Increasingly looking like their large-cap equity counterparts, Canadian dividend funds continue to have the edge on broader Canadian equity funds. The continuing popularity of dividend funds reflects a shift in investor psychology since the turn of the century, when fast-growing stocks that generally paid no dividends were all the rage. As well, cuts in the effective dividend tax rate have boosted the value of dividend income for investors.

The average annual compound return in the Canadian dividend fund category for the 10 years ended Jan. 31 was 10.3% — compared with 8.5% for Canadian equity funds and 10.5% for the S&P/TSX 60 index of blue-chip stocks that serve as their benchmark — which the dividend group accomplished with much lower volatility.

Two strong performers in this category are the giant $8.4-billion RBC Canadian Dividend Fund, offered by RBC Asset Management Inc. , and the $2.4-billion TD Dividend Growth Fund, sponsored by TD Asset Management Inc.

A top-quartile performer over the past five years, the RBC fund has shown itself to be a steady performer in all markets, most recently returning 12.9% in 2004, 21.1% in 2005 and 15.1% last year. Its five-year average annual compound return is a stellar 14%, eclipsing the benchmark. Year-to-date, it is up slightly less than 1%.

The TD fund is also a top-quartile performer over five years, producing an even better annual compound return of 15.3% over that period. It also delivered a strong 16.8% in 2004, gaining 23.8% and 15.9% in the subsequent two years, respectively. So far, the fund is a break-even proposition in 2007.

Both funds have earned four-star rankings from Morningstar Canada, with the TD fund’s risk-adjusted performance over the past three years making it the stronger of the two by a very slight margin.

Although there was once more variety, most dividend funds now fall into one of two categories: they are either conservative equity funds that emphasize high-yielding common stocks or they hold a broader mix of equities, preferred shares and income trusts. Both the RBC and the TD funds clearly fall into the first category.

John Varao started his career at RBC Dominion Securities Inc. in 1989, assisting brokers in making portfolio recommendations to clients. In 1991, he moved to Royal Bank Investment Management, the precursor of his present employer. Varao uses a proprietary process that incorporates quantitative, fundamental and technical indicators to identify high-yield stocks that exhibit sustained earnings and dividend growth potential. His low-turnover portfolio owns few income trusts or preferred shares, opting almost exclusively for common shares.

By contrast, Doug Warwick, who has been with TDAM and its related companies since 1984, following a short stint with Bank of Nova Scotia, has pulled together a broader portfolio, including a roughly 14% weighting in income trusts — which can go as high 20% of assets. Warwick seeks steady businesses that have above-average returns on equity, good yields and quality management. In addition, he favours companies with stability throughout the business cycle. Portfolio turnover has averaged less than 10% in recent years.

Holding a portfolio of 57 stocks, the RBC fund’s top holdings account for about 48% of assets. With 63 stocks currently, the TD fund plants a much larger portion of its assets — recently about 67% — in its top 10 holdings. In fact, the top 20 names in the TD fund currently make up more than 80% of assets.

Both funds invest primarily in large-cap stocks, enjoying overall dividend yields of 3% (TD) and 2.7% (RBC).

A large portion of the dividend yield comes from investing in other Canadian banks; 45% of the TD fund is held in just five Canadian banks, including TD Bank Financial Group. Add in major insurers, and the fund’s overall allocation to financial stocks hovers around 60%. It also holds more than 21% in the energy sector and 8% in telecom.

The RBC fund has a somewhat smaller 35% holding in bank stocks, including its own, and holds 47% of its portfolio in financials overall. Because there are generally fewer established dividend-paying stocks in the energy sector, the fund has only a 21% weighting there.

The TD fund’s energy exposure is driven primarily by income trusts, with long-lived assets such as Canadian Oil Sands Trust. The RBC fund, on the other hand, has chosen to support suppliers such as TransCanada Pipelines.

@page_break@The RBC fund carries essentially the same P/E and price/book measures as its TD counterpart, with both funds mirroring the benchmark quite closely.

Given the narrow holdings and blue-chip emphasis, it’s not surprising these funds present parallel risk profiles. The RBC fund has a standard deviation of 7.8 over the past five years, while the TD fund’s is 8.7. Both results are still much lower than the benchmark.

Similarly, the funds’ identical five-year Sharpe ratios (1.37) indicate they have been moving in tandem, although the RBC fund has been the better risk-adjusted performer recently with a standard deviation lower than 90% of the funds in the category.

Both offerings could add value to a domestic portfolio, but not if it included with other dividend funds, many of which are quite similar, Morningstar Canada reports.

It’s difficult to pick a winner, but investors should realize the RBC fund is the less expensive of the two. Its 1.72% MER (TD’s is 2.01%) is lower than more than 83% of the funds in its category. The benefits of this may be more evident in a low-return environment because they create a lower hurdle for the fund, Morningstar Canada says. IE