An exchange traded fund, or ETF, is a publicly-traded fund that tracks an index such as the S&P 500. There are thousands of ETFs in the U.S., but only a few hundred funds are specifically classified as dividend ETFs.
Dividend ETFs can provide a number of benefits for investors seeking safe retirement income or long-term growth. In fact, many investors own a combination of dividend ETFs and individual stocks in their portfolios.
However, there is a never-ending debate over the merits of actively picking stocks versus allocating a portfolio completely into low-cost, passively-managed ETFs.
The reality is that an investor’s mix of dividend ETFs and individual stocks almost completely depends on the investor’s personal preferences. There are numerous pros and cons to each approach, and unfortunately there is no one-size-fits-all solution.
In this article, I will evaluate some of the most common questions facing investors who are considering dividend ETFs:
- What are the pros and cons of owning dividend ETFs?
- How can I tell which ETFs are “good” ones?
- Who should buy dividend ETFs?
By the end of the article, you will know the key advantages and disadvantages of investing in dividend ETFs and have an understanding of whether or not dividend ETFs are for you.
The Benefits of Dividend ETFs
Dividend ETFs offer a number of attractive characteristics. Most notably, in my view, dividend ETFs can save investors a lot of time and potential headaches compared to owning individual stocks.
The majority of dividend ETFs hold between 50 and several hundred companies and are well-diversified across a number of industries.
Purchasing shares of most dividend ETFs provides instant diversification to a portfolio, providing an investor with some protection against being overly exposed to a sector that falls out of favor.
Perhaps more importantly, dividend ETF investors do not need to worry much about monitoring their holdings because many ETFs are diversified across hundreds of companies.
In other words, no single company is likely going to make or break the performance of an ETF, so there is practically no need to stay up to date on news about individual businesses owned in the fund.
Once an investor has found a diversified dividend ETF that comes close to matching his or her objectives, the investor can simply focus on accumulating as many shares as possible and letting the investment ride for the long term.
While ETFs will rise and fall with the underlying indexes that they follow (there is always market risk), it should be easier, in theory, for investors to ride out price volatility in diversified ETFs compared to individual stocks.
For example, suppose you owned a portfolio of 20 individual dividend stocks, and Cisco was your biggest position at 7% of your portfolio’s total value.
If Cisco were to fall by 30% this year on company-specific news, you would be faced with some very difficult, stress-inducing questions:
- Cisco has been a dog. Should I sell now?
- Or is Cisco bottoming out and potentially a bargain? Maybe I should buy?
- Is the company’s dividend at risk? Why is the stock so weak?
Owning individual stocks requires more time commitment to stay on top of new developments and can sometimes encourage excessive trading activity, which is often the enemy of investment returns.
An investor in dividend ETFs can usually sleep better at night than an investor running a portfolio of individual stocks. For every Cisco owned in a diversified ETF, there is likely to be an equal number of winners to balance things out.
While ETFs will match any steep declines in price of their underlying indexes, prudent investors should know that the collective long-term value of a fund’s diversified holdings has not been impaired – the stock market is simply volatile and unpredictably rises and declines.
Unlike Cisco, where something could be structurally wrong with the company to make its stock a poor long-term investment, it would take some sort of apocalyptic event to impair the long-term value of all of a diversified ETF’s holdings.
Put another way, dividend ETF investors can feel more comfortable buying additional shares on a dip instead of worrying about whether or not the long-term earnings power of their individual stock has been impaired.
Investing in dividend ETFs is also just an easy strategy to follow. Investors who own a portfolio of individual stocks typically have at least several dozen holdings to pick between when they have new money to invest.
Trying to decide which individual stock(s) to buy more of often feels complicated, but an ETF investor can simply allocate across several funds to remain diversified and continue following the underlying index.
Simply put, an ETF strategy is much easier to consistently execute and can help an investor maintain more time in the market to enjoy the benefits of compounding.
Investing in dividend ETFs can be particularly appealing for small investors. Generally speaking, most of the benefits of diversification kick in once a portfolio has accumulated as few as 15 to 20 total holdings spread across different sectors.
While trading commissions are generally quite low today, building a portfolio of 20 stocks can still eat into an investor’s returns if their portfolio value is low.
For example, an investor with $10,000 to invest equally across 20 stocks would target an initial value of $500 per holding. A $10 trading commission equates to a steep 2% fee ($10 / $500), which is incurred again every time the investor buys more shares.
