Rising Dividends in ETFs
Reader ML asks the following good question (edited for length):
The short answer is that ETF dividends do grow. The dividends that low-cost index ETFs pay are mainly the dividends collected from all the individual stocks held within the ETF. There is a small deduction for the costs of operating the ETF and possibly a small increase from securities lending, but for the most part, you’re just getting the collected individual stock dividends.
If you follow blogs and Twitter accounts of dividend enthusiasts, you’ll see frequent reports of companies increasing their dividends. This focus on dividends can be a good thing in that it helps some investors keep holding their stocks through market crashes. But celebrating each dividend increase can also create the illusion that dividends are rising faster than they really are. If three stocks have dividend increases of 3%, 5%, and 7%, this feels like a total increase of 15%, but collectively, the annual dividend increase for holding all three stocks is 5%.
Whether your collection of individual stocks produces faster rising dividends than an ETF’s dividends depends on the fortunes of the companies you own. If your companies grow their profitability faster than the index average, then your dividends will grow faster. If their profitability grows slower, your dividends will grow slower.
In the end, it comes down to whether you’ve chosen better stocks than the average. Stocks that pay high dividends can go in and out of favour over the decades, so dividend investing will have good and bad periods. If you’re sufficiently diversified, you’ll likely get about the same results as an index biased to value stocks. However, it can be challenging to own enough individual stocks to be properly diversified.
I’m not sure what you mean by “ETFs switch over their portfolio.” Index ETFs tend to have very little turnover of stocks. Perhaps you’re referring indirectly to the idea of “yield on cost.” Some dividend investors like to calculate their annual dividend divided by what they paid for the stock. So, a stock might be paying a 4% dividend, but this looks like a 12% dividend to someone who bought the stock a decade earlier for one-third the price. This may feel good, but it has little meaning. I’ve owned some ETFs long enough that my dividend yield on cost is getting high, but yield should be thought of based on current prices, not what you paid in the past.
In summary, ETFs aren’t missing out on a big chunk of money. Their dividends tend to rise over time. It’s important to look through any type of “container” like low-cost stock index ETFs to see that under the covers they hold many individual stocks. Whether you hold an individual stock directly or hold it indirectly in an ETF, you get the same results of rising or falling dividends and capital gains.
I am relatively new to investing for dividends. Currently my strategy is to invest in high quality stocks and hold them for a long time. You are one of the bloggers who switched from buying individual stocks to buying ETFs. I get the strategy of ETFs in that it’s hard to beat the market with individual stocks.
My question: Over years the dividend you receive from an individual stock continues to grow. If ETFs switch over their portfolio would they not miss out on this increase in dividends, year over year? It seems to me that the dividends stay pretty steady in the ETFs. Is that not a big chunk of money to miss out on?
The short answer is that ETF dividends do grow. The dividends that low-cost index ETFs pay are mainly the dividends collected from all the individual stocks held within the ETF. There is a small deduction for the costs of operating the ETF and possibly a small increase from securities lending, but for the most part, you’re just getting the collected individual stock dividends.
If you follow blogs and Twitter accounts of dividend enthusiasts, you’ll see frequent reports of companies increasing their dividends. This focus on dividends can be a good thing in that it helps some investors keep holding their stocks through market crashes. But celebrating each dividend increase can also create the illusion that dividends are rising faster than they really are. If three stocks have dividend increases of 3%, 5%, and 7%, this feels like a total increase of 15%, but collectively, the annual dividend increase for holding all three stocks is 5%.
Whether your collection of individual stocks produces faster rising dividends than an ETF’s dividends depends on the fortunes of the companies you own. If your companies grow their profitability faster than the index average, then your dividends will grow faster. If their profitability grows slower, your dividends will grow slower.
In the end, it comes down to whether you’ve chosen better stocks than the average. Stocks that pay high dividends can go in and out of favour over the decades, so dividend investing will have good and bad periods. If you’re sufficiently diversified, you’ll likely get about the same results as an index biased to value stocks. However, it can be challenging to own enough individual stocks to be properly diversified.
I’m not sure what you mean by “ETFs switch over their portfolio.” Index ETFs tend to have very little turnover of stocks. Perhaps you’re referring indirectly to the idea of “yield on cost.” Some dividend investors like to calculate their annual dividend divided by what they paid for the stock. So, a stock might be paying a 4% dividend, but this looks like a 12% dividend to someone who bought the stock a decade earlier for one-third the price. This may feel good, but it has little meaning. I’ve owned some ETFs long enough that my dividend yield on cost is getting high, but yield should be thought of based on current prices, not what you paid in the past.
