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Wed. Nov. 17, 2010

Dividend Stocks vs. Dividend ETFs *

In 1993, State Street Global Advisors launched the first exchange-traded fund (ETF). Now there are literally hundreds of ETFs out there covering sectors, countries, popular indexes and various strategies, including income investing. A frequent question that I get is ‘Why do you invest in individual dividend stocks instead of income-based ETFs?’ On the surface this seems like a reasonable question since most ETFs are indexed, tax efficient, easily traded, passive and have low expense ratios. However, as we look beyond the ETFs luster, there are several significant reasons why many dividend investors prefer owning individual stocks…

I Tax Efficiency

ETFs tax efficiency is only in comparison to traditional mutual funds. Consider, when you redeem your mutual fund shares and the fund does not have cash on hand, it must sell some of the underlying securities for cash to pay you. The sale will generate a taxable event (positive of negative) for all shareholders, even if you didn’t redeem any shares. Since an ETF’s can be sold on the open market its liquidity is not tied to selling the underlying investments; thus, not creating a taxable event to those that own the fund, but didn’t sell. Individual dividend stocks are exactly the same – no taxable event until you sell your shares.

II Low Expenses

Again, compared to traditional mutual funds, ETFs generally have lower management fees. However, if you manage your own portfolio of dividend stock, there are no management fees.

III. Income Volatility

As an income investor, my primary goal is to create an ever-0increasing income stream from my income portfolio. To do this, I look for stocks with a long track record of increasing their dividends and the ability to sustain the dividend increases in the future. Indexed ETFs are forced to buy the bad stocks along with the good stocks. This will inherently increase the volatility of the fund’s dividend payments as underlying companies that are poor performers are forced to cut or eliminate their dividends.

IV. Performance

Not surprising, individually selected dividend growth stocks will out perform an indexed ETF over the long-term. Again, since Indexed ETFs are forced to buy the bad stocks along with the good stocks often the yield and the performance suffers.

Consider the SPDR S&P Dividend ETF (SDY). The fund uses a passive management strategy designed to track the price and yield performance of the S&P High Yield Dividend Aristocrats index. Dividend aristocrats are generally considered the best blue-chip, large-cap, dividend growth stocks available. To be a constituent of this list the company must be a member of the S&P 500 and have raised its dividend for 25 consecutive years. See SDY’s performance data below, along with some popular dividend growth stocks:

SPDR S&P Dividend ETF (SDY)
- Current Yield: 3.4%
- Annual Dividends: 2009 $1.73, 2008 $2.21, 2007 $1.97
- Dividend Adjusted Return: 2009 19.2%, 2008 (24.0%), 2007 (6.7%)
- Value of $100 invested in 2007: $84.52

Johnson & Johnson (JNJ)
- Current Yield: 3.4%
- Annual Dividends: 2009 $1.93, 2008 $1.795, 2007 $1.62
- Dividend Adjusted Return: 2009 11.3%, 2008 (7.7%), 2007 3.61%
- Value of $100 invested in 2007: $106.44

The Coca-Cola Company (KO)
- Current Yield: 2.8%
- Annual Dividends: 2009 $1.64, 2008 $1.52, 2007 $1.36
- Dividend Adjusted Return: 2009 30.3%, 2008 (24.1%), 2007 30.4%
- Value of $100 invested in 2007: $128.96

Procter & Gamble Co. (PG)
- Current Yield: 3.0%
- Annual Dividends: 2009 $1.802, 2008 $1.64, 2007 $1.45
- Dividend Adjusted Return: 2009 1.2%, 2008 (13.8%), 2007 16.6%
- Value of $100 invested in 2007: $101.72

McDonald’s Corp. (MCD)
- Current Yield: 3.1%
- Annual Dividends: 2009 $2.05, 2008 $1.625, 2007 $1.50
- Dividend Adjusted Return: 2009 4.0%, 2008 8.6%, 2007 36.38%
- Value of $100 invested in 2007: $154.03

Wal-Mart Stores Inc. (WMT)
- Current Yield: 2.2%
- Annual Dividends: 2009 $0.952, 2008 $0.88, 2007 $0.67
- Dividend Adjusted Return: 2009 (2.6%), 2008 20.0%, 2007 4.9%
- Value of $100 invested in 2007: $129.15

Conclusion

Good dividend stocks raise their dividends each and every year. SDY, an ETF tracking a subset of the Dividend Aristocrats, lowered its dividend in 2009 to a level below its 2007 dividend. It also suffered losses in two of the three years listed. Granted the last 3 full years is a short period of time to look at, but it was one of the most volatile in the market’s history. I want investments that will not only meet my goals in good times, but also in the bad. ETFs have their place in my overall portfolio as strategic investments, but not a prominent place in my income portfolio.

