Hidden Cost Of Mutual Funds: Why Dividend Growth Investors Should Go It Alone

Includes: DVY, SDY, VIG, VYM
by: Skyler Greene

My fellow SeekingAlpha contributor Shaun Connell recently wrote an article titled Can You Beat The Market, and Should You Even Try? In it, he referenced the fact that many mutual funds don't beat the market.

It started me thinking about the fact that the dividend growth investing strategy (one of my favorites) seems fairly incompatible with mutual funds -- yet there are dozens, if not hundreds, of these mutual funds.

Why do I say dividend growth investing is incompatible with the idea of a mutual fund?

Well, the point of investing in a mutual fund is twofold: first, diversification (a small investment can hold a lot of different stocks). Second, and more importantly -- as this is the factor that differentiates mutual fund investing from truly passive index investing -- you're paying a professional to manage your portfolio for you.

Does this make sense for a dividend growth strategy? Probably not. Dividend growth investing is based on constructing a portfolio of "blue chip" stocks that offer strong dividends and more importantly, a history of raising dividends.

This approach is generally a fairly long-term approach, with "trading" occurring only when a company looks like it's about to collapse or perhaps when it becomes rather overvalued and you want to harvest capital gains to reinvest in a more reasonably valued blue chip. (For an excellent analysis of the latter phenomenon, see Can A Dividend Growth Investor Be A Trader? by David Crosetti. One of my favorites.)

The dividend growth strategy is by nature, then, a passive strategy. You're not supposed to be constantly shifting positions. You're supposed to be sticking with reliable blue chip companies for a fairly long time, and watching your reinvested dividends earn you more dividends in the future.

It's pretty easy to see intuitively why actively managed mutual funds aren't necessary for dividend growth investing -- but let's go a step further and do actual calculations.


The Vanguard Dividend Growth Fund (MUTF:VDIGX) is pretty cheap, as far as mutual funds go. The expense ratio is 0.31%, meaning that each year, 0.31% of assets are used to pay the fund managers and overhead expenses.

Let's examine this more closely. The VDIGX fund holds 48 stocks, according to its prospectus. So let's construct a fictitious $48,000 portfolio of our own comprising 48 hand-selected dividend stocks, perhaps even the same stocks.

The thing you run into when you're trading individual stocks is commissions. My broker, Fidelity, offers a flat $7.95 commission for stocks, but let's just say that you have to pay a $10 commission.

Your initial portfolio start-up cost is 48 x $10 = $480. This is your only cost the first year.

Your first year in the mutual fund, with a $48,000 investment, you pay $48,000 x 0.31% = $148. So far, the mutual fund is ahead (lower expenses).

Now let's think about the next year. If you have a 48-stock portfolio of solid blue chip companies, it's highly unlikely that you're going to have to significantly rebalance your portfolio. (Really think Walmart, Procter and Gamble, and Coke are going to fall off the face of the earth next year? I think not.) Thus, let's say that you make three trades for rebalancing purposes. You've now spent $60 this year. ($10 commission each way, 3x buy and 3x sell.)

On the other hand, your mutual fund again charges you $48,000 x 0.31% = $148. This year, picking your own 48 stocks saved you $88.

Assuming this trend continues, your expenses will "break even" sometime during Year 5, and by the end of Year 5, the mutual fund expenses will total $740, vs start-up and trading costs of $720 for your own portfolio. After this point, the mutual fund will continue racking up an additional $88 in expenses for the rest of eternity.

But Wait, There's More

My analysis above was an oversimplification, because there's something I didn't take into account.

Even assuming the expense ratio stays stable, invested capital doesn't. Hopefully, your capital has been growing. Let's assume a very conservative annual growth rate of 6%, including invested dividends. So each year, the Vanguard fund expense ratio will be applied to an increasing amount of capital.

Now what do your expenses look like?

  Pick-Your-Own-Portfolio Vanguard Dividend Growth Fund
Year 1 $480 $148
Year 2 $60 $152
Year 3 $60 $159
Year 4 $60 $167
Year 5 $60 $175
Year 6 $60 $184
Year 7 $60 $193
Year 8 $60 $203
Year 9 $60 $213
Year 10 $60 $224
Total $1020 $1821

Clearly, the Vanguard Dividend Growth Fund is much more expensive (~80%) than the pick-your-own portfolio strategy. And the Vanguard fund is pretty cheap -- other mutual funds, like the Fidelity Dividend Growth Fund, have expense ratios of 0.93%. This means that investing in the Fidelity Dividend Growth Fund would cost you $5,463 over a decade -- a staggering 5.35x multiple of the cost to pick your own portfolio.

(Please note these calculations are inexact, and just intended to provide a general overview.)

Further Analysis

There are several factors to consider here. First, continuing with the arguments in favor of picking your own stocks -- if you're planning to hold them to the grave, then picking them yourself is a no brainer. If you aren't going to be trading, you're going to save thousands of dollars over the long term by holding your own stocks.

On the other side of the coin, there are definitely times when the mutual fund will be the best option. In this example, the investor had a $48,000 portfolio. However, what if the investor had only $4,800 to invest? Say they were an early-20s college student with a drive to invest but limited means? Setting up 48 individual positions ($480) would obviously be cost prohibitive. On the other hand, the mutual fund provides a very cheap ($14.88/yr) way to hold a diversified portfolio of 48 stocks. In this instance, the mutual fund definitely wins out.

The other scenario where a mutual fund might make more sense is if you were investing in a taxable account and the mutual fund was managed with a good tax structure. Some mutual funds are structured to give you the opportunity to take some small capital gains over time and reduce the eventual capital gains "hit" when you sell your shares.

Conclusion + Ideas

As I mentioned in The Art of Finding Rock Solid Retirement Stocks, it takes some guts to break the mutual fund shackles and choose your own stocks. After all, in a downturn, it's easier to point to the money manager and say "it's his fault" than it is to stomach the idea that you made bad picks that lost you money. However, think about it this way -- if you constructed a similarly-weighted portfolio of the 48 stocks that the Vanguard fund holds, how would that be any different from holding the mutual fund, with the exception of lower cost?

Plus, on the bright side, dividend investing isn't like growth investing where you have to hit home runs. As explained by Tim McAleenan in Proof that Forever Investing Works, buy-and-hold investing truly does work. (I definitely recommend checking out some of Tim's articles -- he's really awesome and gives great advice.)

Another point to assuage your fears about picking your own stocks. In another article, The Good News About Failure With Blue Chip Investing, Tim analyzes how even if a few of your blue chips fail, the phenomenal returns from the others will more than outweigh the loss. Given the list of blue-chip dividend stocks below, do you really think that a large percentage will suddenly go belly-up before you can recoup at least some of your investment?

Hormel Foods (HRL), Kroger (KR), Praxair (PX), McCormick & Company (MKC), The Hershey Company (HSY), Comcast Corp (CMCSK), Walmart Stores (WMT), Coca Cola Enterprises (CCE), Deere & Co (DE), Lowe's (LOW), Colgate-Palmolive (CL), Becton Dickinson (BDX), Target (TGT), PepsiCo (PEP), JM Smucker (SJM), Coca Cola (KO), Microsoft (MSFT), Exxon Mobil (XOM), United Parcel Service (UPS), Automatic Data Processing (ADP), Chevron (CVX), Altria (MO), Philip Morris (PM), McDonald's (MCD), Air Products and Chemicals (APD), Abbott Laboratories (ABT), Intel (INTC), General Mills (GIS), Kellogg Co (K), Campbell Soup (CPB), Kimberly Clark (KMB), Clorox (CLX), Procter and Gamble (PG), Johnson & Johnson (JNJ), Walgreen Co (WAG), Lockheed Martin (LMT).

An equally-weighted portfolio of the above stocks, held forever, would probably do pretty well.

So my core recommendation here is -- if you have a large enough portfolio, especially in a retirement account -- you should definitely consider managing at least part of your money on your own. The cost of not doing so is just too high. I know it can be hard to break the mutual fund mindset because initially, I was happy to let money managers manage my money for me, even though I kept up with the market and generally made pretty good predictions. But I'm starting to realize that with a few notable exceptions (great stock pickers like William Danoff and Donald Yacktman), most mutual funds don't deliver huge benefits to investors.

Especially for a dividend growth strategy, which is by nature a passive "buy and hold" type of investing, you don't garner much additional benefit from a professionally managed dividend growth fund. A well-diversified portfolio of blue chip holdings such as the ones mentioned above will keep up with -- or even exceed -- any dividend growth fund. Why? Well, the fund is going to be picking from the same list of stocks, because there are only so many dividend blue chips out there. And as an individual investor, you have a key advantage: lower expenses.

The way I look at it, if Coca Cola, Procter and Gamble, and McDonald's all cease to exist... well, let's just say we have bigger problems than expense ratios and portfolio allocation.

Key takeaway: don't let fear rob you of your hard-earned money. If you're a dividend growth investor, you should have the courage to go it alone.

Disclaimer: I am an individual investor, not a licensed investment advisor or broker dealer. Investors are cautioned to perform their own due diligence. All information contained within this report is presented as-is and has been derived from public sources & management. Always contact a financial professional before making any major financial decisions. All investments have an inherent degree of risk. The future is uncertain, and actual results may be materially different from those expected. Past performance is no guarantee of future results. All views expressed herein are my own, and cannot be interpreted as the views of my employer(s) or any organizations I am affiliated with. Presentation of information does not necessarily constitute a recommendation to buy or sell. Never make any investment without conducting your own research and reading multiple points of view.

Disclosure: I am long INTC.

Additional disclosure: I may initiate long positions in any of the stocks mentioned in the next 72 hours.