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?
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(Photo: Steve Woods)

A couple of years ago, I started adding select ETFs and CEFs to my income portfolio. At the time, my thought process was that these funds would diversify my risk and add a degree of stability to my income portfolio. Initially, I had high hopes for their success.  Here’s what I am holding and a synopsis of how they have performed:

Vanguard Financials ETF (VFH)

Vanguard® Financials ETF seeks to track the performance of a benchmark index that measures the investment return of financial stocks.

I first purchased VFH in August 2007. Like the financials it tracks, VFH’s dividend has steadily fell from $0.45/share in October 2007 to $0.06/share in March 2009.

PowerShares International Dividend Achievers Portfolio (PID)

PID seeks to match the performance of the International Dividend Achievers Index by investing at least 90% of its total assets in dividend paying common stocks of this index. This index tracks the performance of dividend paying American Depositary Receipts or ordinary stocks trading on the NYSE, NASDAQ or AMEX.

I initially invested in this fund back in July 2008.  It has paid out three dividends since then, each less than the one before (9/08-$0.14/share, 12/08-$0.09/share and 3/09-$0.03/share). Not a good trend.

Vanguard REIT ETF (VNQ)

Vanguard® REIT ETF seeks to provide a high level of income and moderate long-term capital appreciation by tracking the performance of a benchmark index that measures the performance of publicly traded equity REITs.

I initiated my VNQ position in August 2007.  VNQ’s dividends have been unpredictable and inconsistent.

SPDR S&P Dividend ETF (SDY)

The Fund seeks to replicate as closely as possible, before expenses, the price and yield of the S&P High Yield Dividend Aristocrats Index. The Fund uses a passive management strategy designed to track the price and yield performance of the Dividend Index.

I first purchased SDY in August 2007. I have received seven dividends ranging between a low of $0.4410 (April 2009) to a high of $0.5917 (January 2009). I found it somewhat odd that the low and high dividends both came in 2009.

Vanguard High Dividend Yield ETF (VYM)

Vanguard® High Dividend Yield ETF seeks to track the performance of a benchmark index that measures the investment return of common stocks of companies that are characterized by high dividend yields.

I first bought into VYM in August 2007.  It dividends have slowly drifted lower since that time. They have not been as volatile, but there is no question as to the direction.

Vanguard Dividend Appreciation ETF (VIG)

Vanguard® Dividend Appreciation ETF seeks to track the performance of a benchmark index that measures the investment return of common stocks of companies that have a record of increasing dividends over time.

VIG is another ETF that I first purchased in August 2007. During the time I owned it, VIG’s dividend has flucuated between $0.22/share and $0.28/share.

Eaton Vance Tax-Advantaged Global Dividend Opportunity (ETO)

ETO is a diversified, closed-end management investment company. The Fund’s investment objective is to provide a high level of after-tax total return. It invests primarily in dividend-paying common and preferred stocks.

I first purchased ETO in July 2008. ETO paid a steady dividend of $0.1795/share through December 2008. It then dropped its dividend to $0.1167/share.

Alpine Total Dynamic Dividend Fund (AOD)

AOD attempts to optimize both dividend income and long-term growth of capital. This is a very diverse and flexible fund. It employs a global, multi-cap, multi-sector, and multi-style investment approach. The fund combines four research-driven investment strategies – Growth, Value, Special Dividends, and Dividend Capture Rotation.

I first purchased AOD in December 2007. It paid monthly dividends of $0.18/share through February 2009 before cutting its monthly dividend to $0.12/share.

Vanguard Long-Term Bond ETF (BLV)

The Fund seeks to match the investment performance of the Lehman Brothers Mutual Fund Long Government/Corporate Index. Holdings include Corporate Notes/Bond 51.5%, Treasury Notes/Bonds 40.2% and Government Agency Securities 6.5%.

I first purchased BLV in December 2008. Since that time I have received five dividend all approximately $0.34/share. This has been the one bright spot amoung the group. As a long-bond fund, it has behaved as I expected it would.

Conclusion

Back to the original question: Are Exchange Traded Funds (ETFs) and Closed Ended Funds (CEFs) a good fit for this dividend investing? At this point, I would say no, for the most part. For many of the same reasons that international investments are not a good fit for a dividend-based investing strategy, I have found the same true with ETFs and CEFs.

It has been my experience that ETFs/CEFs dividends exhibit a higher degree of volatility than individual dividend stocks. Since most of the above funds are based on an index, they are forced to buy the bad stocks with the good stocks. This will inherently increase the volatility of the funds dividend payments. Those with international holdings are subject to currency conversion and a different dividend payout philosophy. In the income portion of my portfolio, I place a great deal of value on stability and consistency. ETFs and CEFs have a difficult time delivering either.

The funds are listed is ascending order from least desirable to most. I have already stopped purchasing the above funds, except BLV.  I will now work on eliminating or minimizing my position in most of them, starting at the top of the list and working down.

Full Disclosure: Long VFH, PID, VNQ,  SDY, VIG, VYM, ETO, AOD, BLV.  See a list of all my income holdings here.

My goals were defined in this December 1, 2007 Investing Goals post and updated in my 2009 Investing Goals post. I am pleased to note that both of my goals were achieved in 2008 – not may investors can say that. Below is an updated version of the table found in the original post.

The above information covers the current month and year-to-date through the current month.

Click here for a Detailed Historical Progress Table.

For the month, annualized dividend income increased $80, and Yield on Cost (YOC) decreased -0.10%. These changes were driven by new purchases, dividend changes and sales. Let’s examine each of the these categories:

Purchases: The $362 increase in annual dividend income and 0.30% increase in YOC related to the following purchases (yield at the time of purchase):

• $46 MFC (4.56%)
• $56 BLV (5.16%)
• $150 ED (5.87%)
• $49 LLY (5.15%)
• $61 CTL (9.78%)

All except ED and CTL lowered my YOC. As noted in earlier updates, I generally expect YOC to drop each month since most new investments will yield less than my current YOC, and dividend increases will not be sufficient to offset it.

Dividend Changes: The ($77) decrease in annual dividend income and (0.07%) decrease in YOC related to the following dividend changes (a=dividend stated in annual terms, q=quarterly, m=monthly):

• ($64) SDY $2.99a>$2.21a -0.07%
• ($7) CNI $0.2277q>$0.18852q -0.01%
• $1 O $0.14112m>$0.1418m 0.01%
• $1 SYY $0.22q>$0.24q 0.01%
• ($8) ETO $2.15a>$2.09q -0.01%

The decrease in CNI was due to currency conversion resulting from a strengthening U.S. dollar compared to the Canadian dollar. SDY and other ETFs/CEFs dividend volatility continue to concern me.

Sales: The ($108) decrease in annual dividend income and (0.06%) decrease in YOC related to the following sale:

• ($108) : AOD : (0.06%)
• ($97) : PFE : 0.00%

As previously discussed, I am over-allocated in AOD and ETO from a dividend income standpoint. I continue to reduce my allocation in each by selectively selling a portion of my holdings. This will position me to better withstand a dividend cut from them. PFE was sold after its January dividend cut.

That’s it for this time. The next monthly progress update will be on Saturday, March 7th.

(Photo: sanja gjenero)