It would probably make more sense for the small investor to achieve appropriate diversification and lower fees by accumulating shares of an ETF until his or her account was more sizeable.
Finally, it’s worth pointing out that even Warren Buffett advocated for passive index funds in his 2013 shareholder letter.
After he passes away and his shares of Berkshire are distributed to charity, Buffett’s trustee has very clear instructions to follow:
"My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers."
Warren Buffett owns several dozen dividend-paying stocks in his portfolio, but it’s clear he sees the benefit of cheap, passive indexing – most active investors simply fail to generate performance that justifies their higher fees.
However, there are a number of disadvantages to owning dividend ETFs over individual dividend stocks – especially for conservative retirees primarily focused on capital preservation and safe income generation.
The Downsides of Dividend ETFs
Some dividend ETFs now offer rock-bottom fees as low as 0.05% per year, but ETF investors have no ability to fine-tune a fund for their unique investment objectives and risk tolerance.
For example, suppose a retired investor has $1 million of cash to invest and wants to generate safe income from dividend-paying stocks while preserving capital.
Vanguard is a well-known and trusted brand, and the investor happens to come across the Vanguard High Dividend Yield ETF (VYM).
The fund certainly sounds appropriate for his needs and charges an extremely reasonable fee of 0.08% per year. The fee amounts to less than $1,000 per year for his account and is well worth it for the time savings alone – he can now take a “hands off” approach to generating income by investing in a well-diversified fund.
However, there are a few issues to consider here. First, the fund’s dividend yield is nothing to get overly excited about for current income. It has a dividend yield near 3%, which is too low for many retirees’ income needs.
Second of all, how safe is that income? The Vanguard High Dividend Yield ETF is invested in more than 400 companies – certainly not all of their dividend payments will be safe throughout a full economic cycle.
Unfortunately, we can see that the fund’s dividend payments were hit hard during the last recession. Total dividend payments reached $1.44 per share in 2008 before falling to $1.17 in 2009 and $1.09 in 2010, representing a peak-to-trough decline of about 25%. Annual dividend payments didn’t recover back to their 2008 peak until 2012.
Put another way, if the retired investor above owned 25,000 shares of VYM, he would have received $36,000 of dividend income in 2008.
By 2010, his annual dividend income had fallen to about $27,000 – a drop of more than $725 per month. Depending on his budgeting and margin of safety, life could suddenly have become much more stressful.
Even when times are good, a dividend ETF's income is highly unpredictable, making monthly budgeting in retirement more challenging. ETFs are constantly rebalancing, and the many companies they own are adjusting their dividends up and down throughout the year. Here is a look at VYM's volatile quarterly payouts over the course of several years.
Building a portfolio of several dozen blue chip dividend stocks requires some time, but it also allows investors to customize the dividend yield, diversification, and dividend safety of a portfolio to their unique needs.
You will also know exactly how much you are getting paid each month of the year since each company has a set dividend payment schedule.
While numerous “safe” dividend stocks such as General Electric and Bank of America surprised investors during the financial crisis and slashed their dividends, I believe it is possible to construct a portfolio with a higher yield and more resilient income stream than what is attainable from dividend ETFs today.
Besides greater customization, accumulating a portfolio of individual dividend stocks lets investors keep more of their dividend income.
Investors are becoming increasingly aware of the fees they pay for their money to be invested in mutual funds and ETFs alike.
Passive ETFs have rapidly grown in popularity because they are, on average, substantially cheaper than their actively managed counterparts.
One of the main reasons why ETFs are cheaper is because they do not need to employ a high-paid research team in an effort to beat a benchmark – they are simply trying to match a benchmark’s performance at the lowest cost possible.
I am not going to beat a dead horse and discuss the merits of investing in low-cost ETFs versus active money managers. In the far majority of cases, I would advocate for the ETF due to the fee savings and generally more dependable performance.
Instead, the focus of this article is on investing in dividend ETFs compared to individual stocks.
The beauty of owning individual stocks is that there are no ongoing fees – you only incur costs when you buy or sell a stock, and trading commissions are generally quite low today (typically $5 to $10 per trade at most discount brokers).
While dividend ETFs trade just like stocks, every ETF charges a recurring fee based on the value of your portfolio.
Many fees charged by ETFs appear rather harmless. Fees generally range from less than 0.1% to 0.5% per year for some of the largest and most popular dividend ETFs.
For small investors, these fees are almost a no-brainer to achieve proper diversification and gain time in the market – a $10,000 account might pay as little as $10 per year.
