IN THIS CHAPTER

Examining the role of dividends in your portfolio

Determining the potential payoff of dividend funds

Understanding how to best employ dividends

The check is in the mail. When you know it’s true (it isn’t always), there are perhaps no sweeter words in the English language. To many investors, the thought of regular cash payments is a definite turn-on. Always willing to oblige, the financial industry of late has been churning out “high-dividend” funds — both mutual funds and ETFs — like there’s no tomorrow.

The idea behind these funds is simple enough: They attempt to cobble together the stocks of companies that are issuing high dividends, have high-dividend growth rates, or promise future high dividends. In this section, I spell out some of the high-dividend ETF options and then debate the value of investing in them.

But before I get to that, let me say to the one poster on the Bogleheads online forum who read an earlier edition of this book, that Russell Wild does not hate dividends. I don’t hate dividend ETFs. Not at all. I love dividends. I just don’t think that they are the answer to everything. And I don’t think that they should be your sole criterion, nor the most important criterion when building an investment portfolio.

Your High-Dividend ETF Options

The oldest (launched March 11, 2003) and still one of the largest ETF dividends is the iShares Dow Jones Select Dividend Index Fund (DVY). If you really want a fund that pays high dividends, neither that fund nor any of the funds listed here would be bad options:

• Schwab U.S. Dividend Equity ETF (SCHD)
• Vanguard Dividend Appreciation ETF (VIG)
• Vanguard High Dividend Yield ETF (VYM)
• SPDR S&P Dividend ETF (SDY)
• First Trust Morningstar Dividend Leaders Index Fund (FDL)
• iShares Core Dividend Growth ETF

And if you really want to invest in high-dividend-paying international stocks, the following ETFs wouldn’t be so bad, either:

• Schwab International Dividend Equity ETF (SCHY)
• Vanguard International High Dividend Yield (VYMI)
• First Trust S&P International Dividend Aristocrats ETF (FID)
• SPDR S&P International Dividend Equity ETF (DWX)

If you want to fine-tune your dividends and have them come from, say, small-cap stocks, mid-caps, or even emerging-markets small caps, you can find these and much more among the ETF high-dividend-paying offerings from WisdomTree. They offer not only the U.S. SmallCap Dividend Fund (DEM), the U.S. MidCap Dividend Fund (DON), and the Emerging Markets SmallCap Dividend Fund (DGS), but also a Europe SmallCap Dividend Fund (DFE), a Japan SmallCap Dividend Fund (DFJ), and even an International Dividend ex-Financials Fund (DOO).

And if you want even more fine-tuning of where your dividends come from, try Invesco. They have the plain-vanilla-ish Invesco Dividend Achievers ETF (PFM), the Invesco International Dividend Achievers ETF (PID), the Invesco Dow Jones Industrial Average ETF (DJD), and the Invesco S&P 500 High Dividend Low Volatility ETF (SPHD).

There are also high-dividend ETFs of various shapes and sizes offered by ProShares, VanEck, and FlexShares. These tend to be narrower and more exotic.

In a way, seeking dividends makes sense. After all, what’s wrong with getting a monthly check? In another, larger way, though, the logic is a bit loopy, just as the marketing of high-dividend ETFs (sort of like toilet paper and breakfast cereal marketing) can be a bit intense and sometimes silly, and too often, slightly deceptive. Let me explain.

Promise of Riches or Smoke and Mirrors?

Dividends! Dividends! On the face of it, they look like free money. But nothing in life is quite so simple. Here are the typical arguments for buying a high-dividend fund, along with my retort to each.

• Argument for dividends #1: Steady money is just like honey. Huh? Are you crazy, Russell? Who in his right mind wouldn’t want dividends? A stock that pays dividends is obviously more valuable than a stock that doesn’t pay dividends. If I buy a high-dividend ETF, my account balance will grow every month.

  Retort: Suppose you own an individual share of stock in the McDummy Corporation (ticker MCDM), and MCDM issues a dividend of $10. The market price of your one share of MCDM, as a rule, will fall by $10 as soon as the McDummy Corporation issues the dividend. That’s because the dividend comes from the company’s cash reserves, and as those cash reserves diminish, the value of the McDummy Corporation diminishes (just as it would if it gave away, say, 101 plastic pink flamingoes from the front lawn of its corporate headquarters, or any other asset for that matter). As the value of the company diminishes, so too does the value of its shares. And the very same holds true for every stock held in an ETF. Thus, when a dividend-paying ETF issues a dividend, the price of the shares drops, and you are left no richer, no poorer.

• Argument for dividends #2: They lower my tax hit. But…but…suppose I need a steady stream of income. Isn’t it better that I rely on dividends, which are generally taxed at 15 percent, instead of interest from bonds or CDs, which is taxed at my higher income tax rate?

  First retort: First, if you need a steady stream of income, nothing is stopping you from creating artificial dividends by selling off any security you like. You may pay capital gains tax, but that will be no higher than the tax on dividends. In the end, whether you pull $1,000 from your account in the form of recently issued dividends or $1,000 from the sale of a security, you are withdrawing the same amount. And what if one month you find you don’t need the income? You can sell nothing and pay no tax, whereas with a high-dividend ETF, you’ll pay the tax regardless.

  Second retort: If you’re really concerned about taxes, maybe you should be investing in tax-free municipal bonds.

