In the last week, two different people from completely different circles, ages and walks of life have approached me and said (to paraphrase): “my advisor tells me to invest in a dividend mutual fund. He/she says they are safe in this environment. What do you think?” I think the dividend mutual fund can be a huge trap product. It looks great. It sounds great. It often does not perform as billed.

In theory, this product should work. Studies have shown that stocks which pay increasing dividends over time out-perform stocks that pay dividends which are not increased or non-dividend paying stock. But in order to build a well-balance dividend portfolio, an investor probably requires 10-15 stocks from differing industries and over $100,000 in capital. Why not just buy a dividend mutual fund instead and benefit from diversification with a low entry fee? Plus, dividends yield stocks are safe to invest in.

But, in practicality, a typical dividend fund runs into a host of issues:

• Fees eliminate most of your dividend gain. In normal times, a typical dividend yield is anywhere from 2-3%. A typical MER on a mutual fund? To pick random examples, the TD Dividend Growth (a 5 star rated mutual fund by Morningstar) has a MER of 1.92%. Manulife Dividend Fund has a MER of 2.3%. The IG Mackenzie Maxxum Dividend Growth (Class A) Fund has a MER of 2.69%. In other words, your aggregate dividend yield in a fund is substantially eliminated by the MER.
• The definition of “dividend” can be loose. The TD Dividend Growth Fund’s largest holding is Canadian Oil Sands Trust. Not a bad stock but it doesn’t pay dividend. Its distribution is taxed as income which is not taxed as efficiently as dividends (ideally, you want to be taxed on dividends and income). Other Canadian based dividend funds hold U.S. companies. Guess what? Dividends from U.S. companies are treated as income for Canadian taxes. The result? If you hold the mutual fund outside your RSP, the fund is much more tax unfriendly than the name sounds.
• Dividend funds can create redundancies in your portfolio. Do you own a blue-chip equity mutual fund? An exchange traded fund tracking a major stock index? A host of financial stocks? If you do, why would you buy a dividend fund. Most of the largest holdings are already in equity funds and ETF’s. All you are doing is concentrating your risk and not spreading it as per a prudent asset allocation strategy.
• Buy the issuer and not the fund. IG Mackenzie Maxxum Dividend Growth (Class A) Fund is a large dividend fund (approximately $1.2 billion assets under management) issued IGM Financial Inc. (TSX: IGM). Its 5 year performance was 6.6% according to Morningstar. IGM’s 5 year performance is 16.10% (and 10 year compounded growth was 16.5% ending December 31, 2007). In other words, the shareholders of IGM are doing better than the mutual fund holders of its products by a large margin.

There are certainly well-performing dividend mutual funds out there and an exchange traded fund tracking dividend stocks would certainly elminate most of the fee issues (but perhaps not solving the redundancy issue depending on your portfolio). The point being don’t get caught in the safety and security that the brand of a dividend mutual fund may give you. Study its holdings and fees closely before you decided to take the plunge.