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DIY Dividend Investing VS the ETF!

Reuben is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Along with my MBA (and experience as the Director of Research at Value Line), I also have an MSSW (Master of Science in the field of Social Work). That's an odd combination, but one that gives me a unique view of investing. One thing that my experience in social work taught me was the importance of being where the “client” is. In other words, if your patient wants to talk about his or her mother, he or she needs to talk about mom and you should be careful about moving them on to a different topic. To bring it back to finance, I think the asset management industry is largely ignoring where their “dividend focused clients” are.

Now I believe mutual funds and exchange traded funds (ETFs) are wonderful investment vehicles in some ways, but they tend to be a bad option for anyone looking to live off of dividend income. Why? Because you can't predict their dividend steams since asset managers are constantly buying and selling stocks in pursuit of their total return yardstick. While dividend investors care about total return, often the more important metric is the absolute level of dividends they are receiving.

Many dividend investors are looking to use the income they generate from their portfolios to replace their paycheck. This means you want a steady, and hopefully growing, stream of dividends. The stocks of long-term dividend paying companies that have a history of increasing their distributions are the perfect solution. But not if you actively trade the portfolio and, thus, create a volatile income stream, like the vast majority of dividend products in the fund space do.

Sure, individual investors may focus too much on the absolute level of their dividends, but if this is where their minds are, then the asset management community should step up and be where the client is. Total return is clearly the bigger picture, but you can't live off of total return and that's what dividend investors are looking to do.

The counter argument is that you can sell appreciated shares and live off of the capital gains. Perhaps this is a more enlightened view of investing, but perhaps it isn't. We just lived through a deep recession from which we have yet to fully recover. Having to sell shares in a rapidly falling market to pay for living expenses would not only have felt pretty awful, but it likely would have diminished the ability of your portfolio to pass along income over time. This is why I believe dividend focused investors should own individual stocks in a do-it-yourself approach.

To prove the point, I compared the SPDR S&P Dividend ETF against a five stock portfolio pulled from my watch list of mega-cap dividend increasers. Although the ETF started off with the dividend income advantage, the simple five stock portfolio easily won out in the end.

To start I looked at the income that $10,000 would generate invested solely in the SPDR S&P Dividend ETF between June 1, 2006 and November 1, 2012. I truncated the shares, so that only a whole number of shares would be purchased and used the highest price achieved on June 1 as the purchase price. That hypothetical investment would have resulted in 176 shares and a quarterly dividend of $70 in the third quarter of 2006.

As a comparison, I created a portfolio of five mega-cap companies with long histories of dividend increases using an initial investment of $2,000 in each stock for a total portfolio value of $10,000. The stocks I used suffer from survivor ship bias, but would have been as obvious as selections in 2006 as they are today: Johnson & Johnson (NYSE: JNJ), 32 shares; ExxonMobil (NYSE: XOM), 32 shares; Coca-Cola (NYSE: KO), 45 shares; McDonald's (NYSE: MCD), 59 shares; and Wal-Mart (NYSE: WMT), 41 shares.

The beauty of this portfolio is that it gives such diverse exposure with so few companies. For example, Johnson & Johnson has operations around the world and spans both the medical and consumer products spaces. There are few other companies that can boast both of those claims, particularly with JNJ's financial strength. ExxonMobil has a similar global reach and provides exposure to all levels of the oil and natural gas industry. The company pulls the commodities out of the ground, transports them, refines them, makes chemicals out of them, and sells them to businesses and individuals under well-known brands. Coca-Cola has a massive presence around the world and is particularly strong in emerging markets. Its products are cheap and consumed often; this is increasingly so in up and coming nations suggesting the potential for years of growth ahead. McDonald's has a similar profile, but sells food. Although it has gone through periods where management seemed to have lost its way, those missteps never tarnished its image. Wal-Mart, on the other hand, has a less than a sterling image, but sells products in its global store base so cheaply that its customers don't seem to mind that many consider the company socially undesirable. So, the collection provides geographic diversification, industry diversification, and some exposure to emerging markets. Not bad for five mega-cap stocks that many would consider stodgy and boring. Best of all, an investor wouldn't have any difficulty keeping tabs on these companies since they are so frequently in the news.

All were “purchased” at their highest price on June 1, 2006 and the share counts were truncated. The initial dividend achieved by the five stock portfolio was $50.85. (Note that McDonald's changed from an annual dividend to a quarterly dividend in 2008, so I broke the first two years into quarterly figures to make the comparison more meaningful.)

I only considered the dividend payments in my review, since this is the most important aspect for someone seeking to live off of their dividend income. The ending results were astounding. The ETF ended the period with a total dividend distribution of $83.51, only marginally above where it started. The stock portfolio, meanwhile, ended with a total disbursement of $106.85, over double where it started just six years or so before.

The total return bias and active management/re-balancing of mutual funds and ETFs pretty much doomed the ETF to provide less dividend growth. Thus dividends wind up being more of a selection criteria than a portfolio goal despite the use of dividend in the fund's name. An individual investor, meanwhile, can stay the course and simply hold a stock through good times and bad collecting the dividend. The start and end points, however, are only the beginning of the divergence.

Along the way, the stock investor's dividend income went up every year. The ETF investor, on the other hand, experienced a jagged pattern of dividend payments, with a high quarterly payment of $104.14 in early 2009 and a low payment of $64.72 in early 2007. The average payment was $82.11 with most payments falling in an effective band between $94 and $70. That's hard to plan around, particularly if you start to scale up the portfolio.

For example a half a million dollar portfolio would have an effective quarterly band of $4,700 and $3,500. That $1,200 range, $400 a month, could be the difference between making rent or buying medication. If you sold shares to make up the difference, as the experts suggest, you would wind up with fewer shares from which to receive dividends the next quarter, compounding the problem.

I'm not suggesting that you don't own any mutual funds, closed-end funds, or ETFs, only that you carefully consider the purpose and benefit of the funds you do choose to own. I strongly believe in outsourcing (using a fund) the things that I can't do well myself. For example, I own Matthews Asia Dividend Fund (MAPIX) for that very reason. I'm not an expert in investing in Asia, Matthews is. I am, however, more than capable of creating and monitoring a portfolio of domestic stocks. In fact, I even enjoy doing it.

I highly recommend that you treat dividend investing as a do-it-yourself effort, and only outsource those parts of your portfolio that you either don't have the time, desire, or experience to do yourself.

Yours,

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ReubenGBrewer has no positions in the stocks mentioned above. The Motley Fool owns shares of Johnson & Johnson, McDonald's, and ExxonMobil. Motley Fool newsletter services recommend Johnson & Johnson, The Coca-Cola Company, and McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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