One of the biggest mistakes I see dividend investors make is confusing income with total return. A stock or exchange-traded fund (ETF) paying a generous dividend isn’t necessarily creating more wealth than one paying very little.
Remember, dividends aren’t free money. On the ex-dividend date, a stock’s price or an ETF’s net asset value theoretically adjusts downward by the amount of the upcoming distribution, all else being equal. Any subsequent price recovery is a separate economic event.
You can see why this distinction matters by comparing two popular Canadian ETFs. Over the trailing 10 years, the iShares S&P/TSX Composite High Dividend Index ETF (TSX: XEI) delivered an annualized total return of 11.8%, compared with 12.5% for the iShares S&P/TSX 60 Index ETF (TSX: XIU). Yet XEI currently offers a higher trailing 12-month yield of 3.5%, versus just 2.1% for XIU.
Personally, I enjoy the idea of receiving a monthly paycheque tax-free inside a Tax-Free Savings Account (TFSA) as much as anyone. But if you’re reinvesting that income rather than withdrawing it to cover living expenses, I think prioritizing total return makes more sense. And there are several reasons why a high-dividend strategy can underperform a broader stock market portfolio over time.
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Higher fees can reduce returns
The first consideration is cost. Dividend-focused ETFs often charge more than conventional market-cap-weighted index funds because their underlying indexes require additional screening for yield, dividend sustainability, or other fundamental characteristics.
XEI, for example, charges a 0.22% management expense ratio (MER). That’s not particularly expensive in isolation, but it is noticeably higher than some broad Canadian equity ETFs.
XIU is actually something of an anomaly here. Despite tracking a straightforward index of 60 Canadian blue-chip stocks, it charges a relatively high 0.18% MER, partly reflecting its status as one of Canada’s oldest ETFs. A better comparison might be the iShares Core S&P/TSX Capped Composite Index ETF (TSX), which charges just 0.06% while providing broader exposure to the Canadian stock market.
The difference between 0.22% and 0.06% might seem insignificant, but it represents an additional $160 annually on a $100,000 portfolio. Over several decades, those costs compound. Of course, fees alone don’t determine performance. But when two ETFs provide broadly similar exposure, I generally prefer keeping more of my investment returns rather than paying for additional index screening.
Dividend strategies can miss growth opportunities
The second problem is sector concentration. Canadian dividend ETFs tend to emphasize established companies in financials, energy, utilities, and telecommunications. These businesses often generate substantial cash flow and return a meaningful portion of it to shareholders. There’s nothing inherently wrong with that.
But focusing too heavily on dividend yield can leave investors underexposed to companies that reinvest most of their earnings into future growth. Technology and healthcare companies are a good example. Many fast-growing businesses pay relatively small dividends or none at all because management believes it can generate better returns by reinvesting capital internally.
A dividend-focused portfolio might systematically exclude those businesses, even if they eventually become some of the market’s strongest performers because they prioritized reinvestment or buybacks over dividends.
That’s why I generally prefer broad-market exposure for long-term accumulation. It allows successful companies to become larger portfolio holdings over time without requiring them to meet an arbitrary dividend yield threshold.
Dividends can create a tax drag
The third consideration is taxation. Inside a TFSA, eligible Canadian dividends and capital gains are generally tax-free, so receiving distributions doesn’t create an immediate Canadian tax liability.
But the situation changes in a non-registered investment account. Canadian dividends may qualify for the dividend tax credit, which can make them relatively tax efficient compared with interest income.
However, they’re still generally taxable in the year they’re received, even if you immediately reinvest them. That creates a potential tax drag for investors who don’t actually need the cash.
By contrast, a company that retains earnings and reinvests them internally may generate more of its shareholder return through capital appreciation. Investors can generally defer capital gains tax until they sell their shares.
