Friday, April 18, 2014

Dividend ETF’s Are Bad for Investors: Here is Why

The Exchange Traded Funds (ETF) industry has ballooned since 1993, when the first ETF on S&P 500 was introduced. Currently, there are hundreds of ETF’s covering many investment strategies present. One strategy which is also being covered with dividend etf’s includes dividend paying stocks. In this article I would discuss the positives and negatives of dividend ETF’s, and explain why they are bad for income investors.

Pros:

Some of the positives of owning dividend ETFs include instant diversification, ability to invest passively and the ability to gain exposure if you do not have a lot of money.

1) Instant diversification,

The biggest allure of dividend ETF’s is the fact that investors can easily purchase a basket of shares with just one trade. This basket of shares would be representative of different industries included in the index, and would reduce the risk that our investor overcommits to a certain sector if they are prone to chasing yield for example. Plus, you get to pay one commission to purchase a whole basket of stocks, or some companies might let you purchase ETF's commission free.

2) Ability to invest passively

Another appeal of dividend ETF’s is that it lets investors purchase a basket of stocks, and then not have to worry about analyzing stocks, monitoring 30 - 40 companies in detail. This is the job of the investment manager in charge of the ETF, who reads annual reports, keeps up with current environment, calls companies and does all the leg work so that the investor does not have to do it. Reading annual reports could sometimes be an intimidating or very boring task for some investors. The dividend ETF is ideal for investors who want to set the investment, and forget it.

3) Good for beginning investors who are still learning and have less than $10,000

The investment in a dividend ETF or dividend mutual fund is probably best for beginning investors who have less than $10,000 to start with. It offers them instant diversification and passive investment at the fraction of the cost of a do-it-yourself portfolio using an online broker. Dividend ETF’s also make it very easy for investors to put additional funds to work, while maintaining sector diversification in the index and without worrying which of the 30 - 40 securities is the best one to buy.

Cons:

1) Annual costs

While Dividend ETF’s provide investors with instant diversification and the ability to let someone else to worry about the mundane details, the Ivy League investment manager comes at a price. In addition, most companies that offer dividend ETF’s also want to earn a fair profit on this product. As a result, investors in some of the largest dividend ETF’s like SPDR S&P Dividend (SDY) and iShares Dow Jones Select Dividend Index (DVY) pay 0.35% – 0.40% per year in management costs. If the stock portfolios in those ETF's yield 3% on average, this means that 12%-13% of your dividend income will be paid out as an investment tax. If our investor is also in the top bracket, and pays 23.80% federal tax on the income, they would end up with only two-thirds of their desired dividend income. While placing your stocks in a tax-deferred account such as a Roth IRA can eliminate taxation issues, placing your investments in ETF’s would result in recurring annual charges. In fact, investment companies end up charging their fees on a daily basis. This compounding of fees could cost investors large amounts of money over a normal 20 - 30 year investment period. While many ETF’s are now commission free at various brokerage houses, investors would need to pay a commission for most of the dividend ETF’s out there.

2) Investors have no say about which stocks the ETF holds

Another negative of dividend ETF’s is that investors have no say on how these baskets of stocks should be invested. Sometimes, a dividend ETF might hold shares that do not fit in its strategy for months. For example, back in 2008 and 2009, the SPDR S&P Dividend ETF (SDY) held on to shares of companies that cut or eliminated distributions for several months after the fact. As a result, a portion of the capital of this ETF was not properly invested and was not generating much in dividend income for investors. In addition, many dividend ETF’s are placing higher weights on higher yielding stocks, which could increase risk for income investors. This increases exposure to companies with accidental high yields which are large because the dividend is in danger. In addition, some of these ETF’s also tend to focus mostly on higher yielding sectors like utilities and financials, which could increase risk as the portfolios would not be properly diversified.

3) Investors fail to learn about investing

The most successful investors make their own investments, after a careful analysis. If investors simply purchase an ETF, they might not truly get an understanding of what they are buying and could pay a high price over time. Educating yourself on how companies make money, how the economy works and understanding how to value a security would be beneficial to investors who follow stocks, bonds, commodities or real estate. If they blindly buy ETF’s or mutual funds without fully understanding what they are getting into, they might be much more likely to lose money by selling out during bear markets or by getting overly excited about the wrong investments at the most inopportune times.

4) If not enough money is attracted, the ETF could be closed

Another less known risk about dividend ETF’s is that if the fund fails to attract enough investors, it could end up closing and returning money to investors. If our investor is passive and only checks their portfolio once or twice/year, this could mean that they can potentially miss on potential upside by not being invested in the markets. A small ETF size typically also translates into higher bid/ask spreads and higher annual costs.

