With savings rates around the world at record lows, many investors seeking higher levels of income have focused their attention on dividends, in recent years.
While some investors have invested through high-dividend mutual funds and index funds, others have invested directly in dividend-paying stocks.
Is one investment strategy more effective than the other? Let’s take a look at some advantages and disadvantages of each strategy.
Dividend mutual funds / index funds
Funds such as the Vanguard Dividend Appreciation Index Fund (MUTF: VDAIX), the Vanguard High Dividend Yield Index Fund (MUTF: VHDYX), and the Fidelity Equity Income Fund (MUTF: FEQIX) have been popular among income investors, in the current low interest rate environment. Indeed, there are several key advantages of investing in these kinds of dividend funds.
Perhaps the greatest benefit of fund investing, is the diversification that can be obtained. With a small investment outlay and just one simple trade, the investor can purchase a portfolio holding hundreds of securities, and this means that stock-specific risk is reduced significantly.
For example, the Vanguard High Dividend Yield Index Fund currently holds approximately 400 stocks in the portfolio. The Fidelity Equity Income Fund has over 150 holdings. Portfolios of this size provide excellent diversification, and if one or two holdings perform poorly, the investor is unlikely to suffer considerably.
Another advantage of fund investing is that it is considerably less time consuming than investing directly. Continually monitoring a large portfolio of stocks takes time and effort. Therefore, why not leave it to the professionals?
However, the benefits of investing in funds do come at a cost. All mutual funds and index funds charge some form of management fee, and some charge one-off initial charges as well. For example, the Fidelity Equity Income fund has an expense ratio of 0.67% per year. While that may sound insignificant, over a period of 20 years, ongoing fees can add up to a considerable sum. One way of mitigating fees is to invest in index funds instead of mutual funds, as index funds generally have lower expense ratios. For example, the expense ratio on the Vanguard High Dividend Yield Index Fund is just 0.15%.
Investing directly in dividend-paying stocks has its own set of advantages and disadvantages.
One key benefit of investing directly, is that fees can be kept low. While the investor will have to pay brokerage fees to buy and sell securities, ongoing account fees are generally low, relative to mutual fund fees. This can boost portfolio returns considerably, over the long term.
Another advantage of investing directly, is that the investor could potentially construct a portfolio that has a higher yield than many dividend-based funds offer. While dividend funds may hold a selection of high-yielding securities, often, the overall yield passed through to the investor is not as high. For example, the current yield on the Fidelity Equity Income Fund is just 2.3%. With research, a direct investor could no doubt assemble a dividend portfolio with a higher yield than that.
Furthermore, investing directly in dividend-paying stocks gives the investor considerably more investing flexibility. The investor could choose to add a selection of international dividend stocks to the portfolio, or perhaps even look at small-cap dividend opportunities.
However, the downside to investing directly, is that it does require time and effort. Researching the best dividend stocks to invest in takes time, as does the process of monitoring a well-diversified portfolio on a regular basis.
So in summary, both investing strategies have their merits. Mutual funds and index funds provide diversification, however, the fees associated with mutual funds can be considerable over the long term. For those with time to dedicate to investment research, investing directly in individual dividend-paying stocks could generate a yield higher than many dividends funds offer, while at the same time, reduce fees. Of course, the two strategies are not mutually exclusive, and could complement each other at portfolio level.
Disclosure: I have no positions in any stocks mentioned,