In summary, ETFs aren’t missing out on a big chunk of money. Their dividends tend to rise over time. It’s important to look through any type of “container” like low-cost stock index ETFs to see that under the covers they hold many individual stocks. Whether you hold an individual stock directly or hold it indirectly in an ETF, you get the same results of rising or falling dividends and capital gains.
That's a good explanation. Maybe ML is referring to ETF's being reconstituted annually or semi-annually? All the high dividend ETF funds I own have rules applied that insures the stocks they hold are not decreasing dividends - like GE for example.
ReplyDelete@Marko: That could be what ML meant as a reason for ETF portfolio turnover. Turnover creates expenses, but reduced yield on cost is not one of those expenses.
DeleteI really liked this simple explanation and example to explain YOC from the Globe and mail :
ReplyDeletehttps://www.theglobeandmail.com/globe-investor/investor-education/dont-fall-for-the-yield-on-cost-myth/article31390430/
@Paul: That's a good explanation of the problem with yield on cost. It made me think about whether I could do any better. I might give it a go sometime.
DeleteMaybe as a little further explanation to my question, if I look at stock data one of the numbers I like to use is the dividend growth rate. Up until this point I had not seen a similar number for ETF's. Today I just found that information on http://www.ca.dividendinvestor.com for ETF's (3 & 5 year dividend growth rates). I am not sure if this is available in other places.
ReplyDelete@Mark: ETF investors tend to focus on total returns (dividends plus capital gains), so few financial sites give just the growth rate of the dividends alone. However, over the long run, the dividend growth rate has to match the growth rate of total returns.
Delete@Mark: Something else to keep in mind is that you can't invest in past returns. At any given time there are many companies that have done very well in recent years. This success may or may not continue.
Delete@ Mark
DeleteI just wondered if you were referring to you liking a dividend "growth" stock like TJX for example vs. T (At&T)? One having a current dividend of under 2% but growing the dividend 22% average every year vs a mature dividend stock with a high but sustainable dividend that grows very slowly each year 2 to 5% ? I see this controversy discussed a lot on Dividend investor blogs as well. I'm not really sold on the dividend growth premise either.
I only use dividend growth as one piece of information. I like to see dividend growth but only if the company can sustain it and still grow as a company. For most companies that is about 2-5%. Maybe a little more for Canadian Banks? I would be very suspicious of a company that was growing it's dividend by 22% in a year.
DeleteMy goal with dividends is to eventually receive as much in dividends as I paid for the stock. The longer you hold the stock the safer it becomes. The problem with pure dividend ETFs for me is paying someone else to buy companies I would never own. XDV and CDV are prime examples of high cost products full of bad investments IMO.
ReplyDeleteLastly, you never participate in stock splits when you own funds or ETFs. They are buried and you won't participate in the future growth of that individual company split.
*CDZ
Delete@Speculator: Your goal is admirable, but it amounts to little more than a plan to hold stocks for a long time. Eventually, ETFs will pay dividends that exceed their prices in the distant past.
DeleteI'm doubtful about anyone's ability to determine which stocks will perform well in the future.
It's not true that ETFs don't participate in stock splits. If an ETF holds a stock that splits, then it will suddenly hold twice as many shares at half the previous price per share (and half the dividend per share) just like someone who owns the stock directly.
If that is true why don't the distributions grow? They are stagnate at best. ETF providers are slow to raise distributions even when a company raises their dividend or splits it stock. Dividend ETFs are sold to sell you yield so they invest in high yield risky stocks. They are anything but safe over the long term.
ReplyDeleteThe problem with individuals is they never hold long enough to realize long term gains which to me is the only goal.
@Speculator: I prefer broad index ETFs such as VCN, but I assume you're talking about the dividend ETFs XDV and CDZ. XDV dividends have almost doubled in the past 11 years. CDZ dividends have more than doubled in the past 10 years. So, they are not stagnant. If you're focusing on the dividend yield, this stays fairly steady because it is dividends divided by current price, and this price rises over time.
DeleteETF providers must report their MERs. If they kept the rising dividends for themselves, these MERs would go up. I agree that the MERs are far too high, but they're not rising. As for stock splits, this has no effect on dividend payouts. You get twice as many shares that sell at half the price and have half the dividend. The net effect is nil.
All stocks are risky. If you think the individual stock you own are somehow safer, you're fooling yourself.
I agree that people should trade less. Long-term buy and hold is a great strategy, as long as you're adequately diversified. This means owning stocks outside of Canada, stocks in multiple industries, and holding at least dozens of stocks.