Investors who don’t want to deal with the hassle of owning individual stocks are also happy to pay the fee and sleep well at night.
However, fee dollars can really begin to add up for larger account sizes over the course of many years.
Suppose an investor had $1.5 million he wanted to invest in dividend stocks to achieve a yield of at least 3.5% with low volatility.
The PowerShares S&P 500 High Dividend Low Volatility ETF (SPHD) seemed to meet his objectives. The ETF has an annual expense rate of 0.3% and offers a dividend yield around 3.5%.
The table below projects his portfolio over 10 years, assuming an annual 4% return from the fund, no reinvestment of dividends (he lives off the income), and a constant 3.4% dividend yield.
In the first year alone, the investor would have seen $4,500 leave his portfolio to pay ETF fees, which amount to about $375 per month.
We can see that over the next decade, his portfolio generated $612,311 of dividend income, but fees ate over $54,000 of that amount.
Put another way, ETF fees consumed close to 9% of his total dividend income over the period – even despite the “low cost” nature of the fund.
Beyond fees, dividend ETFs with high portfolio turnover can also experience lower returns than their benchmarks because of their higher taxes and transaction costs. Owners of individual stocks can avoid these “hidden” costs and potentially generate slightly higher returns by maintaining a buy-and-hold strategy.
Some retirees are fortunate to have portfolios that are significantly larger than the $1.5 million account I used in the example above. As the size of a portfolio grows, fees also rise – a $3 million portfolio would pay over $700 per month in fees during the first year it was invested in the PowerShares S&P 500 High Dividend Low Volatility ETF.
However, some investors with large accounts are happy to pay ETF fees – if they already have enough passive income and aren’t interested in spending any time analyzing stocks, ETF fees are a small price to pay for the time and convenience they provide.
For investors interested in owning funds, let’s take a look at how to identify the best dividend ETFs.
How to Pick Quality Dividend ETFs
The number of ETFs available has blown up over the last 20 years, and a number of dividend ETFs have hit the market in the last five years.
Despite there being more than 100 dividend-focused ETFs in the market, the biggest challenge picking an ETF is finding one that is mostly aligned with your investment objectives (e.g. dividend yield, diversification, volatility).
As I previously discussed as one of the downsides of owning dividend ETFs, it can be difficult to find a low-cost product that meets your current income needs with a high dividend yield while also providing reasonable dividend safety and diversification.
ETF Database provides an ETF screener that contains a number of helpful metrics to help you find a potentially appropriate list of dividend ETFs. Morningstar also offers an ETF screener, but I am not aware of any others.
Once you have identified a handful of relevant ETFs, what should you look for? Aside from your personal preferences (e.g. dividend yield), it’s important to be aware of an ETF’s expense ratio, objective, diversification, turnover, and size.
As I demonstrated above, even a low expense ratio of 0.3% can really eat into a portfolio’s dividend income stream. My personal preference is to stick with funds with expense ratios no greater than 0.3%.
Many of Vanguard’s products charge fees below 0.1%, which is hard to pass up. The easiest way to maximize your dividend income and performance is to find the lowest cost, best diversified product.
Besides expenses, it is important to review a dividend ETF’s objective. You should be aware of the index an ETF is designed to track and feel comfortable with its selection approach – some ETFs will blindly pick the highest-yielding stocks in a particular group, while others will add in some sort of “quality” filter.
While these factors might not seem important during a bull market, they can make a world of difference during a recession – lower quality ETFs and indexes hold companies that are much more likely to cut their dividends and underperform the market. Unfortunately, there is no easy way to view the most important financial ratios for dividend ETFs since they consist of so many individual dividend-paying stocks.
However, for funds with a long enough history, investors can view their historical dividends paid by calendar year using our website to see how much they cut their dividends during the last recession.
The diversification of an ETF is another factor to consider. Some funds are constructed to be significantly over- or under-weight a sector. For example, the PowerShares S&P 500 High Dividend Low Volatility ETF (SPHD) derives around 20% of its exposure from utility stocks, but less than 1% of the Schwab U.S. Dividend Equity ETF’s (SCHD) holdings are utilities.
Each fund has guidelines to follow as it relates to its maximum exposure to any single sector or stock, and my general preference is for no sector to exceed 25% of the portfolio and no stock to account for more than a 5% weight.
