VDY: Canadian High Yield ETF Is Overweight Financials/Energy

The Vanguard FTSE Canadian High Yield ETF (TSX:VDY:CA) pays a monthly distribution and seeks to reward shareholders by investing in Canadian companies that deliver relatively high yield. On paper, the fund would appear to have an auspicious future given its over-weight in the Financial and Energy sectors. I say that because in a rising interest rate environment, banks typically benefit from higher net-interest-margin, or NIM. Meantime, all investors are aware of the challenges in the energy sector since Putin invaded Ukraine 10-months ago and arguably broke the global energy (and food) supply chains. Today, I’ll take a look at the VDY ETF to see if it might make sense to allocate some of your “dividend income” targeted capital to the fund.

I’ll start off by taking a look at how the fund has positioned investors for success going forward.

Top-10 Holdings

The top-10 holdings of the VDY:CA ETF (as of month-end November) are shown below and were taken directly from the Vanguard.ca VDY ETF webpage where you can find additional information on the fund. The 10 holdings below equate to what I consider to be a very concentrated 71.7% of the entire 47 company portfolio:

The top-two holdings are two of Canada’s largest banks – the Royal Bank of Canada (RY) and Toronto-Dominion Bank (TD) with an aggregate 26.2% weight of the entire portfolio.

The Royal Bank of Canada released Q4 results at the end of November and they were relatively flat yoy: revenue of C$12.57 billion was +1.5% yoy while GAAP EPS of C$2.74 was a C$0.08 beat. RY generally benefited from a 350 bps rise in the Bank of Canada’s benchmark interest rate from March to October 2022: the bank experienced higher spreads as compared to the prior year. However, the quarterly results included $381 million of provisions – primarily taken on loans made during the current quarter. That compared to $(227) million in the prior year due to “releases of provisions on performing loans, primarily in Personal & Commercial Banking.” ROE was a healthy15.6%.

RY stock is down 9.6% over the past year and currently yields 4.1% after increasing the quarterly dividend 3.1% to $1.32/share.

Earlier this month, Toronto-Dominion Bank raised its dividend 8% after posting Q4 earnings that were a beat on both the top- and bottom-lines. Q4 non-GAAP EPS of C$2.18 was a C$0.14 beat while revenue of C$12.25 billion (+12.0% yoy) came in C$950 million above consensus estimates. That said, the stock is still down 13.5% over the past year.

Oil and natural gas pipeline infrastructure company Enbridge (ENB) is the #3 holding with an 8.4% weight. Enbridge and partner EDF recently completed France’s first off-shore wind farm. The 480 MW Saint-Nazaire wind farm is expected to power the equivalent of 700K people with electricity – or 20% of France’s Loire-Atlantique region’s annual electricity consumption.

Due to strong liquids and natural gas pipeline volumes, Enbridge expects relatively strong EBITDA and DCF growth for the full-year:

But while the stock has held up relatively well during the 2022 bear-market (+3.9%), the recent 3% dividend increase was a disappointment for shareholders who – in light of the company’s expected DCF growth – expected significantly more. Enbridge currently yields 6.7%.

The # 5 holding is Canadian Natural Resources (CNQ) – considered one of Canada’s best energy companies – with a 6.6% weight. CNQ stock is up 40% over the past year and currently yields 4.2%. Last month, CNQ raised its dividend 13.3% after posting very strong Q3 results that included free-cash- flow of ~C$1.7 billion after total dividend payments of ~C$2.5 billion and base cap-ex of ~C$1.0 billion.

Canada’s largest tar sands producer, Suncor (SU), is the fund’s #7 holding with a 4.5% weight. Suncor raised its quarterly dividend 10.6% to C$0.52 after strong Q3 earnings beat expectations. Total upstream production increased to 724,100 boe/d in Q3, compared to 698,600 boe/d in the prior year quarter. During the quarter, refinery crude throughput was 466,600 bpd and refinery utilization was 100%. SU stock is up 28% this year and currently yields 4.9%.

The portfolio as a whole – as mentioned earlier – is considerably over-weight two sectors – Finance & Energy:

Performance

As of the end of November, the VDY ETF had a relatively solid 10-year average annual return of 9.66%:

However, I would point out that Seeking Alpha reports rather tepid dividend growth, including three years (2015, 2016, and 2021) when total distributions actually declined yoy:

These declines were basically due to big trouble in the Canadian energy patch, when pipeline exit capacity could not keep up with production (2015, 2016) and the bottom fell out of the Western Canadian Select (“WCS”) price as a glut developed in oil sands production. In 2021, it was – of course – the negative impact of the global pandemic on demand.

The graphic below compares the 10-year returns (not total returns, just capital appreciation) of the VDY ETF versus the Schwab U.S. Dividend Equity ETF (SCHD):

As you can see, the SCHD ETF outperformed its Canadian peer by 100%+. That demonstrates a clear advantage when it comes to capital appreciation. When we add in dividends, SCHD’s 10-year performance is even more impressive:

What this shows is that the SCHD ETF has been a superior investment from both a capital appreciation and a dividend income perspective.

Risks

The VDY ETF is significantly over-weight two sectors – Financial & Energy – and is therefore not a good choice for investors looking for the safety and income a much more diversified ETF would deliver (like the SCHD ETF).

That is especially the case given the Canadian energy sector’s continuing challenge of a lack of adequate pipeline exit capacity which acts to effectively constrain production growth. That being the case, note that despite a very good couple of years recently, stocks like ENB and Suncor have gone relatively nowhere over the past 10-years. Indeed, both stocks are actually down over the past decade:

If you hold the VDY ETF in a qualified retirement plan, funds distributions are exempt from the Canadian foreign-tax on dividends. Otherwise, will be hit with a 15% Canadian foreign-tax on dividends.

Lastly, for U.S. investors there is additional foreign exchange risks as the relative exchange ratio of the U.S. dollar and the Canadian Loon can impact both capital appreciation and distributions.

Summary & Conclusion

While the Vanguard Canadian High Yield ETF is interesting given its over-weight in two sectors that should be relatively defensive in nature given the macro-investment environment (i.e. rising interest rates and high oil & gas prices), this is not the way to play those themes. While VDY’s yield is relatively attractive, the long-term performance of the fund significantly lags that of its U.S. counterpart – the SCHD ETF. This is from both a capital appreciation and dividend growth/income perspective. That being the case, I recommend selling the VDY ETF and moving the proceeds into SCHD.

Also, note that VDY’s 0.20% expense fee is a whopping 14 basis points higher than SCHD’s (0.06%).

I’ll end with a 1-year total returns comparison of the two funds and note that – even in a rapidly rising interest rate environment and a strong energy sector, the VDY ETF barely eked out a win over SCHD: