The Case Against Using Mutual Funds As Dividend Growth Proxies

Includes: CVX, JNJ, KO, PG, WMT
by: Eli Inkrot

As you likely deduced from the title, I'm about to take a stand that suggests an individual collection of dividend growth stocks is likely a better alternative than a mutual fund touting a similar name. Additionally, it should be known that I have previously made a comparable argument against the Vanguard Dividend Appreciation ETF (NYSEARCA:VIG); or in bookie parlance the "VIG." It follows that this article's rationale is likely to be quite analogous - I make no claims of great originality.

While my substantiated dislike for aggregation vehicles has remained constant, I understand why some are attracted to their possible "benefits" - namely not having to do any investment homework on the weekends. But for those of us willing to roll up our sleeves, I believe that immense satisfaction is to be gained.

As a consequence, I normally go about my day looking for wonderful business partnerships at reasonable valuations whilst simultaneously ignoring the forced promotion of pooled vehicles. However, a recent advertisement for a dividend focused mutual fund provoked a response. The advertisement read:

"Looking to add dividend income to your portfolio? Fidelity Strategic Dividend & Income Fund can help."

First of all, unless you're dealing with pure growth equities, any mutual fund will add dividend income to your portfolio. That's like saying: "Want to add food to your stomach? Come to Strategic Food restaurant, the only place you can get food where you need it." The question isn't whether or not you want food (income), the question is "how much", "when" and "what?"

Yet despite the unlikely advertising appeal - along with my prior research on less expensive yet still poor substitute ETF's in the same category - I decided to take the bait and see what was being offered.

You can glance over the 'Strategic Dividend & Income Fund' (MUTF:FSDIX) by clicking here, but I must warn you that it could be difficult to look at as an individual dividend growth investor. In any event, I'll summarize the highlights with the commentary below.


Here is a look at the top 10 holdings of the FSDIX, along with their respective current yields, which represents roughly 20% of the portfolio:

Current Yield
Microsoft (NASDAQ:MSFT) 2.8%
Chevron (NYSE:CVX) 3.2%
Apple (NASDAQ:AAPL) 2.5%
Procter & Gamble (NYSE:PG) 3.1%
Johnson & Johnson (NYSE:JNJ) 3.0%
Pfizer (NYSE:PFE) 3.3%
Cisco (NASDAQ:CSCO) 2.8%
Simon Property (NYSE:SPG) 3.1%
Coca-Cola (NYSE:KO) 2.9%
Merck (NYSE:MRK) 3.6%

So far it looks pretty sensible right? In fact, as a dividend growth investor I personally partner with Chevron, Procter & Gamble, Johnson & Johnson and Coca-Cola . In turn, I would have no apprehensions whatsoever in suggesting that the above list is a reasonable place to start in looking for solid companies with the potential to increase their dividends. However, the issue comes in when you view the fund's SEC quoted yield: 2.51%. In other words, you could literally own any one or a combination of the top 10 holdings outside of the fund and be guaranteed to achieve a larger current yield.

Turnover = 70%

Let me say that number again: 70%. That means for every 10 holdings the fund manager is selling 7 of them and finding new replacements each year. Perhaps you're perfectly fine with an active management style, but the whole point of dividend growth investing is to eventually watch your dividends grow - this takes years not weeks. Long-term investing certainly isn't dead, but you might think so by looking at pooled vehicles - this is no peculiarity.

Holdings = 358

Again, it should be noted that I have no issue with the top holdings of FSDIX. In addition, I would guess that I'd be fine with many of the additional securities within the fund. However, there are three fundamental problems with buying a mutual fund. And it should be made clear that these problems exist in all aggregation vehicles: when you buy into a collective investment you are buying all of the holdings at current prices.

Problem #1: Perhaps you believe that Procter & Gamble, Johnson & Johnson and Coca-Cola are three of the best companies in the world. (I actually do have this view) But that doesn't mean that you would be willing to partner with them at any price. (I might not buy at today's prices) In fact, balanced investment sense would prohibit you from such an undertaking. Yet when you buy into the FSDIX mutual fund or any other aggregation vehicle with these holdings, you are purchasing all of the positions at the current price. There's no way to differentiate the fact that you might want to buy Chevron today but hold off on adding Coca-Cola .

Problem #2: Buying a portion of companies you don't like. In my opinion this one is more dangerous than the first - you can recover from overpaying for a great company. Yet in buying a pooled vehicle you are buying companies that you might believe have awful prospects or that you simply have a moral objection to. If you don't want to own say Bank of America (NYSE:BAC) or Altria (NYSE:MO), yet it's in the fund, then guess what? Tough luck.

Problem #3: Buying companies you know nothing about. This one is worst of all. I'm not a wagering man, but with 358 holdings I'd be willing to suggest that there are a handful of companies that you have never even heard of. It is impossible to make rational expectations for things in which you have no knowledge whatsoever. In effect, when you invest in a mutual fund and don't know every holding, you're investing a portion of your money with some guy that says "I'm in a lot of businesses."

When you own individual companies you know exactly what to do with volatile price movements. As depicted by the F.A.S.T. Graph of Wal-Mart (NYSE:WMT) below - as long as earnings remain intact and the dividend keeps rising - the answer is usually nothing. On the other hand, if you have no idea what you're holding it's impossible to judge the underlying foundation of your business partnerships.


Finally, it should be fairly obvious that these "grand" proposals for otherwise unattainable diversification come with a charge for their convenience. In the case of FSDIX the running annual rate is 0.81%. Which may or may not seem like a lot, but let me reassure you: it can add up over time. As I have previously detailed, fees can be a "sneaky inhibitor of returns." For instance, if you look to Yahoo's profile of FSDIX you'll notice that the 10-year expense projection is $1,002 per $10,000 invested.

Said differently, I have no idea what the market will do over the next decade, but I'm fairly confident a mutual fund will take 10% of your principal away in the form of fees. Instead, an individual investor could pay the transaction costs to own 20-30 dividend growth companies, throw $500 out of the window and still have enough left over for a solid weekend trip. And keep in mind, you could likely build a portfolio with a higher initial yield, a more rational long-term mindset and actually know what businesses you are partnering with. Personally I'd pick the latter, but that's just me.

Of course it occurred to me that perhaps this single mutual fund was an aberration. So I went out and surveyed the field. Let me spare you the suspense, the prognosis is widely the same. Perhaps the most extreme example came from the seemingly promising 'Fidelity Dividend Growth Fund' (MUTF:FDGFX).

Almost instantly I came to the conclusion that these guys just don't get it. In reviewing the Fund Overview under 'objective' it simply states: "Seeks capital appreciation." Whoops. Shouldn't the 'objective' of a fund with the title "Dividend Growth Fund" be - oh I don't know - "dividend growth?" Now granted I have before contended that a growing dividend necessitates capital appreciation. However, I would imagine that investors of this fund would be more concerned with a rising payout rather than unpredictable price movements. In addition, one of the top holdings of the fund is Google (NASDAQ:GOOG), a company that doesn't pay a dividend yet. I suppose if you want to do it right, you have to do it yourself.

My lasting word of caution will be this: deciding between an individual dividend growth strategy and a dividend focused mutual fund sound quite a bit alike. However, it's my contention that this is an area where the individual investor was a wide advantage over the institutional powerhouses. Without doing anything that spectacular one can likely create a tailored long-term investment approach that generates a greater amount of income while paying less in fees. Perhaps I'm biased, but I don't see much reason to adventure into the mutual world to find a dividend growth proxy.

Disclosure: I am long JNJ, KO, WMT, CVX, PG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.