  Third retort: You should be comparing dividend-paying stocks to bonds anyway. Dividend-paying stocks are way, way riskier than almost any kind of bond.

• Argument for dividends #3: Taxes, what taxes? Russell, what gives? If I invest in an ETF, I won’t have to worry about taxes because, as you’ve told us all along, ETFs are incredibly tax efficient.

  Retort: ETFs are above most mutual funds when it comes to tax efficiency, but that tax efficiency is aimed at reducing taxable capital gains, not dividends. An ETF can’t do a whole lot to lessen the tax hit from dividends. ETF or mutual fund, you’ll pay.

• Argument for dividends #4: It’s a new world! Russell, you sound like a stick in the mud. This is an exciting new development in the world of investments.

  Retort: New development? Really? Equity income funds have been around for years and years, and they haven’t exactly set the world on fire. And consider the age-old Dogs of the Dow strategy. Many people have believed that if every year you purchase the ten highest-paying dividend stocks in the Dow (the so-called Dogs), you can rack up serious returns. The strategy has been well studied, and it clearly isn’t as powerful as the hype. The Dogs do seem to have some bark, but no more so than any other similarly sized and similarly volatile stocks. In other words, put a value lean on your portfolio, as I suggest in numerous places throughout this book (see especially Chapters 6 and 8), and you’ll be getting plenty of dividends and much of the edge that high-dividend investors seek.

• Argument for dividends #5: Don’t you read history? Over the course of history, Russell, much of the stock market’s returns have come from dividends. You should know that.

  First retort: Yeah, so? During the longest bull market in history — the 1990s — stock market returns were running double digits a year, and very little was being shelled out in dividends. A company that isn’t paying dividends is either investing its cash in operations or buying back its own stock. Either way, shareholders stand to gain. Just because much of the stock market’s past returns have come from dividends doesn’t mean that future returns must or will come from the same source.

  Second retort: If you look at high-dividend-paying sectors of the economy, you don’t necessarily find that those sectors beat the broader market over long periods of time. The utilities sector is a perfect example. If the power of dividends were as great as the dividend hawks say they are, wouldn’t the historical returns of the utilities industry and financial stocks and especially REITs clobber the S&P 500? That isn’t the case.

• Argument for dividends #6: Back to history… Over the course of history, the total return on high-dividend stocks has been greater than the total return on nondividend-paying stocks.

  Retort: Maybe. Depends on the time period. But over the long haul, a high-dividend strategy would in no way have beaten a solid value strategy (focused on stocks that are inexpensive in relation to the company’s earnings). And in more recent years, high-dividend-paying stocks haven’t come close to the total returns of even the broad market. Remember at the beginning of this chapter, I talked about the iShares Select Dividend ETF (DVY) being the first of its kind? If you look at the total performance of DVY over the past 10 years, you find a very impressive return of 12 percent annually. But that isn’t nearly as impressive as returns of the iShares Core S&P 500 ETF (IVV), with its 10-year annual return of 14.8 percent.

• Argument for dividends #7: Dividends offer protection. Stocks that pay high dividends are going to be less risky than stocks that don’t. Those dividends create a floor, even if only psychologically. High-dividend-paying stocks cannot become worthless.

  Retort: You would think that high-dividend-paying stock ETFs would be less likely to fall precipitously should there be a major downturn in the stock market. On the face of it, the argument seems logical. In the real world, however, some studies of high-dividend-paying stocks indicate that they actually may be somewhat more volatile than the broad market. Go figure. Besides, if your main goal is to temper risk, you have other, more effective, ways of doing that. (See Part 3 on bonds.)

• Argument for dividends #8: But still, it can’t hurt. All right, I concede, maybe these funds aren’t the greatest thing since sliced bread. Still, can it hurt to buy one?

  Retort: Look, I don’t despise these funds. Far from it. If you want to buy one, buy one. Put it into your retirement account, if there’s room in there, and you won’t even have to worry about any tax on the dividends. But don’t assume that you’re going to beat the broad market over the long haul. And know that you are buying a fund that is mostly large value stocks, typically within just a handful of industries (notably pharmaceuticals, utilities, and consumer staples). Your risk may be greater than you think. And if dividend-paying stocks are incredibly hot at the moment, be aware that their prices may be inflated.

• Final argument for dividends #9: Waaaaaah! I want my dividends! I don’t care what you say. I’m going to buy a high-dividend ETF.

  Final retort: Fine. Consider the Vanguard options (VIG or VYM) or Schwab’s US Dividend Equity ETF (SCHD). All three charge a very reasonable 0.06 percent — far less than the competition. (The difference between VIG and VYM is that VIG focuses on companies that historically have increased their dividends; VYM couldn’t care less about history and is more concerned with current yields.)

  On the international front, I’d also recommend the Schwab (SCHY) or Vanguard (VYMI) options, which charge 0.14 percent and 0.28 percent, respectively.

  By the way, for income, consider real estate investment trusts (REITs); dozens of ETF REIT options exist, and they tend to yield double the dividends paid by so-called “high-dividend” stock ETFs. (For information on REITs, see Chapter 11.)

Last but not least, if you’re not going to be using that dividend money right away, make sure your ETF is held in an account at a brokerage house that will reinvest your dividends automatically without charging you a commission. The vast majority will do so, but not all.