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Reader Question – Why don’t you just buy dividend ETFs?

Every week, I receive many requests and questions from readers in my inbox.

Thanks for those by the way and keep those questions coming folks.

One of the more frequent questions to My Own Advisor is:

Why don’t you just buy and hold a dividend ETF instead of individual stocks?

Good question.

Before I provide you with my answer, a bit about dividend ETFs and why I do like them.

Why dividend ETFs are great

First of all, like many other ETFs, I like the transparency dividend ETFs provide.  Within a few clicks of a mouse, I can see what every single holding is in each of these popular products:

iShares Dow Jones Canada Select Dividend ETF (XDV)

iShares S&P/TSX Canadian Dividend Aristocrats Index Fund (CDZ)

BMO Canadian Dividend ETF (ZDV)

Horizons Dividend ETF (HAL)

The high transparency of dividend ETFs certainly trumps the “black box” approach to many other investment products.

Secondly, I like dividend ETFs because of their moderate management fees.  The fact is, dividend ETFs are cheaper than most if not all, actively managed dividend mutual funds, at least the ones I can find.  Many mutual funds buy and sell stocks frequently in an attempt to beat the market. Buying and selling frequently incurs costs, and those portfolio costs are passed on to you. Instead of all this trading, investors can simply focus on buying and holding an ETF to follow a dividend index or a benchmark index like the S&P/TSX Composite Total Return Index.  Many dividend ETFs have management fees in the neighbourhood of 0.60%.  Compare that to TD Dividend Growth Fund (at just over 2% as of December 2011) and RBC Canadian Dividend Fund (at about 1.8% management expense ratio (MER)), and you’re saving a bunch of money in management fees.  Good on you to do so.

Thirdly, dividend ETFs are low effort.  If you’re going to invest in individual stocks, you need to spend some time understanding these companies.  I read annual reports and follow metrics like yield, payout ratio, earnings per share, cash flow and company debt to name a few.  Buying stocks means another investor is selling this company so you need to make time to understand what you are buying and when.  Dividend ETFs don’t have this complexity.

Why I prefer individual dividend paying stocks

All this said, dividend ETFs are great products but there are a few reasons why I prefer to own stocks directly where I can, and I intend to buy and hold many more of them in my investing future.

First of all, some dividend ETFs have specific criteria and measure some constructed indexes I don’t fully agree with.  For example, the iShares S&P/TSX Canadian Dividend Aristocrats Index Fund (CDZ) “has been designed to replicate the performance of the S&P/TSX Canadian Dividend Aristocrats Index®”.   For a company to qualify as a holding in this product, the company must have increased their ordinary cash dividend every year for at least five consecutive years, among other criteria as well.  This is sound criteria but it also means some stellar Canadian companies that have great histories of paying dividends are not included in this product.  Bank of Montreal is just one example that comes to mind.  BMO has been paying dividends every year, uninterrupted, since 1829.  Therefore, while CDZ has some great companies in it, it does tend to leave a few solid companies out.

Secondly, as a consequence of the management criteria; these products are designed and marketed to investors after all, so not all dividend ETFs are created equal.  To meet my investment objectives I would need to own a couple dividend ETFs to get what I want.  For example, XDV is particularly weighted in Canadian financials; to the tune of almost 55% of its holdings. That’s a bit too much bias in this sector for me.  It might be wise to offset this ETF with another, like CDZ or HAL to balance things out.  Given this, I might as well own XIU for the diversification and the ultra low management fee, 0.18% MER.  Actually, I do own it. :)

Thirdly, on the topic of fees, I save money. By owning individual dividend paying stocks instead of just dividend ETFs, I don’t pay management fees.  Yes, I miss the low-cost, built-in diversification with ETFs but if you get the point of owning 25+ dividend paying companies in Canada, maybe some of the same ones listed in the popular dividend ETFs like XDV and CDZ, you’re indexing by proxy at this point and you can forget the 0.60% or more MER.  Within the next 5 years, I hope to have my own dividend index of over 30 Canadian companies.  I’m over halfway there.

