One of the big questions many dividend investors face early on is whether or not it’s worth managing a portfolio of individual dividend stocks instead of keeping things easy and buying a dividend ETF.
In fact, I recently emailed with a reader who was interested in comparing the performance of our Conservative Retirees dividend portfolio with the PowerShares S&P 500 High Dividend Low Volatility Portfolio ETF (SPHD), for example.
While total return is certainly a very important consideration, there are a number of other factors that can swing the decision one way or the other. Let’s start by taking a closer look at SPHD, which is one of my favorite dividend ETFs.
The SPHD fund was launched in October 2012 and seeks investment results that generally correspond to the price and yield of the S&P 500 Low Volatility High Dividend Index.
This index essentially takes the 75 highest-yielding stocks in the S&P 500, sorts them based on lowest realized price volatility over the past year, and selects the top 50, with the number of stocks from each sector capped at 10.
The reader I emailed with noted that the performance of our portfolio was more or less the same as the returns generated by SPHD since our inception in June 2015.
This is admittedly too short of a period of time to glean any real insights, but it’s better than nothing. All else equal, why not go with SPHD?
With similar returns, a somewhat longer track record (dating back to October 2012), an easy-to-understand benchmark, and no incremental portfolio management work required, SPHD offers a number of benefits.
I believe that the choice to go with an ETF or build a portfolio of individual stocks is largely a personal preference, and it involves more than just total return potential. I wrote an article about the tradeoffs that you can read here, if you are interested.
What’s nice about ETFs is that they are completely passive – there is nothing for you to actively manage, and you know the performance of ETFs will generally track their underlying benchmark for only a small fee.
The main drawbacks to owning ETFs over individual stocks are that you are stuck with whatever dividend yield they offer (which is often too low for investors needing income today), their income streams can be riskier because they own good and bad quality businesses, and they can lack reasonable diversification depending on how they are constructed.
All of these factors can be a bigger deal for dividend investors than simply comparing total return potential of different ETFs and hand-picked dividend portfolios.
In SPHD’s case, its annualized dividend yield is 3%, and its 0.3% management fee drops the net yield to 2.7%. Building a portfolio of high quality dividend stocks can achieve a yield closer to 4% with no fees, which is nearly 50% more current income than owning SPHD.
For someone planning to live off dividends in retirement, this difference in income generation can be a dealbreaker.
SPHD’s dividends can also be less predictable than a portfolio of hand-picked dividend stocks. Since ETFs tend to very diversified and focus less on dividend safety and business quality, they end up owning some low quality stocks that cut dividends.
For example, SPHD only looks at a stock’s dividend yield, trailing 12-month price volatility, and sector classification to determine what it owns. No attention is given to a company’s payout ratio, financial leverage, or recent business trends, which are some of the factors that matter most for dividend safety.
As a result of its yield-chasing and lack of focus on business fundamentals, you can see that SPHD’s monthly distribution was reduced by close to 10% in May. The fund also experienced 50% turnover last year, which can create further volatility in its dividend stream as its holdings change (our portfolios run with very low turnover – typically close to 10% or less).
Since ETFs typically own many dozens or even hundreds of stocks, changes in dividend payouts like this tend to come with no warning and can make budgeting and forecasting more difficult for income investors.
For investors who have decided to manage their own portfolio of individual dividend stocks, reviewing the business quality and dividend safety of each holding can help generate much more predictable income compared to owning an ETF.
You will know exactly when each company is paying you, how much it is paying, and how safe its payment appears since you can review the company’s financial health.
Our Dividend Safety Scores can help because they scrub a company’s financial data to assess how likely it is to cut its dividend in the future.
By focusing more on dividend safety factors rather than only buying based on yield and price volatility, which is SPHD’s approach, we should have a much better shot at providing more reliable and much less volatile income over a full market cycle.
In fact, our Conservative Retirees dividend portfolio has recorded more than 55 dividend increases since inception and has not experienced any dividend cuts.
You can see below that our portfolio’s dividend income (the blue bars) has been much steadier than the income provided by Vanguard’s high dividend ETF (VYM), which is the benchmark we use:
I would be very content to continue achieving similar total returns to the high dividend ETFs out there if we are generating up to 50% more current income and achieving much less income volatility thanks to our focus on dividend safety and long-term investing.
You will also note that the dividends receivable chart above plots income on a quarterly basis. Some high dividend ETFs, such as Vanguard’s VYM, pay dividends on a quarterly basis (SPHD pays monthly).
Investors living on dividends can budget more easily if they receive dividends on a monthly basis. A portfolio of individual stocks makes it possible to completely customize a reliable monthly income stream, and you have full visibility into the exact amounts you are set to receive.
Here’s a look at the dividend income stream our Conservative Retirees portfolio is projected to generate over the next 12 months, courtesy of our Portfolio Analyzer tool:
Diversification can be another downside of owning dividend ETFs. SPHD is significantly overweight the real estate (24%) and utilities sectors (19%), which account for more than 40% of the portfolio’s value.
For comparison’s sake, the real estate and utilities sectors only account for 3% and 3.3% of the S&P 500, respectively.
Falling interest rates have significantly helped most bond-like stocks in these parts of the market, and it’s hard to say what could happen to their total return performance and/or dividends when rates rise from historic lows.
Personally, I doubt the strong performance SPHD generated in recent years (15.6% annualized return from 2014 through 2016 versus 8.9% for the market) will repeat itself going forward since interest rates have little room to move lower unless there is a slump in the economy.
Our Conservative Retirees portfolio only has 6.8% in real estate and 12.9% in utilities, providing greater diversification and arguably better positioning us for any type of interest rate or other macro environment going forward.
At the end of the day, there’s no right or wrong answer on which approach investors should take. It really does come down to personal preferences and financial goals, in my opinion, because there are a number of factors to consider beyond just total return.
Staying on top of a portfolio of individual dividend stocks certainly requires some ongoing work (more tips on how to manage a dividend portfolio here), but it can provide greater income, safer dividends, more control, and effective diversification.
Dividend ETFs require little to no maintenance time once one has been selected, but it’s very important to do your homework upfront. Make sure you understand and are comfortable with the ETF’s fees, yield, income volatility, dividend track record, diversification, and stock selection process.