Seeking Alpha

7 Reasons Why ETFs Are Useless (For Me)

by: The Dividend Guy
Summary

There is an eternal debate between index (ETFs) and dividend investors.

I don’t claim to hold the keys of knowledge, but I’ve made my choice a while ago.

While ETFs have many advantages, I think one can build a solid portfolio with handpicked stocks.

The debate between active vs passive investing has been around for many years. It was probably first brought up to compare early ETF products tracking indexes such as the S&P 500 with mutual funds. Many academic studies have shown that it's almost impossible for mutual funds to beat the market. In this case, I think it's clear that ETFs are superior to mutual funds. Mutual funds' higher fees and limited trading flexibility (it's hard to swing money into a position when you manage a $10B+ fund) are heavy burdens to deal with. No wonder so many investors make the switch to ETFs.

However, I don't think the result of a comparison between ETFs and individual dividend stocks draws a clear line. While there are several advantages to using ETFs for your portfolio, there are also numerous reasons to ignore them and select your own companies to build your "personal ETF". When I selected dividend growth investing as my main investing strategy, I didn't make that decision lightly. I've made sure I am not wasting my time and my energy on something people at Vanguard or iShares could have done for me. Here's why ETFs are useless for me (please keep in mind I refer to MY personal situation, we all have different situations, strategies, and investing goals).

There are too many holdings

The first thing I dislike about most ETFs is that you rapidly hit 100+ stocks in your portfolio. One may argue that this offers investors a wide diversification by giving access to various market caps, countries, and sectors. If you are starting your investing journey and you are still learning the basics, I think buying ETFs is a safe way to build your portfolio.

As a reference, I've listed the top largest dividend paying ETFs according to the ETF database. Only one shows fewer than 100 stocks and 4 have over 400 stocks.

Symbol

ETF Name

Assets ($MM)

YTD

Dividend Yield

Expense Ratio

Nb of Holdings

VTI

Vanguard Total Stock Market ETF

$117,181.91

19.51%

1.82%

0.03%

1600

VIG

Vanguard Dividend Appreciation ETF

$35,804.09

19.36%

1.78%

0.06%

183

VYM

Vanguard High Dividend Yield ETF

$24,721.32

14.41%

3.06%

0.06%

420

SDY

SPDR S&P Dividend ETF

$18,752.97

14.40%

2.39%

0.35%

113

DVY

iShares Select Dividend ETF

$17,453.97

13.68%

3.38%

0.39%

101

VT

Vanguard Total World Stock ETF

$12,589.13

17.13%

2.22%

0.09%

852

SCHD

Schwab US Dividend Equity ETF

$9,588.04

15.60%

2.88%

0.06%

100

DGRO

iShares Core Dividend Growth ETF

$7,828.80

17.42%

0.60%

0.08%

478

HDV

iShares Core High Dividend ETF

$7,334.58

14.33%

3.24%

0.08%

75

VXF

Vanguard Extended Market VIPERs ETF

$7,171.73

20.13%

1.32%

0.07%

1897

Source: data from ETF database and Seeking Alpha (yield)

However, if I want to make a difference in my portfolio, it will be hard because any company held will represent less than 1% of my total holdings. Therefore, I can't expect a substantial impact coming from any single company's good move. Microsoft (MSFT) shares surged in the past 2 years? Awesome! The weighted performance from MSFT within the ETF is… +0.18%. In my portfolio? +3.3%.

There are always "bad" stocks included

The fact that most ETFs include over 100 stocks also increases the chances of holding companies I would never put a penny on if I were to choose my own stocks. Each ETF's holding is not followed by a professional portfolio manager on a monthly or quarterly basis. For example, ProShares S&P 500 Dividend Aristocrats (NOBL) will include all companies from the S&P 500 that have grown dividends for at least 25 consecutive years. When does NOBL drop a "bad" aristocrat? When the company cuts its dividend and loses its "aristocrat" title. The ETF will never take proactive measures to sell it prior to the dividend cut. I can. I don't want to become dependent on the ETF's investing policy with no words to say.

By following a meticulous investing process, I increase my chances of making smart investments, and I can reduce my number of holdings to around 40 positions. Most importantly, I have the luxury of following each stock on a quarterly basis and reading their earnings reports to make sure there aren't clouds gathering in the sky. This doesn't mean I won't make any mistakes, but I definitely feel better knowing I'm in control, and I have a chance to sell before it's too late.

It's hard to beat the market with so many stocks

My ultimate investing goal is to maximize my return over a long period of time. I have about 30 years ahead of me before I use my portfolio as a source of income. While I don't chase returns, and I don't obsess about beating the market, I think it's fair to compare my results with a benchmark. Managing my money requires additional time and energy. I must make sure I use my resources wisely. If I can't beat the market on average, I might as well buy ETFs and use my time for something else.

Although ETF investing is a great tool for gaining immediate diversification, it is very hard to outperform the market. By definition, ETFs will follow a specific underlying basket of companies and will likely trail behind due to small expense fees.

I started to track my results and have compared them with the overall market and dividend ETFs since 2012, the time my portfolio was fully invested in dividend paying stocks. So far, I'm doing better than both benchmarks. I can't tell if this streak will continue or not, but I feel confident that a solid dividend growth portfolio can beat the market over a long period of time.

ETFs are expensive

Even though ETFs are the cheapest investing product around, many of them are more expensive than what my online broker costs me on a yearly basis. The average annual cost for the top 10 dividend paying ETFs is 0.19%. When you look at the above list, you realize that 2 ETFs cost a lot more while the average is more around 0.07%.

My pension plan portfolio was worth slightly over $147K as of June 2nd. Last year, I did 5 trades (3 buys, 2 sells) for a total of $49.95. Therefore, my expense ratio is 0.034%, half of what the average dividend ETFs would charge. On top of that, my average dividend yield is 2.40%, which is higher than the top 10 average (2.06%).

I pay less and I get paid more… I like that kind of math!

There is a feel of "losing the dividend growth aspect"

Following the relatively low yield some dividend ETFs are paying, I also feel that you lose out on the excitement of watching your dividend grow quarter after quarter. Using Seeking Alpha dividend growth history for the VIG, you can't tell there is a real feel of dividend growth here:

Source: Seeking Alpha

While the long-term dividend growth is there, there have been some moments (such as between 2015 and 2017) where the dividend paid remains the same.

When I compare it to my portfolio, I only see a straight line always climbing higher, quarter after quarter. Each month, I review my pension plan portfolio and notice significant dividend increases compared to last year. Most of the time, I show a high-single digit to low-teen dividend growth compared to the previous year (please note that I don't add any money into this account).

The ETF investing strategy isn't the same

When you chose an ETF, you also choose someone else's investing strategy over yours. Each ETF is built following a specific model or underlying assets.

For example, VIG "tracks the performance of the NASDAQ US Dividend Achievers Select Index, which offers exposure to dividend paying large-cap companies that exhibit growth characteristics within the U.S. equity market." (Source).

Some are a little vague about their focus such as the DVY that "screens the equity universe by factors such as dividend per share growth rate, dividend payout percentage rate, and dividend yield."

Then again, it must be a valid methodology, but it's not mine. I have spent years building my investing process, and I appreciate a combination of metrics along with a good old human brain to analyze trends, growth vectors, and potential threats. I would have a hard time fully agreeing with an ETF.

ETFs are boring, investing is fun

I must admit that the main reason I want so much to invest and manage my own money is because I'm passionate about the stock market. If I had to go with an ETF portfolio, I would spend a few hours in a single day to create that portfolio and then simply rebalance it every 6 months. This would be incredibly boring compared to following the news, reading quarterly statements and adding new dividend stocks.

I really enjoy the process of investing, and therefore, I think it's best for me to handpick each of my holdings. I'm also very aware that ETF investing is full of advantages too. I don't want to leave you on a bitter note, so I thought I should share some of the reasons why one would prefer ETFs over dividend growth stocks.

When ETFs could be useful

I think that one can successfully invest in the stock market. However, to become successful, the investor needs a very specific combination of time, knowledge and interest. If you lack any of those three factors, chances are you will be better served by ETFs.

If I had to start a small portfolio today with new money, I would be tempted to use ETFs as well. In contrast to stock picking, you can easily invest $500 in an ETF and get a wide diversification. You can also add to this ETF with minimal (read zero) fees as opposed to add new positions in a different stock. A systematic investment of $200 every two weeks would fit perfectly with an ETF strategy. Not so much if you want to select stocks one by one.

ETFs also give you an easy access to "more complex" asset classes. Instead of doing additional research on preferred shares, for example, you could simply invest in ETFs tracking them for you.

If you have limited knowledge or time to track your portfolio, a "couch-potato" approach to ETF will help you avoid making bad decisions or simply not making decisions at all. The fact that you can put your investing strategy on autopilot is probably one of the most powerful ways to grow your portfolio. I'm a big believer that the less you play with your portfolio (e.g. stick to your plan), the better your performance on the market will be.

I'm curious to hear from you; which strategy do you like best, and why? I'm sure many of you will tell me they use a combination of both. I'd also like to know what you get out of this strategy!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Additional disclosure: I do not hold any ETFs in my portfolio.

The opinions and the strategies of the author are not intended to ever be a recommendation to buy or sell a security. The strategy the author uses has worked for him, and it is for you to decide if it could benefit your financial future. Please remember to do your own research and know your risk tolerance.