5) Too much turnover

I am a pretty passive dividend investor, who makes sell transactions very rarely. In fact, I have realized that one of my largest mistakes I have committed in the past few years was selling fine companies in order to get something that I thought is better. The end result of this mistake is that I have ended up with more paperwork, and transaction costs, without really achieving a better benefit. Talk about reinvestment risk. Therefore, I am not a fan of ETFs or Mutual funds that have turnover, which produces capital gains that investors have to foot the bill for, without really getting anything extra. The issue with dividend ETFs is that they contain quite a lot of turnover, and unfortunately the investor does not have any say about it. Honestly, if a company I own froze dividends for a few years, it would not be a strong enough sell signal for me. I also don't want to sell a company when it splits into two after raising dividends for 40 years, despite the fact that the new companies lack a record of dividend increases. This happened with Altria (MO) after it spun-off Kraft (KRFT) and Phillip Morris International (PM) in 2007 and 2008.

For my personal portfolio, I tend to invest in stocks directly, and build my exposure to different sectors from the ground up. I have a direct say on portfolio weights, and selecting only companies whose stocks are attractively priced at the moment. My only cost is the commission to buy or sell securities. If commissions were $5/trade, an investors purchased shares in $1000 increments, then this comes out to a 0.50% one-time cost. This is a much better cost than paying 0.35% – 0.40% every year. During a 20 - 30 year period the costs are going to reduce income over time. In addition, I have flexibility to exit stocks that do not make sense right away, and reinvesting the funds into another security that makes sense. Plus, if you achieve a certain net worth, your investment costs might be close to nill with some brokerage houses.

Full Disclosure: Long MO, PM, MDLZ, KRFT,

Relevant Articles:

Dividend ETF or Dividend Stocks?
Dividend ETF’s for busy investors
Are Dividend ETF's for you?
Should dividend investors invest in index funds?
The ultimate passive investment strategy

20 comments:

  1. Vanguard VIG symbol ETF holds dividend achievers and its ecpense rstio is .10. It is an excellent fund and I purchase through Vsnguard brokerage so my cost to purchase is zero. I own some dividend stocks and I enjoy buying them, but the VIG ETF is an excellent fund. I must disagree with your conclusion that this particular ETF is bad for an investor.

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    1. The issue with VIG vs my own dividend portfolio is not only the fee but the inconsistancy of the dividend. VIG pays quarterly and the last 5 or 6 quarters went something like 0.49/ share, 0.38, 0.39, 0.41, 0.43, 0.39/share. With DGI your divies are paid monthly and since it is buy and hold your monthly income goes up. I believe the authors pocket change portfolio has never had a decrease in monthly income since inception. Can't say that with VIG just looking back 6 months.

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  2. In my account that I can purchase what I want, I go with dividend stocks. I really don't like paying other people to manage my money as you do with mutual funds or ETFs.

    Unfortunately, in my brokerage account I am unable to buy individual companies, so I have purchased some Dividend ETFs (which I can purchase) and then some index funds. I may go back to all index funds if it doesn't seem to be working as well.

    Now, if I ever left my employer I would reinvest all this money into dividend stocks =)

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  3. Sorry Investor 57, but dividend ETF are awful. One major point that DGI missed is that the benefit of dividend growth investing is that you can act as a value investor. If you buy VIG right now, you are essentially buying CLX, CL, JNJ, ADP, APD, and many other beautiful dividend stocks at HUUUUUGE valuations. When you buy more in ten years, you may get a great deal on the stocks mentioned above, but others will probably be over valued. By buying an ETF, you miss out on the second biggest benefit to dividend growth investing.

    Instead, just find something like Loyal3 and build your own fund one stock at a time, buying undervalued securities that meet your personal growth criteria.

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    Replies
    1. True, but I am not buying VIG now. I have a valuation approach just like for the individual stocks that I buy. VIG makes us about 40% of my portfoilio, it is kind of the base of my individual stock portfolio. I do not need the dividend income now, but will need it in 10 years. I add to my VIG portfolio when it passes my valuation entry points. I have accumulated VIG beginning at a price of around $32 and then again at around $36, low 40's in a few month time frame, and then again in the upper 60's. So, I may not be buying every potential dividend growth stock at the optimum price, I am not randomly buying and I have excellent portfolio diversification. Also, I am able to concentrate on a few number of dividends stocks which allows me some time to do other things instead of so much research on dividend growth stocks.

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  4. There is another cost associated with picking your own stocks....time. depending on how you value your time this cost can far exceed that of etf commissions

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  5. I have been trying to decide if ETF is right for me vs purchase stocks directly. As a beginning investor with approx. $1,000 start up capital and $100 monthly to invest, what should I do? I have been reading and educating myself on drips and like a few, and have looked at loyal3. The loyal3 drawback is the limited selection available and it is a farily new company. I have plenty of time on my side (hopefully) but not a lot to start with. I would most likely be limited to one or two stocks to start with. Any of the readers input / suggestions / tips are welcome. Thank you kindly.

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    1. I'm not an expert, but I think Loyal3 is worth the drawbacks for someone in your position. Commissions and fees are pretty significant when looking at a $1,000 initial purchase and additional purchases of about $100. If you buy shares every month and pay $7 commission, you're shelling out 7% of your principal, which might be an entire year's total return, right off the bat in commissions each month. You'd also pay that $7 again when you sell (although to be fair, you could sell many months' purchases at one time, causing the commission hit to be lower).

