Dividend Investing, Go it Alone or Use a Fund?
The popularity of dividends has waxed and waned through the years, but they have always been an important part of investing. With a large portion of the population (the baby boomers) nearing or entering retirement, dividends have swung back in favor.
The reason is pretty obvious, baby boomers are either in the disbursement phase of their financial lives or getting very close to it. Previously, this demographic was in the accumulation phase, which lends itself more to capital appreciation than generating income. When building assets, ignoring dividends isn’t as big an issue because the saver typically has a job—this funds the accumulation phase, covers daily living expenses, and provides a sense of security that the “nest egg” isn’t needed.
Once that job goes away, or at least the end of one’s work life becomes a visible reality, people start to come to grips with the idea that what they have could very well be all they will ever have. The fact that the nest egg must be broken open, and that time is now, can cause people to think very differently about investing. Suddenly, protecting principal becomes much more important. So living off of the income generated by a portfolio instead of living off of the assets of a portfolio starts to sound very appealing.
And well it should, as the idea isn’t new and it’s well tested. When dividend investing is done well, investors can have their cake and eat it, too. When it is done poorly, however, investors can wind up with big, negative surprises. This is why many individuals turn to professionals for help. When it comes to dividend investing, however, there is a big question mark as to how much help the pros can be.
Take, for example, Fidelity Dividend Growth Fund (FDGFX). Finding its dividend yield by visiting the pages devoted to the fund at Fidelity’s website requires going to the bottom of the Fees & Features tab and calculating a yield yourself! For starters, the fund only pays dividends two times a year. It takes a lot of planning to live off of two disbursements a year. Second, in 2011, the Fidelity Dividend Growth Fund paid out a “massive” $0.122 per share. No, the decimal isn’t misplaced. Based on the trailing dividends and the latest month end price displayed on the site, that’s a 0.4% dividend yield.
Worse, the dividend payment in 2010 was $0.149, which means the meager payment actually went down year to year. For a fund with the words “dividend” and “growth” in its name, something seems amiss. Forget the fact that in order to find any mention of dividends requires searching through five pages of other content—Front and center would make more sense, one would think.
To be fair, the fund’s website clearly notes that the manager can invest in companies that “pay dividends or that FMR believes have the potential to pay dividends in the future.” Also, the fund’s objective is clearly listed as capital appreciation—not dividend income. So, at the end of the day, dividends aren’t all that important anyway, it seems. While Fidelity Dividend Growth may be a big name example, it is far from the only example of a mutual fund that doesn’t seem to be living up to the use of the word dividend in its name.
So, if an investor is going to use a supposedly dividend focused mutual fund, it pays to be extra careful. Another recently popular option is an exchange traded fund (ETF). These are very similar to mutual funds, except that they trade like a stock and, usually, follow an index. This allows for a far more clear understanding of what is taking place at the ETF, but opens up the need to dig into the exact construction of the index that is being followed.
For example, some indexes are weighted by market cap, while others use dividend yield as the weighting factor. These two options may seem subtle, but they can result in very large differences. In one, the largest companies, regardless of their dividend yields, will have the biggest sway on both performance and the overall dividend payments that investors will receive. However, a large market cap could signal a company that is very popular with investors and, thus, it may have a relatively small yield.
On the other side of the equation is an ETF, such as those from Wisdom Tree, that weight by dividend yield. Using yield as a weighting factor may be alluring, since it will likely result in a larger yield than market cap weighting. However, high dividend yields are sometimes associated with companies that are having financial or operating difficulties. This could, then, place a large percentage of the ETF’s assets in the riskiest securities. That is not necessarily the ideal.
Unfortunately, it can be hard to find the index logic when examining ETFs. The sponsors will gladly tell you what index their ETFs follow, but won’t go into enough detail about the index’s construction. Without that knowledge, it is hard to make an educated decision. Moreover, as the ETF universe has expanded, the indexes used have become increasingly esoteric and complex. So a large yield could actually be big warning sign. Once again, ETFs are not a clear answer.
Closed-end funds are an interesting alternative. Still, these securities are just mutual funds in a different flavor. And some of the flavor is less than ideal. For example, while there are a lot more closed-end funds that offer monthly distributions, they are typically set at a static and high level. While this makes the distributions more “paycheck” like, they are often set far too high to be supported by dividend income alone. So funds either dip in to capital, essentially returning principal to shareholders, or use other methods to boost income. Some methods, like covered call writing, create some complexity around what is dividend income and what is a return of capital, making it difficult to understand exactly how the closed-end fund is supporting its payout. Moreover, with a static payout, even if it is relatively large, inflation is again a big issue.
Making matters even more complicated is the fact that closed-end funds trade like stocks. During the initial public offering (IPO), shares are sold at a dollar figure that includes the fees paid to the brokers who are selling the fund. So, if a closed-end fund is sold initially at $15 per share, it is likely that the assets of the fund are only worth about $14 a share (or less, in many cases). So buying a closed-end fund at its IPO is usually a bad decision. Second, a closed-end fund has a net asset value (NAV is the value of the fund’s assets divided by the shares of the fund) and a market price, since the shares trade based on market demand. This is very different from an open-end mutual fund, which can only be traded once a day and with the fund family at NAV. So, closed-end funds often trade at premiums or discounts to NAV, which makes understanding what you are actually buying more difficult. To add insult to injury, the information provided by many closed-end fund sponsors is minimal, at best. So it can be very hard to know what is being done with the money you are giving to a professional to handle.
While there are many professional options available for dividend investors, each option has problems associated with it. Some of the problems are more severe than others, but all of them are material. Which brings an investor back to the idea of going it alone. This option adds complexity to one’s life, since managing money is not an easy task. However, it increases control. Sure, a fund may be such dividend stalwarts as Johnson & Johnson (JNJ – Free Johnson & Johnson Stock Report) and McDonald’s (MCD – Free McDonald’s Stock Report), but what about all of the other things they have in the portfolio?
Some funds (such as the Fidelity fund noted above) own hundreds of stocks. A portfolio of 20, or so, companies in different industries would provide ample diversification and be small enough to knowledgably manage. After all, is it that hard to figure out that 3M (MMM – Free 3M Stock Report) is a great company? Clearly, there is a yield component to this, too, so investors have to think about their approach (See related article about investing for dividend income). But, if the negatives of paying someone else to invest are too great, the do-it-yourself approach isn’t as hard as it may seem.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.