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Summary

  • The ETF industry has ballooned since 1993, when the first ETF tracking the S&P 500 was introduced.
  • In this article, I list a few positive factors behind Dividend ETFs, coupled with a few negatives of Dividend ETFs.
  • For an individual dividend investor, dividend ETFs might not be the best solution.

The Exchange Traded Funds industry has ballooned since 1993, when the first ETF on the S&P 500 was introduced. Currently, there are hundreds of ETFs covering many investment strategies present. One strategy, which is also being covered with dividend ETFs includes dividend paying stocks. In this article, I will discuss the positives and negatives of dividend ETFs, and explain why they are bad for income investors.

Pros:

Some of the positives of owning dividend ETFs include instant diversification, ability to invest passively and the ability to gain exposure if you do not have a lot of money.

1) Instant diversification

The biggest allure of dividend ETFs is the fact that investors can easily purchase a basket of shares with just one trade. This basket of shares would be representative of different industries included in the index, and would reduce the risk that our investor overcommits to a certain sector if they are prone to chasing yield for example. Plus, you get to pay one commission to purchase a whole basket of stocks, or some companies might let you purchase ETFs commission free.

2) Ability to invest passively

Another appeal of dividend ETFs is that it lets investors purchase a basket of stocks and then not have to worry about monitoring 30 to 40 companies in detail. This is the job of the investment manager in charge of the ETF, who reads annual reports, keeps up with the current environment, calls companies and does all the leg work so that the investor does not have to do it. Reading annual reports could sometimes be an intimidating or very boring task for some investors. The dividend ETF is ideal for investors who want to set the investment, and forget it.

3) Good for beginning investors who are still learning and have less than $10,000

The investment in a dividend ETF or dividend mutual fund is probably best for beginning investors who have less than $10,000 to start with. It offers them instant diversification and passive investment at the fraction of the cost of a do-it-yourself portfolio using an online broker. Dividend ETFs also make it very easy for investors to put additional funds to work, while maintaining sector diversification in the index.

Cons:

1) Annual costs

While Dividend ETFs provide investors with instant diversification and the ability to let someone else to worry about the mundane details, the Ivy League investment manager comes at a price. In addition, most companies that offer dividend ETFs also want to earn a fair profit on this product. As a result, investors in some of the largest dividend ETFs like the SPDR S&P Dividend (NYSEARCA:SDY) and the iShares Dow Jones Select Dividend Index (NYSEARCA:DVY) pay 0.35% - 0.40% per year in management costs. If the stock portfolios in those ETFs yield 3% on average, this means that 12%-13% of your dividend income will be paid out as an investment tax. If our investor is also in the top bracket, and pays 23.80% federal tax on the income, they would end up with only two-thirds of their desired dividend income. While placing your stocks in a tax-deferred account, such as a Roth IRA, can eliminate taxation issues, placing your investments in ETFs would result in recurring annual charges. In fact, investment companies end up charging their fees on a daily basis. This compounding of fees could cost investors large amounts of money over a normal 20 - 30 year investment period. While many ETFs are now commission free at various brokerage houses, investors would need to pay a commission for most of the dividend ETFs out there.

2) Investors have no say about which stocks the ETF holds

Another negative of dividend ETFs is that investors have no say on how these baskets of stocks should be invested. Sometimes, a dividend ETF might hold shares that do not fit in its strategy for months. For example, back in 2008 and 2009, the SPDR S&P Dividend ETF held on to shares of companies that cut or eliminated distributions for several months after the fact. As a result, a portion of the capital of this ETF was not properly invested and was not generating much in dividend income for investors. In addition, many dividend ETFs are placing higher weights on higher yielding stocks, which could increase risk for income investors. This increases exposure to companies with accidental high yields, which are large because the dividend is in danger. In addition, some of these ETFs also tend to focus mostly on higher yielding sectors like utilities and financials, which could increase risk as the portfolios would not be properly diversified.

3) Investors fail to learn about investing

The most successful investors make their own investments, after a careful analysis. If investors simply purchase an ETF, they might not truly get an understanding of what they are buying and could pay a high price over time. Educating yourself on how companies make money, how the economy works and understanding how to value a security would be beneficial to investors who follow stocks, bonds, commodities or real estate. If they blindly buy ETFs or mutual funds without fully understanding what they are getting into, they might be much more likely to lose money by selling out during bear markets or by getting overly excited about the wrong investments at the most inopportune times.

4) If not enough money is attracted, the ETF could be closed

Another less known risk about dividend ETFs is that if the fund fails to attract enough investors, it could end up closing and returning money to investors. If our investor is passive and only checks their portfolio once or twice/year, this could mean that they can potentially miss on potential upside by not being invested in the markets. A small fund size typically also translates into higher bid/ask spreads and higher annual costs.

5) Too much turnover

I am a pretty passive dividend investor, who makes sell transactions very rarely. In fact, I have realized that one of my largest mistakes I have committed in the past few years was selling fine companies in order to get something that I thought is better. The end result of this mistake is that I have ended up with more paperwork, and transaction costs, without really achieving a better benefit. Talk about reinvestment risk. Therefore, I am not a fan of ETFs or Mutual funds that have turnover, which produces capital gains that investors have to foot the bill for, without really getting anything extra. The issue with dividend ETFs is that they contain quite a lot of turnover, and unfortunately, the investor does not have any say about it. Honestly, if a company I own froze dividends for a few years, it would not be a strong enough sell signal for me. I also don't want to sell a company when it splits into two after raising dividends for 40 years, despite the fact that the new companies lack a record of dividend increases. This happened with Altria (NYSE:MO) after it spun-off Kraft (NASDAQ:KRFT) and Philip Morris International (NYSE:PM) in 2007 and 2008.

For my personal portfolio, I tend to invest in stocks directly, and build my exposure to different sectors from the ground up. I have a direct say on portfolio weights, and selecting only companies whose stocks are attractively priced at the moment. My only cost is the commission to buy or sell securities. If commissions were $5/trade, and an investor purchased shares in $1000 increments, then this comes out to a 0.50% one-time cost. This is a much better cost than paying 0.35% - 0.40% every year. During a 20 - 30 year period, the costs are going to reduce income over time. In addition, I have flexibility to exit stocks that do not make sense right away, and reinvesting the funds into another security that makes sense. Plus, if you achieve a certain net worth, your investment costs might be close to nil with some brokerage houses

Source: Are Dividend ETFs Appropriate For Dividend Investors?