BMO Nesbitt Burns Inc., for which he was a financial services analyst. He favours a GARP philosophy, looking for mature companies with diversified business lines, effective barriers to entry, high levels of profitability and solid price/free cash flow measures.

Gord MacDougall is one of the founding members of CC&L and, along with long-time partner Alastair Dunn, has been actively involved in the management of the AGF fund for more than 20 years. MacDougall’s earlier career included stops at Sun Life Assurance Co. and Yorkshire Trust.

MacDougall is a top-down investor. Prior to any stock-picking decisions, the CC&L team develops a macroeconomic view, using a checklist that looks at the economy, inflation, monetary policy, valuations and investor sentiment. The resulting score, which is updated regularly, drives sector allocation and individual stock choices, which are drawn largely from the S&P/TSX 60.

Presently, roughly 41% of the assets in the AGF fund are in its top 10 picks. Although the AGF fund holds 267 positions overall, the Canadian portion is generally much more concentrated than the foreign holdings. And despite holding significantly fewer positions (80 overall), the PH&N fund plants a still larger portion of its assets — recently, 49% — in its top 10 holdings. Both funds generally keep portfolio turnover low, which keeps trading costs at a minimum.

Although it is not surprising that both funds have major stakes in the financial services sector, the portion of the portfolio devoted to the major Canadian banks and insurance companies is significant, given the current turmoil. The PH&N fund has 47% of assets under management in the financial services sector, whereas the AGF fund holds 38%, vs a 29% weighting in the index.

The AGF fund has been backing industrial products and slightly underweighting energy and materials; it has limited exposure to technology and health-care companies.

The PH&N fund holds fewer energy issues, maintaining a modest 11% weighting — among the lowest in the fund category. Aside from its major exposure to financials, it leans toward consumer and industrial stocks, as well as utilities.

In recent years, Harrison has been adding more U.S. names to the PH&N portfolio, often taking foreign content up to 25%, a self-imposed limit. Right now that level is about 16%, all of it across the border.

In contrast, although out-of-country equities account for a similar portion of the overall AGF fund’s portfolio, only about 6% of that is in the U.S., with the balance split equally between Asia and Europe.

@page_break@The AGF fund sports a higher price/book and price/earnings ratios than its PH&N counterpart, producing a considerably lower dividend yield, although one that is in line with the median dividend fund. Both funds clearly favour large-cap stocks.

The PH&N fund has a standard deviation of 8.1 over the past five years, while the AGF fund’s standard deviation is a slightly higher 8.9, with the difference being more evident in recent years. Again, in terms of risk, the PH&N fund registers numbers that are lower than most dividend funds.

In addition, the two funds’ relative five-year Sharpe ratios — 1.4 for the AGF fund and 1.1 for the PH&N offering — indicate the AGF fund has been the superior risk-adjusted performer over the period, with both funds faring better than the category median.

However, the PH&N fund’s Sharpe ratio remains at the top of the category for the past 10 years, Morningstar notes.

Fears of further subprime mortgage troubles and their impact on Canadian banks could be a problem for the entire dividend fund sector, but both these offerings have shown their ability to be good houses in bad neighbourhoods in the past.

Although the AGF fund has been winning the comparison battle recently and has a solid record, the PH&N fund’s admirable history and cost — at a modest 1.14%, its MER is roughly half the fund category’s median — suggest that it may be the better choice in choppier markets.

The PH&N fund tends to underperform during hot markets, only to find favour during the inevitable corrective phase. Consequently, it should appeal to risk-averse investors more interested in stability than absolute returns.

Of interest is the fact that PH&N recently launched a new advisor-oriented series that offers a trailer fee of 50 basis points. IE