Fourth and finally, I control the portfolio and the portfolio turnover.  My long term goal is to grow my dividend stock portfolio to the point where I can live off part of the income in retirement, with many investments across many industries.  I’ve been on this journey for a few years now and the progress is starting to show.  By owning individual stocks, I’m in control of the portfolio.  I can weight the companies however I wish.  By choosing a dividend ETF, I would not have as much control because these products often weight their holdings by market capitalization and have predefined turnover periods; the reconstitution is done for me so I wouldn’t know how many companies I will indirectly own until the ETF is rebalanced.  Another benefit, I can take advantage of the discounts these companies provide for dividend reinvestments (DRIPs).  Believe it or not, many established Canadian dividend paying companies provide you with a discount for DRIPping shares, some up to 5%.

In closing, dividend ETFs are great but they are not perfect, they are financial products and all products have flaws.  I’ll never be able to replicate the indexes, which is why I will always have a two-pronged approach to manage my portfolio, owning some broad market, low-cost ETFs and some dividend paying stocks.  This way, I feel I’m getting the best of both worlds.

Thanks to all the readers who have emailed me this question…I hope I have provided you with an answer.

Comments on my reasoning?  Comments on comments?  Have a question for My Own Advisor?  Fire away and maybe, your question will be part of a future blogpost!

Filed in: Exchange Traded Funds (ETFs), Index Investing, Investor Behaviour, Reader Questions

11 Responses to "Reader Question – Why don’t you just buy dividend ETFs?"

  1. stan smith says:

    not being a very good accountant, what would be the most informative, easily understood statement to give me an overview of a company?
    Stan

  2. Hey Mark, great post! :)

    The main reason I would prefer to hold dividend stocks directly is simply yield. You will get a higher yield by holding the dividend payers directly than through an ETF. I can hold big solid conservatice blue-chips and still get a 3.5% to 4%+ yield. The yield’s are pretty low for XIU ond XIC in comparison. Just buy the 5 or 10 top holdings that these ETFs hold and your set IMO!

    What I have a problem with are ETFs that go for the higher yield by using high yield stocks to get the return, and follow a yield weighted index. CUD is a great example of this:

    http://www.dividendninja.com/claymores-new-dividend-etf-cud

    There are a lot of stocks in that ETF I wouldn’t want to own, since weighting by yield results in higher risk for a higher return. (people forget that risk in this case means share price declines).

    Cheers!
    The Dividend Ninja

    • Of course yield is good, but so is capital appreciation. On the comparison, yes, individual dividend stocks pay more than XIU or XIC but you are not as diversified as you know. That said, we are totally aligned here: you hold the top-10 or top-15 stocks in the big ETFs and I don’t think you can go wrong. You do go wrong if you sell though :)

      The weighted index annoys me as well. This reminds me these are financial products, with rules to follow, which for a buy and holder of blue-chip companies makes little sense.

      Thanks for the comment! I look forward to watching your dividend portfolio take shape.

  3. Excellent post Mark, while your explanation makes total sense I’m lazy when ti comes to the divvy stocks. I prefer to own ETFs for the long run as I wouldn’t want to keep a close eye on multiple sectors.

  4. Modest Money says:

    It sounds like individual stocks are definitely the way to go. Since I’m just starting to get into investing, maybe some ETFs are still a good idea to limit the amount of constant research I need to be doing. Then once I get more comfortable I can focus on individual stocks.

    • @Jeremy,

      It is for me. I will always own a few ETFs, and probably have at least 50% of total portfolio in ETFs, but the rest will be in dividend paying stocks. I see no reason to pay people fees when I can own the same stuff myself.

  5. Bernie says:

    The major reason I prefer to own the actual dividend stocks vs the dividend ETF is that I invest for dividend growth. I pick stocks that have good track records of increasing their dividends. Dividend ETF’s have very poor records of increasing distributions. They are just as likely to decrease them as they are to increase them.

    For me its dividend growth rather than just dividend.

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