Monday, December 9, 2019

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 income 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 or 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-increasing income stream from my portfolio. To do this, I look for stocks with a long track record of increasing their dividends and the ability to sustain 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 stand a very good chance of out performing 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 holds all the stocks in the S&P 1500 that have raised their dividends every year for the past 20 years. A very small group of less than 100 out of 1,500 names qualify to be included. See SDY's performance data below, along with some popular dividend growth stocks:

SPDR S&P Dividend ETF (SDY)
- Current Yield: 2.4%
- 5-Year Annualized Return 11/29/2014-11/29/2019: 10.88%

Microsoft (MSFT), the world's largest software company, develops PC software, including the Windows operating system and the Office application suite.The company has paid a cash dividend to shareholders every year since 2003 and has increased its dividend payments for 17 consecutive years.
- Current Yield: 1.3%
- 5-Year Annualized Return 11/29/2014-11/29/2019: 14.4%

McDonald's Corporation (MCD) is the largest fast-food restaurant company in the world, with about 35,000 restaurants in 119 countries.The company has paid a cash dividend to shareholders every year since 1976 and has increased its dividend payments for 42 consecutive years.
- Current Yield: 2.6%
- 5-Year Annualized Return 11/29/2014-11/29/2019: 15.0%

Illinois Tool Works Inc. (ITW) is a diversified manufacturer that operates a portfolio of 60 business units that serve industrial and consumer markets globally. The company has paid a cash dividend to shareholders every year since 1933 and has increased its dividend payments for 56 consecutive years.
- Current Yield: 2.7%
- 5-Year Annualized Return 11/29/2014-11/29/2019: 15.6%

Erie Indemnity Co. (ERIE) is a management services company that provides sales, underwriting, and policy issuance services to the policyholders of Erie Insurance Exchange in the United States. The company has paid a cash dividend to shareholders every year since 1991 and has increased its dividend payments for 29 consecutive years.
- Current Yield: 2.1%
- 5-Year Annualized Return 11/29/2014-11/29/2019: 16.4%

Lockheed Martin Corp. (LMT) , the world's largest military weapons manufacturer, is also a significant supplier to NASA and other non-defense government agencies. LMT receives about 93% of its revenues from global defense sales.  The company has paid a cash dividend to shareholders every year since 1995 and has increased its dividend payments for 14 consecutive years.
- Current Yield: 2.5%
- 5-Year Annualized Return 11/29/2014-11/29/2019: 18.21%

Conclusion

Good dividend stocks raise their dividends each and every year. SDY lowered its dividend in 2017 (2.099 vs 2.235 in 2016). 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 MSFT, MCD, ITW, ERIE, LMT,

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