Full Disclosure: Long JNJ, KO, MCD, PG, WMT. See a list of all my income holdings here.

Related Posts
- Who is Charles Mangum and Why Should We Listen to Him?
- Should You Still Buy-And-Hold Stocks?
- The Next Great Company
- 8 Dividend Stocks With Above Market Performance
- Seven Important Reasons for Dividend Investing

(Photo: Steve Woods)


9 Responses to “Dividend Stocks vs. Dividend ETFs *”

  1. mike says:

    I agree with your fundamental point about the advantages of owning individual stocks, but your math conveniently sidesteps the issue of imploded financial stocks. It’s misleading to cherry pick stocks without acknowledging that most dividend-oriented investors would have also been in banking stocks in 2007.

  2. D4L says:

    Mike: Your point is well taken. It helps empathize the importance of asset allocation with strict sector limits on equity holdings. Many of the income ETFs were adversely affected as a result of their high percentage of financials. By holding individual stocks we can control this allocation.

    Best Wishes,
    D4L

  3. dizzy7 says:

    For me, your point about the volatility of income ETF’s is the reason why I don’t own them. I’ve considered the SDY and also Vanguard’s Dividend Appreciation ETF (VIG), but the way their dividend payouts bounce up and down every quarter just doesn’t work if your aim is to produce a consistent flow of gradually increasing income. I do agree with Mike’s point that virtually every income investor was hit when all the formerly reliable dividend increasing banks cut their payments, but that was a (let’s hope) very rare occurrence. It’s normally quite feasible to put together a diversified portfolio of dividend paying stocks in which your income increases each year and isn’t as likely to go down as up the way it does with ETF’s. You’ve proven that quite well with your portfolio.

  4. Bill66 says:

    Mike: The thing with the financial stocks, and their running mates the real-estate REITS, is that you had to know when to hold them and when to fold them. We (the marital we) held them for the better part of two decades. But buy-and-hold does not mean buy-and-hold forever. When it became clear they were tanking (for good reason), we sold. No, we didn’t get out at the exact tippy top, but few ever do that with consistency. That’s a bit of a fool’s goal, as in bulls make money, bears make money, hogs don’t. That’s an actively managed portfolio; if you want a truly passive portfolio, well, that’s something else.

    Beyond that, many of us likely were far too heavy into these stocks. Allocations? Rebalancing the portfolio? Now you tell me!

    Dizzy7: We can hope that all the dividend cuts were a rare occurrence. But it could well be that many companies during the coming years will struggle to produce year-over-year financial gains that will allow them to post ever-rising dividends. Dividend growth might not be as great as the historical record would indicate. It’s probably time to focus on the best of the best companies. … And here’s hoping people can ascertain which those are.

  5. TMT says:

    D4L,
    I am not too sure about SDY. That ETF has all the highest yielding Div aristocrats & as you have pointed out on some of your posts, Higher yield = more risk.

    To me the SDY is comprised of stocks that have the highest risk in the Aristocrats and are most likely to perform poorly & have their dividends cut.

    Just my 2cents….

  6. dizzy7 says:

    Bill66: I think you’re right about the rate of future dividend growth slowing down. I get a bit concerned when I see so many companies consistently increasing their dividends at a faster rate than their profits are increasing, resulting in ever higher payout percentages. Sooner or later comes the inevitable need to freeze or even cut the dividend. A good example of that are the many electric utilities which have frozen/cut their dividends over the past few years, including many which had long records of increases. I sometimes think the strategy many European companies use of paying a specific percentage of the previous years profit as a dividend this year makes better economic sense even tho it results in a variable dividend flow.

  7. ETFs are for fools. IMO, best to eliminate middle people as much as possible, better chance at getting accurate information. Plus, ETFs are relatively new, another reason to stay away.

    Basically, they are a gimmick, “Trust us, so you don’t have to do any thinking.”

    BTW, I favor quality dividend stocks, among stocks, however I never fell for any of the bank and similar financial stocks, because it is simply too difficult to understand their reported balance sheet, etc. If you don’t understand stocks enough to pick among them, one shouldn’t be in any stock vehicle, ETFs, mutual funds, etc.

  8. Bill66 says:

    Joseph: ETFs are for fools? Well, I’ve been called worse.

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