Wednesday, July 7, 2010

Dividend ETF or Dividend Stocks?

Dividends have historically contributed about 40% of common stocks annual average returns. Reinvested dividends however have contributed almost 97% of S&P 500 total returns since 1871. Add to that the fact that retirees are looking for a better way to generate income than the low rates on bank deposits. Thus it is no surprise that investors’ interest in dividend investing is increasing. 

Two differing paths are presented to aspiring dividend investors. One path is to do it on your own. Another path is to trust the experience of an investment professional and invest in dividend funds or dividend ETFs. In this article I would compare and contrast the two methods and also outline some of the most widely held alternatives for both scenarios. 

 The main advantages of dividend funds are the instant diversification that investors achieve, since many of them hold a large basket of securities. It might also be cheaper to purchase one ETF than purchasing 30 or 40 individual securities. 

 Another advantage of holding dividend ETF’s is the time saved in research or portfolio rebalancing. This benefit of dividend ETF’s is especially important for busy investors. 

 One disadvantage of dividend ETF is that they might follow an index or a strategy which is too slow to react to changes in the companies owned. For example, the companies which are members of the S&P High Yield Dividend Aristocrats index (SDY) are added or removed once an year. This means that a company like General Electric (GE), which cut dividends in February 2009 stayed in the index until December 2009. Most income investors would have disposed of the stock immediately after the dividend announcement. 

 Another disadvantage might be that these dividend indexes could be constructed and ran on autopilot. One recent example is dividend indexes which overweigh companies with a higher yield, without taking into consideration the sustainability of the dividend payment. Because of this many dividend etf’s were overweight financial stocks such as Bank of America (BAC) or Fifth-Third Bank (FITB) before they had cut dividends substantially. This added further pain to the ETF’s already depressed share prices.

 A third disadvantage of dividend funds is annual management fees. Because they typically have smaller asset bases, and because they are more actively managed than regular index funds, investors pay between 0.40% for iShares Dow Jones Select Dividend Index ETF (DVY) and 0.60 % for the The PowerShares Dividend Achievers ETF (PFM). This could detract from long-term performance and could prove costly in the long run. 

Another disadvantage is the fact that investors would be subject to excessive turnover within their etf portfolios. Many indexes such as the dividend achievers for example have a small but consistent turnover which might detract from long term performance. 

 Another issue with ETF’s is that most of their holdings are concentrated in large cap dividend stocks, which account for a large portion of the movement in the underlying indexes. For example, the ten largest holdings of the Powershares Dividend Achievers ETF (PFM) include:

The ETF currently has 212 holdings. The top 10 holdings account for almost 46% of the total portfolio.

Thus, by purchasing the ETF, dividend investors are being charged an annual management fee, are subject to large annual holdings turnover and essentially hold a portfolio which is not as diversified as it looks initially. If you simply purchased stock in large cap companies such as Wal-Mart (WMT), Procter & Gamble (PG), Johnson & Johnson (JNJ), Chevron-Texaco (CVX), PepsiCo (PEP) and others, investors could benefit from dividend investing, without having to pay fees each year for the privilege of being an income investor. 

 If instead investors focus on building their portfolios, they could pay little or no commissions, they could adjust portfolio weights any way they want and could invest not only in the large cap stocks but also in small but promising dividend growth stocks. 

 Full Disclosure: Long PG, T, XOM, CVX, WMT, JNJ,KO,PEP ABT

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