Wednesday, August 3, 2022

Dividend Stocks versus Dividend ETFs

Readers often ask me about my favorite dividend ETFs. I do tend to prefer to build my own portfolios consisting of individual dividend stocks, over buying dividend ETFs. However, I realize that not everyone is like me.

I have listed several reasons why I prefer selecting my own companies over using a dividend ETF:


1) Cost

Buying individual stocks in the US is commission free. It doesn’t cost me anything to buy stocks in individual companies like PepsiCo, Johnson & Johnson or Lockheed Martin. In addition, it doesn’t cost me anything to hold on to individual companies in my portfolio. In comparison, ETFs have an annual charge, which can range dramatically. Paying 0.40%/year does not seem like much, but if you hold a portfolio worth $100,000, that’s $400 that goes out of your pocket each year. Over time, these fees can add up.


2) Portfolio holdings

When I select individual companies for my portfolio, I can control which companies to add and what criteria to use for inclusion. I can vary the number of holdings to as low or as high number as I choose. I can decide which types of companies can be included, and which don’t stand a chance. I can also decide when to remove a company and what to do with the proceeds. 

With ETFs, you are basically letting someone else decide what to include. You have to trust that they will follow their process consistently.


3) Portfolio Weights

I can decide how to properly weight my portfolio holdings. If investing a lump-sum, I can decide to allocate money equally between the number of holdings I have. I believe in giving each company I own an equal chance of success.

Most ETFs weight their holdings based on factors that make building an ETF easy for the ETF provider, not necessarily the best method for investors. For example, most ETFs are based on a market capitalization basis, which assigns the highest portfolio value to larger companies. 

Very often you see ETFs that may have 100 or more individual holdings. When you dig further however, you see that half of the portfolio value is concentrated in 10 - 20 companies, while the rest are just filler.


4) Portfolio Turnover

I have more control over turnover than a dividend ETF. For example, I try to be as passive as possible, because turnover costs in terms of commissions, taxes, fees, and opportunity costs. I try to avoid selling, for as long as the dividend is not cut. I would have turnover, as companies split, merge, get acquired, and cut dividends. But I have found that selling for other reasons has been a mistake for me.

I also like knowing that I own certain businesses, when I design a portfolio. With ETFs, I cannot say that the businesses I own would still be in the portfolio. For example, the Schwab Dividend ETF had Microsoft (MSFT) in 2016, but doesn’t have it today in 2022. The company is a quality one, and has kept raising dividends in the past 5 years. I am not sure why it was deleted, but in my opinion, this is not a good move. Not just because it did so well, but because it was removed for no reason in my opinion.


That being said, there are reasons for using ETFs. Of course, for some investors, ETF’s may have appeal.


1) Time Factor

The main reason someone may like investing in a dividend ETF is because they do not want to select any of the companies themselves, and are fine to delegate this responsibility to someone else for a recurring annual fee. Some folks do not feel comfortable selecting well-known dividend growth stocks, which is fine. It’s better to let a more qualified party select companies for you, than to end up selecing the wrong companies in the process.


2) Instant Diversification

One advantage of ETFs is that you get instant diversification at the click of one button, albeit at the cost of a recurring annual fee that would increase in dollar amount as your investment accounts grow. I would argue that today I can generate this instant diversification by selecting companies one at a time, but I do understand the appeal of clicking just one button versus say 50.


3) Re-Balancing

The biggest advantage of ETFs is that they do not generate any capital gains to shareholders when they re-balance their portfolios. In other words, if an ETF decided to eliminate a certain company from its portfolio, and realizes a capital gain in the process, its shareholders do not get taxed on it. However, if there is a loss when an individual portfolio holding is disposed of, the ETF shareholders won’t be able to take the loss for tax purposes. This tax discussion only centers around the ETF portfolio holdings. If you sell the ETF at a gain, you will pay tax in a taxable account; if you sell an ETF at a loss, you will get a benefit.


Conclusion:

I have tried to summarize the pros and cons of selecting my own individual dividend stocks versus selecting a dividend ETF. I have discussed this topic a few times on the blog too. You may check out the "Relevant Articles" below for more information on my thought process.


Relevant Articles:

- The Best Dividend ETF to Consider








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