I haven't expressly written before about the differences between dividend growth investing and index investing, and why I prefer the former over the latter. But, always better late rather than never and so I find myself compelled to put my thoughts to paper.
Before I delve too deep into this, it should be noted that I find index investing to be a fantastic strategy for a great many people out there, and probably the vast majority of investors would do better to invest in a small group of high quality, low expense index funds and be done with it. It's extremely easy to manage, very passive and usually a yearly or semi-annual portfolio rebalance is all you need to keep a proper asset allocation to stocks, bonds, real estate, etc.
Okay, with that aside let's get into it.
First, let's define exactly what an "index fund" actually is. Per investopedia an index fund is defined as:
A type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the Standard & Poor's 500 Index (S&P 500). An index mutual fund is said to provide broad market exposure, low operating expenses and low portfolio turnover.
There are thousands of index funds available for an inclined investor to research, and invest in. For simple comparisons today, I'm going to use VIG, which is Vanguard Dividend Appreciation, since it's fairly close to an apples-to-apples comparison to dividend growth investing. This fund typically focuses on businesses with at least a 10-year track record of dividend growth.
Okay, let's talk about fees.
I pay $7.00 per transaction with my broker, Scottrade. I typically have about two transactions per month on average. That's $14 per month, for a total of $168.00 per year. We could safely round this up to $200, to make room for months when I have more than two transactions. Based on the last published value of my Freedom Fund, that works out to about .19% of my total assets on a yearly basis.
Index fees are famously heralded for their low fees, and rightly so. Many active mutual funds charge a pretty hefty fee to pay their directors and fund managers for the fund management services they provide, whereas index funds typically are not as actively managed. VIG, for instance, charges an annual management fee of just .13% of total assets under control. So, this must be the better way to go, correct?
Not so fast.
My "management fee" will only decline over time as my portfolio value, and total assets under my control, rises and the transaction fees my broker charges remain fairly static. The discount brokerage market is fairly competitive, so I don't anticipate a large increase in fees any time soon.
Also, and this is a key point, once I'm done accumulating assets and buying stocks I'll no longer be paying any management fees at all! This is a discussion point about fees that I see rarely/never brought up. I plan to retire from full-time work by 40 years old and shift from investing in dividend growth stocks to living off my dividends at that time. That means I'll no longer be paying any fees at all. So, just about the time my portfolio value peaks in terms of market value (and hopefully increases over time), I'll be paying exactly $0 in management fees.
So, let's extrapolate this out in the future.
Let's say it's 2023 and I have $500,000 in dividend growth stocks. My dividend income at this point completely covers my expenses and I now consider myself financially independent. I stop buying stocks, and shift my attention to writing, spending time with family and friends, volunteering my time, reading and casually checking in on my portfolio to make sure everything is humming along. I'll be paying $0 in fees if I stick with a dividend growth investing strategy here. I'll just collect my dividends as they are deposited into my brokerage account. Can't get much better than that!
Let's pretend for a moment that instead I had $500,000 invested in VIG. I'll be paying $650 in annual fees based on the total amount of assets under control. That's $650 that doesn't go in my pocket because I want to buy into an index fund that just so happens to own many of the same companies I do. The top 5 holdings of VIG are currently: Wal-Mart Stores, Inc. (WMT), The Coca-Cola Company (KO), The Procter & Gamble Company (PG) and Chevron Corporation (CVX). Hmm, I already own all five.
Next, let's talk about yield.
Based on the amount of dividends I'm going to receive over the next 12 months (a little over $3,700) and the total value of my portfolio (currently about $105,000) I have an effective total portfolio yield of about 3.5%. This compares extremely favorably to the 2.17% 12-month yield of VIG. I don't really think this area needs further extrapolation or explanation. That 1.3% spread in yield is tremendous over time.
What about dividend growth?
Many of the companies I invest in have lengthy histories of dividend growth, often well above the rate of inflation. For instance, my most recent purchase of Air Products & Chemicals (APD) is a good example. Just recently, APD raised the dividend by 10.9%. Wells Fargo & Company (WFC) raised its dividend twice this year, most recently by 20%. Wal-Mart Stores, Inc. (WMT) raised its dividend by 18% earlier this year. I get 100% of the net effect of these raises in my portfolio, as there is no middle-man index fund to take these dividends and disperse them any differently than the company would to me as a direct shareholder.
What about VIG? The distributions of VIG have remained relatively static over the last few years. For instance, their total 2011 distributions were 11.8% larger than the 2010 distributions. That was after a 6.6% raise for 2010 distributions over 2009's total. While 2012 looked better, at about 20% larger than 2011, this was mainly due to a very large distribution in December of 2012. This was likely due to the large number of companies that decided to pay accelerated dividends in face of the looming fiscal cliff. Looking at current numbers, the distribution of $0.228 in March was not much larger than the distribution of $0.285 back in September of 2011. I'd rather take my chances as a direct shareholder.
The sale of assets!
One of the most convincing arguments, in my opinion, to invest in individual companies over index funds is the sale of assets. With the strategy I'm engaging in, I look at my portfolio as one big dividend tree. Each branch is a company, and each branch provides bountiful fruit on a monthly, quarterly or semi-annual basis. My plan is to simply pluck that dividend fruit and live off of it once the passive income exceeds my expenses. If I were to slowly sell off assets and live off the capital gains I'd be effectively cutting down my tree one branch at a time until it dies.
Most investors in index funds actually rather plan to sell off assets. The plan is to build a comfortable asset base well into the hundreds of thousands of dollars, or millions of dollars, and sell off 4% of those assets based on the 4% Safe Withdrawal Rate. That means you're selling off 4% of your wealth every year (sometimes actually increasing this fire sale with the rate of inflation) while hoping that the stock market rises in kind to keep your asset base stable or increasing. The problem with this strategy is that in years where the stock market performs very poorly (think 2008-2010) you'll not only be selling off your assets to pay basic expenses like rent, food and the electric bill, but you'll also be losing a large portion of your golden goose as the stock market erases large portions of your wealth. Of course it's important to be diversified away from just the stock market, but this point remains.
What about Voting rights?
This one is pretty simple. While most common stock infers voting rights, index investing generally does not. This can be a benefit or a drawback depending on your viewpoints. I personally believe that the right to cast my vote on certain company matters is important and one I like to reserve.
Which one offers more control?
Another easy one. As an individual dividend growth investor that focuses on high quality companies at attractive long-term prices, I can fully 100% control what companies I own, when and at what price. With an index fund, I have no say over that.
Conclusion.
While there are certain aspects of index investing that are attractive, like the completely passive nature of it, I find that for an engaged and educated investor the better path to wealth accumulation would be to focus on direct partial equity ownership in high quality companies that have a lengthy history of paying, and raising, dividends.
Again, I would stress that many people don't have the interest or time to educate themselves about finance and investing to the point where a dividend growth strategy makes sense. In these cases, index investing (even factoring in the shortcomings) would be the better investment vehicle. I personally quite enjoy reading stock analysis reports and looking at income statements, cash flow statements, balance sheets, annual reports and the like. I find investing to be a wonderful hobby that I'll take an even more active interest in once I'm free from the shackles of full-time employment.
What do you think? Are you a fan of index investing?
Full Disclosure: Long WMT, KO, CVX, APD, PG, PEP, WFC
Thanks for reading.
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