If I am going to invest passively in ETFs, I don’t want to lose sleep over any “active” bets the fund might be taking by not being well-diversified – all it takes is a few large holdings to drag down the entire performance of a fund.
A fund’s turnover is important as well. ETFs with lower portfolio turnover pay less in capital gains taxes and transaction costs, which helps the performance of the fund (and the value of your portfolio) better track its index – especially in taxable accounts. I like to look for ETFs with turnover rates no greater than about 25%.
Finally, the size of an ETF also impacts its risk profile. Of the approximately 1,900 ETFs in the U.S., roughly 400 of them have average trading volume of less than 1,000 shares.
The top 150 ETFs also account for over 90% of overall ETF trading volume. In other words, there are a lot of ETFs that are dangerously small and may not be able to stay in business.
ETFs with very low trading volume are also susceptible to higher volatility and bigger trading gaps when you try to enter or exit a position. As a conservative investor, I avoid ETFs with total assets less than $500 million and prefer funds that have a track record going back at least three years.
To summarize, here are the ETF characteristics I prefer to see:
- Fund objective is simple and tracks an understandable index
- Diversified by sector (no more than 25%) and stocks (no more than 5%)
- Expense ratio less than 0.3%
- Portfolio turnover less than 25%
- Total assets greater than $500 million
- Fund inception at least three years ago
Investors can research most of this information quickly by simply “Googling” the name of the fund and viewing information directly on its website.
An ETF fund’s website and prospectus will tell you everything you need to know about its expense ratio, total assets under management, portfolio turnover, inception date, objective, and diversification. It usually takes just a few minutes to review this information to see if it meets your criteria.
Similar information on ETFs can also be retrieved from Morningstar, and a fund’s annual dividend history and growth can be retrieved using our website.
Closing Thoughts on Dividend ETFs
Dividend ETFs can take a lot of hassle and stress out of income investing. For investors who don’t mind the fees and have little interest in analyzing individual stocks, dividend ETFs are an attractive option to consider for the peace of mind and time savings alone.
For the rest of us, especially those with larger portfolios living off dividends in retirement, building a high quality portfolio of 20 to 30 individual dividend stocks can save hundreds or even thousands of dollars each month.
More importantly, building a dividend portfolio of stocks allows an investor to completely customize the dividend yield, dividend safety, and diversification of a portfolio to match his or her unique objectives. Managing a portfolio of individual dividend-paying stocks can certainly be a worthwhile endeavor.
8 Best Funds for Regular Dividend Income
Reinvestment, in which the generated interim income is reinvested back into the investment, is known to increase long-term returns. However, some investors opt to receive periodic payments from their investments, depending on their specific needs. Periodic coupon or interest payments from bonds, which are debt instruments, and regular dividends, which are cash payments from stocks and mutual funds, can offer investors a steady stream of income. In this article, we explore eight of the best dividend mutual funds, which are known to pay dividends regularly.
- Many mutual funds offer aggregate dividends from multiple stocks that are either reinvested or paid out to account holders.
- Dividend funds are paid out after fees, meaning the best dividend mutual funds should have low expense ratios and high yields.
- Dividend-paying mutual funds tend to focus on large, well-established companies with a strong track record of paying dividends or are expected to increase their dividend payments.
How Do Mutual Funds Pay Dividends?
Mutual funds often contain a basket of securities including equities or stocks, which may pay dividends. Dividends are paid to shareholders at different times. Mutual funds following a dividend reinvestment plan, for example, reinvest the received dividend amount back into the stocks. Other funds follow the dividend payment plan by continuing to aggregate dividend income over a monthly, quarterly, or sometimes six-month period, and then making a periodic dividend payment to account holders.
A fund pays income after expenses. If a fund is getting regular yield from the dividend-paying constituent stocks, those expenses can be covered fully or partially from dividend income. Depending on the local laws, dividend income may be tax-free, which can add to an investor's overall return.
Investors should also note that companies are not obliged to make dividend payments on their stocks, meaning dividends are not guaranteed. Investors looking for dividend income may find dividend-paying mutual funds a better bet than individual stocks, as the latter aggregates the available dividend income from multiple stocks. A mutual fund also helps with diversifying risk from depreciating stock prices since the money invested is spread between dozens of companies.
Top Dividend-Paying Mutual Funds
Here are the best mutual funds that pay high-dividend yields. A useful benchmark for gauging the dividend-paying performance of a fund is to compare the mutual fund yield against the yield of the benchmark S&P 500 index.
