With Index/ETF funds you are still paying fees
The fees for Index Funds and ETFs are much lower than fees for actively managed mutual funds, but there are still fees to be paid by you. If you are investing small amounts of money the fees may seem insignificant, but when you start investing $100K, $300K, $500K or over $1M, the fees will start to negatively impact you.
Here is a list of some sample funds and their fees:
- Vanguard High Dividend ETF (VYM): 0.06%
- Vanguard S&P 500 ETF (VOO): 0.03%
- Vanguard International High Dividend (VYMI): 0.32%
The following values are used to determine the fees for each of the funds:
Total invested: $200,000
Investment held for: 20 years
Front end sales fee: 0%
Past return: 13.8% (Vanguard S&P 500)
Fees paid after 20 years:
- VYM: $11,488.33
- VOO: $5,743.25
- VYMI: $61,356.19
- Individual stocks: $175
$500,000 invested for 25 years in VYM would cost you $57,068.32 in fees.
With mutual funds, the fees are even higher. Here’s the cost of investing $300,000 in a mutual fund where the fee is 2.2%:
- $120,474 would be lost to fees after 10 years
- $471,810 would be lost to fees after 20 years
- $1,390,658 would be lost to fees after 30 years
With Index/ETF funds you are inadvertently buying overvalued stocks
Let’s take a look at the number of companies (stocks) held in each of these funds:
- VYM: 406 companies
- VOO: 511 companies
- VYMI: 995 companies
On any given day not all of the companies in these funds are going to be undervalued (priced low).
When you buy an index fund your money goes to buying both undervalued and overvalued stocks. Therefore you are inadvertently buying stocks that are priced high, those stocks have limited potential to go up even higher since they are already priced high, in the long-term this will negatively affect your portfolio’s performance.
With Index/ETF funds you are inadvertently buying non-quality stocks
A quality company is one that passes all of the 10 SI Criteria.
Would you buy a company that had 500% debt, or P/E of 275, or wasn’t profitable? If you wouldn’t buy even one poor performing company then why would you buy it as part of a larger Index Fund or ETF? With these types of funds your are inadvertently buying non-quality companies.
With Index/ETF funds your dividend yield is lower
Let’s take a look at the current dividend yields of each of these funds:
- VYM: 3.16%
- VOO: 1.97%
- VYMI: 4.24%
Now let’s take a look at the current dividend yields of a few quality companies:
- Enbridge: 6.15%
- Simon Property Group: 5.56%
- The Gap: 5.52%
- AT&T: 5.33%
- Power Corporation: 5.33%
- BCE: 5.05%
- Ryder System 4.67%
- TC Energy: 4.52%
The yield for the funds is lower for two reasons:
- they are invested in companies that pay very little dividends (some companies only yield 0.5%)
- in the case of VOO they are invested in some companies that don’t pay any dividends
Would you rather earn 1.97% on your investment or earn 5%?
$200,000 invested over 10 years (assuming no stock price appreciation to keep the math simple), with dividends re-invested with a 1.97% yield, you would earn: $43,082.78 in dividends
$200,000 invested over 10 years (assuming no stock price appreciation to keep the math simple), with dividends re-invested with a 5.00% yield, you would earn: $125,778.93 in dividends
In the long-term the dividend yield you earn matters.
With Index/ETF funds you’ll eventually have to start selling your shares
With Index/ETF funds you’ll eventually have to start selling your shares, especially with funds like VOO, or similar ones that hold stocks in companies that don’t pay dividends or pay very little dividends. Your living expenses, vacations, homes, cars, boats, clothing, food, giving to charities, education, healthcare all cost money, you cannot pay for these things with stocks. You have to cover your expenditures with cash, you can only do this by using dividends or selling some of your shares. This becomes a bigger issue the longer you live, if you just need 5, 10, or 15 years to live off your investments you might be fine selling your shares in index funds or ETFs.
However if you need to live off your investments for 20, 30, 40 years, or would like to leave your kids/family with a solid investment portfolio, then selling shares in your index funds could eventually lead to you having to sell off all your shares, resulting in no investment portfolio at all. The situation become worse if we are hit with a recession (or downturn) that lasts 5-7 years. During a downturn you still need to live and pay for things, so you start to sell some of your shares in your index funds, the problem is in a market downturn shares prices are already low (this is the worst time to sell), you end up selling more shares (just to cover your costs), which further shrinks your portfolio.
With individual investing, we do not sell our shares, we design our portfolio to maximize on growing passive income. What happens to the dividend when stock prices drop? What happens to the dividend when there is a recession? The dividend continues to go up (see an example of increasing dividends).
Unpredictable dividend income from Index/ETFs
The Vanguard High Dividend Yield ETF (VYM) is invested in more than 400 companies – certainly not all of their dividend payments will be safe throughout a full economic cycle.
The VYM fund’s dividend payments were negatively affected during the last recession. Total dividend payments reached $1.44 per share in 2008 before falling to $1.17 in 2009 and $1.09 in 2010, representing a high-to-low decline of about 25%. Annual dividend payments didn’t recover back to their 2008 peak until 2012.
Put another way, if a retired investor owned 25,000 shares of VYM, she would have received $36,000 of dividend income in 2008.
By 2010, her annual dividend income had fallen to about $27,000 – a drop of more than $725 per month. Depending on her budgeting, margin of safety, living expenses, her life could suddenly have become much more difficult.
VYM’s price also fell by more than 32% in 2008, likely invoking plenty of fear as the value of her nest egg fell from $1,000,000 to less than $700,000. To be fair, even with individual stocks your prices will drop during a recession. However the key here is not the stock price but the income being generated from your portfolio. With individual stocks you can pick and choose the best reliable dividend companies, to ensure that your dividend income is safe and continues to grow even during a recession. How can you ensure growing dividend income? By focusing on buying companies that have a history of consecutively increasing dividends (see an example of increasing dividends in the previous question above).
Over diversification is a problem
Over diversification can be a problem, because when you purchase hundreds (or thousands) of companies via an Index Fund or ETF, there is a higher likelihood that you will:
- buy companies that overvalued (priced high)
- buy companies that are not quality companies
- buy companies that don’t pay dividends or very little dividends
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business at the University of Waterloo wrote, “In recent years, a large number of mathematicians and finance PhDs working on Wall Street and their models were proven wrong because they put too much emphasis on bell curve probability distributions and diversification. Value investors have concentrated portfolios, not because they reject diversification, but rather they operate withing the boundaries of their competence; they select only securities [stocks] they understand.”