      I can't give advice on your personal situation, but if it was me, I'd choose 3 or 4 solid companies at Loyal3 (not saying to go with these, necessarily, but KO, MCD, and PEP might be decent choices) and just invest that $100 each month.

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    2. Fidelity and Vanguard have free ETF trades with a certain dollar threshold. You might need to accumulate enough money before you do ETFs. I used to build up $500 then make a trade. Individual stocks are exponentially more risky than holding an ETF.
      http://www.schwab.com/public/schwab/active_trader/what_you_can_trade/etfs?src=nmk&sv1=sb84sJMwq_dc&sv2=33696346988&sv3=xpxe4op6q0&sv4=schwab%20free%20etf&sv5=e

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  6. While I understand why some folks gravitate to ETFs, I'm not a fan of ETFs either for many of the same reasons DGI has pointed out in this article. Another alternative available for the investor seeking a "basket of stocks" is offered by Motif Investing. (www.motifinvesting.com)

    With this broker you can purchase your own custom designed basket of stocks (up to 30 different), at what ever weighting you choose for each, for a SINGLE $9.95 commission.

    The minimum purchase is very reasonable $250. At $9.95 commission I personally would limit my purchases to at least $1,000- but the real key is being able to diversify with your choice of stocks, and your choice of weightings for each. With up to 30 different stocks, investors could design a well diversified portfolio.

    Motif Investing is not a magic bullet, as it has some downsides: Currently they do not reinvest dividends (except stock dividends, like KMR as one example), and they do not pay any interest on cash balances. Despite those two negative points, Motif Investing may still be a better choice for the investor who wants a "basket of diverse companies" of his own choosing, without having to fork over multiple commissions. Let the dividends pile up, and combined with new cash, perhaps once or twice a year- rebalance the entire basket, again for just a single $9.95 commission.

    Its an alternative worth looking into, at the very least.

    Michael

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  7. I really do not see the point of ETF's. One can either manage their own portfolio, have an index tracker, or use investment trusts ( closed end funds ) that have have expertise in particular areas. Also you are a shareholder.

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    1. The major advantage is you can buy/sell during the day like a stock. They are also passive investments and have less tax issues due to churning in mutual funds.

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  8. DGI,

    Agree 100%. While index investing is probably preferable to the majority of the population, for anyone who has any interest in investing they should be managing their own portfolio. Why pay anyone a fee, no matter how small, when you can buy the same exact companies at valuations and yields that make sense for you? Those fees seem small until you've managed to amass six or seven figures, and then they're not so small anymore.

    Time spent managing a portfolio is a big drawback to active investing, but I personally love researching, managing, reading, investing. I can see how this isn't a fun way to spend time for other people, however.

    Best wishes!

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    1. Jack F The biggest drawback I see to individual stock on line investing is at IRS time, when the preparer charges to calculate tax on each different stock. That can run up a large bill, Otherwise I like controlling my own buys because I take advantage of periodic lows in desired stock prices to improve the dividend return.

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    2. Would you class a REIT as an ETF? I have one REIT
      that is consistent holding value and good dividend
      but I am wary of others.

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    3. A REIT is just real estate mutual fund you can trade.

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  9. Michael J:

    After reading your comment, I checked out Motif. Dude, this thing looks like the real deal. I have always wished there was a cheap way to "build my own ETF" and not have to pay commissions for each stock. Motif makes this happen. You can equal-weight 25-30 positions and rebalance them all for just $9.95? Think about that. Pretty sweet.

    I don't have an account there yet, but the site looks extremely promising.

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    Replies
    1. Yes, I agree. Being able to custom design a basket of wonderful companines, weighting them however each investor desires- equally or of various weights- for a single 9.95 commission is compelling. And if the investor chooses to add or jettison a stock or two from the basket- those individual transactions only cost 4.95.

      I'm in the process of moving a block of investments out of Sharebuilder into Motif. Because Motif does not reinvest cash dividends (stock dividends are reinvested), my Motif basket will focus on the lower paying dividend stocks I own, like BA, CNI, CVS, HP, IBM, MDLZ, NOV, UNP, YUM, etc.

      I envision that once or twice a year adding some cash to the account and at those points, exercising the rebalance, for the single 9.95 commission.

      I'll retain the cash cow dividend payers in my Sharebuilder & TradeKing accounts to take advantage of the no-cost dividend reinvestment they offer.

      Michael

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  10. "My only cost is the commission to buy or sell securities."

    No, it isn't. You are also expending a great deal of time to research and track your investments, and time has value too.

    ReplyDelete
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    1. No, I am not "expending" the time, I am actually "investing" the time, and gaining knowledge. This knowledge accumulates over time, like compound interest. If I know how to build a diversified portflolio with $10K, I can also build a diversified portfolio with $100K, $1M, $10M etc. Investing is a very scalable activity.

      Of course, I discuss what I do with my money, and am not in any way telling anyone how to manage theirs.

      Good luck!

      DGI

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