Also, the 30-day SEC Yield is a standard measurement in the industry mandated by the U.S. Securities and Exchange Commission (SEC) to help investors compare funds before investing.
Please note that any fund that invests in stocks, bonds, or other securities can realize gains in losses due to the price movements of the holdings. Although the market gains can lead to enhanced capital gains in addition to the SEC yield, market losses can also occur. These losses can be so significant that the SEC yield can not only be wiped out but also a loss of the initial investment is possible.
1. The Vanguard High Dividend Yield Index Admiral Shares (VHYAX)
VHYAX is an index fund that attempts to replicate the performance of the FTSE High Dividend Yield Index. This index contains stocks of companies, which usually pay higher than expected, or greater than average, dividends. Being an index fund, the VHYAX replicates the benchmark stock constituents in the same proportion. This fund has maintained a consistent history of paying quarterly dividends since its inception on Feb. 7, 2019.
Being an index fund, this has one of the lowest expense ratios of 0.08% and SEC yield was 2.75%. The fund has a $3,000 minimum investment requirement. It may be a perfect low-cost fund for anyone looking for higher than average dividend income.
For investors looking for a lower minimum investment requirement, Vanguard offers this fund as an exchange traded fund (ETF), which has many similar characteristics. The ETF version is called the Vanguard High Dividend Yield ETF (VYM).
2. The Vanguard Dividend Appreciation Index Admiral Shares (VDADX)
VDADX is an index fund, which attempts to replicate the performance of the benchmark NASDAQ US Dividend Achievers Select Index. This unique index consists of stocks that have been increasing the dividend payouts over time. Being an index fund, VDADX replicates the benchmark stock constituents in the same proportion. This fund is also a consistent payer of quarterly dividends since its inception date of Dec. 19, 2013.
The VDADX also has one of the lowest expense ratios of 0.08% and an SEC yield of 1.65%. The fund has a $3,000 minimum investment requirement.
For investors looking for a lower minimum investment requirement, Vanguard offers this fund as an ETF, which has many similar characteristics. The ETF version is called the Vanguard Dividend Appreciation ETF (VIG).
3. The Columbia Dividend Opportunity Fund (INUTX)
Columbia's INUTX focuses on delivering dividends by investing in the stocks of companies that have historically paid consistent and increasing dividends. The fund offers a diversified portfolio of holdings that include common stocks, preferred stocks, and derivatives for both U.S. and foreign securities of various sized companies.
The INTUX has an expense ratio of 1.05% and an SEC yield of 1.96%. The fund's inception date was Aug. 1, 1988, and also has a $2,000 minimum investment requirement.
4. The Vanguard Dividend Growth Fund (VDIGX)
The Vanguard Dividend Growth Fund (VDIGX) primarily invests in a diversified portfolio of large-cap (and occasionally mid-cap) U.S. and global companies, which are undervalued relative to the market and have the potential for paying dividends regularly. The fund research attempts to identify companies that have high earnings growth potential leading to more income, as well as the willingness of company management to increase dividend payouts.
The VDIGX has an expense ratio of 0.26% and an SEC yield of 1.48%. The fund's inception date was May 15, 1992, and also has a $3,000 minimum investment requirement.
5. The T. Rowe Price Dividend Growth Fund (PRDGX)
Based on the principle that increasing dividends over a period are positive indicators of a company’s financial health and growth, PRDGX looks to invest in mostly stocks of large companies with some mid-sized companies mixed in. The fund seeks companies that have a strong track record of paying dividends or that are expected to increase their dividends over time.
The PRDGX contains mostly stocks of large U.S. companies that pay quarterly dividends. The PRDGX has an expense ratio of 0.63%. The fund's inception date was Dec. 30, 1992, and has a $2,500 minimum initial investment requirement.
6. The Federated Strategic Value Dividend Fund (SVAAX)
For investors who are not satisfied with quarterly dividends, the SVAAX from Federated offers monthly dividends. The fund's investment strategy includes generating income and long-term capital appreciation by focusing on higher-dividend-paying stocks than that of the broader equity market. The fund also seeks out companies with dividend growth potential and the fund is primarily benchmarked to the Dow Jones U.S. Select Dividend Index.
The SVAAX contains mostly stocks of large U.S. companies with some foreign securities. The SVAAX has an expense ratio of 1.06% and an SEC yield of 3.21%. The fund's inception date was March 30, 2005, and has a $1,500 minimum initial investment requirement.
