5.5 Reasons Dividend Payers Beat Index Mutual Funds & ETFs

Index?  Mutual?  Dividend CCC!

Over the past couple months I’ve covered a host of reasons I think investing in strong dividend paying companies is better than parking money in real estate, precious metals and collectibles, non-dividend stocks, annuities, and target date mutual funds.  Therefore, I thought I’d tackle the reasons dividend stock investing is superior to index mutual funds or ETFs.  I’ve had a lot of coffee today and it’s probably a good thing, so here we go.

1) Compound growth is more reliable with dividend stocks than it is with index mutual funds and ETFs in general.  When individually held dividend stocks pay out their dividends, those dividends turn directly into additional shares of the company, assuming you’re enrolled in a Dividend Reinvestment Plan (DRIP).  Many, but not all, index funds and ETFs will retain dividends paid, increasing the Net Asset Value (NAV) rather than turning those dividends into additional shares of the fund for you.  I hold a couple such index funds in a 529 plan for my kids and a 401k so I’m well aware of this fact.  I don’t have much choice in either case.  Otherwise, neither would be in my portfolio.  NAV can fluctuate up and down given the market movement of the stocks it holds, irrespective of dividend payments.  In comparison, directly held dividend payers don’t subtract shares from your bucket unless you sell them.

2) Management fees erode your returns.  When participating in the DRIPs of dividend paying companies, or automatically reinvesting dividends from stock held in your brokerage, you don’t suffer the penalty of management fees.  The same cannot be said of index funds or ETFs.  This is particularly true if you’ve blundered into a managed index or ETF in which case your fees can be as high as a half-percent per year.  That may not sound like much, but once your portfolio reaches $100,000, you’ll lose $500 every year.  Those losses add quickly, particularly when you factor in the power of compound growth foregone.

3) Visibility and manageability of your holdings is much better with a select portfolio of dividend payers.  An index fund or ETF attempts to hold the same companies, in the same proportion, as found in the index it tracks.  Consequently you could own thousands of firms, most of which you’ll care little about – if you know about them at all.  To find out what you own in an index fund you have to sort through multiple pages and potentially thousands of lines of the index fund prospectus to know what’s in your basket.  That’s too much for most amateurs to manage in which case you’ll pay fees for a manager.  Brokerages like this.  See item #2 regarding management fees.

4) Investment diversity is frequently argued as a simple, brilliant form of risk mitigation.  The financial industry has taken the argument to the nth degree by selling the proposition that a fund of hundreds or thousands of companies offers greater diversification i.e., less risk, than a smaller grouping of individually held dividend paying stocks.  But is this true?  I can get considerable diversity or risk mitigation with 20-30 holdings in a well-chosen selection of dividend payers.  Adding hundreds of additional companies doesn’t reduce my risk much beyond that smaller holding – particularly if all those holdings are wrapped in a single package delivered by one financial institution.  In a future post, I’ll take a brief look at the probability underpinning the maxim of investment diversification. 

An index fund allows you to hold many, many companies at once providing the touted investment diversification.  However, I would argue that a vast array of companies is not necessarily better.  Warren Buffett agrees.  Or better, I’m of the same opinion as Warren, who said “diversification is protection against ignorance. It makes little sense if you know what you are doing."  The theory is most investors don’t know a post hole from their pie hole and should buy a huge basket of everything to limit risk rather than learning something about a few things and sticking with what they actually know.  The argument is great for the croupier class taking tine pieces of considerable investment activity via small management fees tacked onto index funds and ETFs.

5) Selective quality with individually held dividend stocks is much great than it is with an index fund or ETF.  Consider the estate sale in which a box of unknown stuff is auctioned off with little or no inspection by the bidders.  Bidders are attempting to buy the box at the lowest possible price hoping they’ll find a diamond among the rubbish they know they’ll get otherwise.  When you buy an index fund or ETF, it’s the same principle.  You’re buying thousands of companies in one fell swoop hoping the handful of gems more than offset the dregs and millstones you’ll invariably get.  It's less risky to pick and choose what you're putting your money into than throwing it over the wall and hoping for the best.

5.5) Additional thoughts:  Advocates of index funds and ETFs argue that diversification for small investors is easier with an index fund than individually held stocks.  This is true if you have only a couple hundred bucks to invest.  Once your investment basket has climbed above a few thousand dollars, I’m not sure that argument still holds.

A second argument is that index funds allow people to invest in with little risk, but complete ignorance.  Investors don’t have to read, research, or even think to participate safely in the market, or so goes the story.  I’m not sure this is a stellar idea to propagate but it’s a thing none-the-less.  It's better to put in a bit of effort when participating than diving in completely unaware.  Contrary to the old axiom, ignorance is not always bliss, particularly when investing for your future.

The thoughts and opinions expressed here are those of the author, who is not a financial professional, and therefore should not be considered as investment advice.  This information is presented for education and entertainment purposes only.  For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional.