The field of behavioural finance observes how we act as investors and often attempts to explain why we act the way we do.
One of the more familiar observations is “home bias,” which is the tendency to prefer investing in domestic firms over foreign firms. This tendency came to mind recently in a conversation I had with an investment colleague who shared with me some historical global data on the contribution of dividends to total return.
While his purpose was to explain his general preference for dividend-paying stocks over non-dividend stocks, it struck me that this could also partially explain home bias. In fact, it could underlie a strategy for tax-managing home bias.
Non-registered taxation
All income and gains in the registered world (i.e., RRSPs, RRIFs) are deferred within the respective plan, then fully taxable when drawn out. By comparison, the after-tax return of a non-registered investment is directly dependent upon income type:
- Interest & foreign income Fully taxable
- Realized capital gains Half is taxable
- Canadian eligible dividends Gross-up/tax credit
On a national basis, the 2011 average combined top tax rates for the three categories above are about 44%, 22% and 24%, respectively (as at February 1, 2011). To be clear, the third category is reserved for Canadian dividends, while foreign dividends fall within foreign income in the first category. In contrast, there is no domestic/foreign distinction for capital gains.
Total return
The return on an investment is a combination of the income it generates and distributes (and when it distributes), and its value when the investor sells it. With respect to stocks, one may expect periodic dividend payments and usually also hope to realize capital appreciation upon disposition.
A key skill of a portfolio manager is to assess the quality of interim flows and expected value of fund holdings at realization. In addition to the manager’s assessment, a Canadian investing in that particular fund also needs to consider a critical tax criterion: the aforementioned tax distinction between domestic and foreign dividends.
So how much might one expect dividends to contribute to total return?
The historical global data
As my colleague pointed out, we are likely at the end of a roughly 20-year bull market that has seen significant capital appreciation for stocks. In the wake of the recent downturn, a shift appears to be emerging toward an emphasis on “yield,” which, in my non-technical view, appears to be the desire for income-producing investments.
Based on the data* we reviewed together, that’s probably a good long-term approach. Over the 30-year period to October 31, 2009, the contribution of dividends to total returns in seven major economies ranged from 35% to 67%, with the worldwide average being 49%. Canada came in at 50% even.
Asset allocation by tax environment
In the non-registered environment, the greater the proportional contribution of dividends to total return, the more important is the domestic/foreign distinction. As a simplified example using the 2011 top bracket national average, a dollar of non-registered return comprising 50% capital gain and 50% dividend will net to 77¢ after-tax on a Canadian stock, versus 66¢ on a foreign stock.
Thus, to maintain geographic/risk diversification across both tax environments, an investor might be inclined to skew registered accounts toward foreign holdings and non-registered toward Canadian.
A further alternative/complement on the non-registered side may be to hold shares in a Canadian mutual fund corporation that in turn has foreign exposure. Such an investor can generally expect to receive eligible dividends, capital gains dividends and capital appreciation, despite that the corporation itself may receive foreign income.
Paying attention to and managing dividend taxation this way enables an advisor to offer useful insight and guidance in recommending appropriate holdings across a client’s entire portfolio.
* Source: FactSet Research Systems Inc. Returns are in local currency. Data as at October 31, 2009. Percentages stated represent the percentage of the total return comprised of dividends.