7. The Vanguard Equity Income Fund Investor Shares (VEIPX)
The VEIPX from Vanguard focuses primarily on established U.S. companies that are consistent dividend payers. The fund's holdings tend to be slow-growth but high-yield companies. As a result, the stock price gains may be limited when compared to other funds. This fund pays regular quarterly dividends and has an inception date of March 21, 1988. The VEIPX has an expense ratio of 0.28% and an SEC yield of 2.24%. The VEIPX has a $3,000 minimum investment requirement.
8. The Neuberger Berman Equity Income Fund (NBHAX)
The NBHAX looks to earn dividend income and capital appreciation by investing in high dividend-paying equities that include common stocks, utilities, real estate investment trusts (REITs), convertible preferred stock, convertible securities such as bonds, and derivative instruments like call and put options.
The fund's inception date was June 9, 2008, and has a $1,000 minimum initial investment requirement. It pays dividends with an SEC yield of 1.50% and has an expense ratio of 1.06%.
The Bottom Line
A company's dividend payments are typically paid from the company’s retained earnings, which represent the saved profit from prior years. However, companies may be better off reinvesting the dividend money back in the business, leading to higher revenue and an appreciation of their stock prices.
Also, dividend payments limit the reinvestment gains due to compounding. Investors looking for regular dividend income should weigh both the benefits of dividend income with the limitations before investing in high dividend-paying mutual funds.
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ETF vs. Index Fund: What Are the Differences?
ETFs and index funds have a lot in common. Both are passive investment vehicles that pool investors' money into a basket of securities to track a market index. While actively managed mutual funds are intended to beat a certain benchmark index, ETFs and index mutual funds are usually intended to track and match the performance of a particular market index.
But the differences between an ETF (exchange-traded fund) and an index fund are not as insignificant as they might seem. It isn't just about performance or which type of fund has the best returns.
ETFs vs index funds
The differences between them boil down to four main areas -- fees, minimums, taxes, and liquidity -- all of which can help you to determine which one is your best option.
1. Fees and expenses
The primary difference between ETFs and index funds is how they're bought and sold. ETFs trade on an exchange just like stocks, and you buy or sell them through a broker. Index funds are bought directly with the fund manager.
Because ETFs are bought and sold on an exchange, you will pay a commission to your broker each time you make a trade. (That said, some brokers offer commission-free trading.)
Dividend distributions compound the issue of the differences between how ETFs and index funds are bought and sold. Dividends paid by index mutual funds can be automatically reinvested (fee-free!) into more shares of the fund.
However, when an ETF pays a dividend, you'll need to use the proceeds to buy more shares, incurring additional commissions and spending time logging into your account to make a quick trade. Some brokers may offer an automatic dividend reinvestment plan on a limited set of ETFs.
ETFs generally have a slight advantage when it comes to annual expense ratios -- which is the percentage of assets you'll pay for managing the fund. But the difference between expense ratios for widely traded ETFs and index funds has narrowed in recent years and nearly disappeared. For more niche indexes, though, expense ratios could differ widely, usually favoring the ETF.
2. Minimum investments
You can invest in an ETF by buying as little as one share, which used to be the easiest way to start investing with very little capital. Several fund managers have lowered their minimum investments for their most popular index funds, so these days you can get started with a relatively small amount of money. The following table shows the minimum investments for S&P 500 mutual funds from three leading asset managers.
Index Fund Manager
Minimum Additional Investment
Data source: Company websites.
3. Tax differences
Long-term investors who are saving for retirement should use tax-advantaged retirement accounts such as 401(k)s and IRAs. I say this not just because it's smart -- because we all know minimizing taxes means more money left in your pocket -- but also because it means you can completely ignore the complicated details of the tax consequences of investing in different types of funds.
Index funds and ETFs are both extremely tax-efficient -- certainly more so than actively managed mutual funds. Because index funds buy and sell stocks so infrequently, they rarely trigger capital gains taxes for investors.
When it comes to tax efficiency, ETFs have the edge. Unlike index funds, ETFs rarely buy or sell stock for cash. When an investor wants to redeem shares, they simply sell them on the stock market, generally to another investor.
When an index fund investor wants to redeem an investment, the index fund may have to sell stocks it owns for cash to pay the investor for the shares. This means mutual funds have to realize capital gains by selling stocks, which results in capital gains (and taxes) for everyone who continues to hold the fund, even if they are currently losing money on their investment.
Liquidity, or the ease with which an investment can be bought or sold for cash, is an important differentiator between ETFs and index funds. As previously mentioned, ETFs are bought and sold like stocks, meaning you can buy or sell them anytime the stock market is open.
On the other hand, index fund transactions (like those of all mutual funds) are cleared in bulk after the market closes. Thus, if you put in an order to sell shares of an index fund at noon, the transaction will actually take place hours later at a price equal to the value of the fund at market close. Typically the cutoff time is 4 p.m. ET. Orders entered after the cutoff are pushed into the next day and completed at the fund's net asset value a day later.
If you consider yourself a trader, this matters. If you consider yourself a long-term investor, it really doesn't matter much at all.
ETFs or index funds: Deciding what's right for you
An ETF is best if you're an active trader or simply like to use more advanced strategies in your purchases. Since ETFs are bought and sold on exchanges like stocks, you can buy them using limit orders, stop-loss orders, or even margin. You can't use those kinds of strategies with mutual funds.
If you're investing in a taxable brokerage account, you may be able to squeeze out a bit more tax efficiency from an ETF than an index fund. However, index funds are still very tax-efficient, so the difference is negligible. Don't sell an index fund just to buy the equivalent ETF. That's just asking for all sorts of tax headaches.
Buy an index fund if your broker charges high commissions on your purchases and you want to be fully invested at all times. In some cases, you may be able to start investing in index funds with a lower minimum than for its equivalent ETF.
Index funds are also a great option when the equivalent ETF is thinly traded, creating a large spread in the difference between the ETF price on the exchange and the value of the underlying assets held by the ETF. An index fund will always price at the net asset value.
Always compare fees to make sure you're not paying too much of a premium for your choice. If you're on the fence between an ETF and an index fund, the expense ratio could be a good tiebreaker.
Dividend vs Index Investing: Both have appeal for investors—and some investments combine the two
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Funds index funds vs dividend
I’m a big advocate of index funds in investing. It’s simple, and you can get a diversified portfolio with just a few mutual funds.
However, another common investment philosophy is to purchase a diversified portfolio of stocks with high dividend yields.
One of the most common debates in investing is whether to invest in dividend-producing stocks index funds. In this article, I make the case against dividend stocks.
Why invest in dividend stocks? Cash Flow!
People love dividend stocks because it can enable you to generate a recurrent cash flow with your portfolio.
If you build up a large enough portfolio with a high-enough dividend yield, you could potentially “live off the dividends of your portfolio.” For example, let’s say you have a $3 million portfolio that is invested in stocks with a 4% dividend yield. You would receive $120,000 in dividends per year, which you could use to fund your retirement lifestyle. Theoretically, you could live off the dividends without eroding the “principal” on your stock investments.
I understand the attractiveness of dividend stocks. Especially among those investors who also used to investing in real estate, the concept of receiving dividends from your stock investments feels like receiving rent from your tenants.
In real estate, there is a strategy where you build up a portfolio of real estate properties, and retire on the cash flow from your tenant’s rent checks, while you retain the property and capture its appreciation. Many investors apply this mentality to stock investing, leading them towards high-dividend stocks.
Downsides of Dividend Stocks
While I did have a period in my life where I invested in high-dividend stocks, I currently invest in index funds and do not seek out high dividend-yield stocks. Here’s why:
Dividends incur taxes
The least attractive aspect of dividend stocks is its tax inefficiency. By paying out more money in taxes, it erodes your returns.
Dividends in taxable accounts are subject to taxes. The tax rates of dividends are either the long-term capital gains rate for qualified dividends or as ordinary income for non-qualified dividends.
If you are young and don’t actually need the dividend to spend (i.e. you would reinvest the dividend back into the stock), then you are paying taxes on some of your investment early rather than letting it continue to compound in your account.
Compared to if the stock had not paid the dividend, this distribution creates a tax drag on your portfolio, lowering your total stock return.
The paying of dividends does not directly add value to a company
One of the most common misconceptions about dividend stocks is that dividends directly add to a stock’s return. They believe that if a stock is expected to return 8% without a dividend, then a stock that offers a dividend yield of 4% should expect to return 8% + 4% = 12%. There is a misconception that the payment of a dividend does not affect the expected return from stock price appreciation.
The payment of a dividend is not a bonus. It is splitting the value of the stock into a dividend and the rest of the stock. On the morning of the “ex-div” date (the day after the day when current stockholders will receive the dividend), the stock price usually goes down by the amount of the dividend.
If the stock did not fall by the amount of the dividend on the ex-div date, then traders could generate a risk-free profit (arbitrage) by buying the stock on the day before the ex-div date (and qualify to receive the dividend), and then sell on the ex-div date. They would get the dividend essentially risk-free. They cannot perform this arbitrage because the stock falls by the amount of the dividend on the ex-div date.
For some stocks with high dividends, this can cause some distress among new investors. When a number of REITs went ex-dividend on the same date in December 2017, investors on the White Coat Investor and the Bogleheads forums were not sure why there was a temporary “drop” in their REIT stocks In actuality, the REITs just went ex-dividend and they would be recouping their “losses” through a large dividend payment within a few days or weeks.
So while the total return of a stock is its stock appreciation plus its dividend, the total return of a company is not significantly changed just because it pays out a dividend. If a company increased their dividend yield by 1%, their expected return would not increase by 1%.
Dividends are an indicator of health, until they cut the dividend
When you see that a stock has a high dividend yield, you have to figure out why the dividend yield is high. Is it because they offer large dividends as a company policy? Is it because the stock is undervalued? Or is the company under distress and about to cut its dividend?
Many times a stock may appear to have a high dividend yield, but that’s only because it has fallen significantly in the previous 3 months. If the underlying financials of the company are unstable, they may be at significant risk for cutting their dividend. In that case, you would not be receiving the yield that you were hoping or planning for.
There is a common strategy of purchasing stocks that have increased their dividend for 25 or 30 years. The theory goes that these companies have stable dividends. Unfortunately, this might be a case of selection or survivorship bias. Just because a company has succeeded for the last 20 or even 30 years doesn’t mean that it will continue to be successful. Sears Roebuck had been a successful company for over a century, but then struggled and cut their dividend.
Make your own dividend whenever you want
The great thing about not owning dividend stocks is that you can make your own dividends whenever you want. This has been advocated by other personal finance bloggers such as Physician on FIRE or Big Law Investor. You don’t have to wait for the quarter to end or for the company to pay out the dividend. If you need cash flow, just create some cash flow by selling some stock.
Remember that the payment of dividends does not significantly change your expected total return, so if you were comfortable receiving dividends from the companies you own, then you should be fine creating your own dividend through selling shares.
Some have suggested intentional purchasing low-dividend stocks. For example, Physician on FIRE holds Berkshire Hathaway, Warren Buffett’s conglomerate company, in his taxable account. Because Berkshire Hathaway pays out no dividends, it is more tax-efficient than investing in the total stock market, which has a dividend yield of approximately 1.7%.
I personally do not invest in such a strategy, as Warren Buffett will likely no longer be with us when I would want to liquidate my taxable account. His portfolio, while diversified, is tilted to certain sectors, and is not as diversified as a total stock market index or even the S&P 500. We also do not know how Berkshire Hathaway will be managed when his successors take the reins of the company.
I understand the attractiveness of dividend stocks, but ultimately its benefits can be replicated by creating your own dividend by selling your stocks. The payment of a dividend does not add value to a company, as is demonstrated when the stock drops by the amount of the dividend on the ex-div date. Dividend stocks are tax-inefficient compared to the total stock market in taxable accounts. I do not believe dividend stocks will outperform non-dividend stocks beyond its potential as a play on value stocks.
What do you think? Do you invest in high-dividend stocks, index funds, or a combination of both?
Wall Street PhysicianSours: https://www.wallstreetphysician.com/high-dividend-stocks/
5 Best Dividend Index Funds for Retirement Income
Role of Dividend Index Funds in Your Portfolio
Investing in these index funds exposes you to dividend-paying stocks that can serve as an income stream during retirement. They can hedge against inflation. But dividends are never guaranteed.
A company can choose to reduce or get rid of its dividend at any time, such as during an economic downturn when its profits might fall. The share price will often go down when this happens, which could reduce the value of the assets you invest in the fund.
Dividend-producing investments should be part of a diversified portfolio that you manage through a holistic plan. They should not be used as a sole source of income.
NOTE: The Balance doesn't provide tax or investment services or advice. This information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor. It might not be right for all investors. Investing involves risk, including the loss of principal.
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Interrupting my mother, I replied with the phrase that he asked to speak to him, and, as if affirming, slapped my palm on. The puddle from my mug with milk on the table, drops of moisture splashed my face. I licked the sweet drop from my lips and kissed my daddy on the nose in the same way.
Stop that idiot.