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.

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