A very popular topic with investors, especially when it comes to discussing stocks, is dividends.
A dividend is a sum of money that is paid out to the shareholders of a particular company. These dividends can be paid on a regular basis, such as annually, quarterly or even monthly. Investors, especially retirees, view dividends as a necessity since they are primarily focused on investments that pay income. However, dividends are also sometimes viewed as a sign of strength in a company, as dividends are usually derived from profits. If a company has strong or even growing profits, it will be more likely to continue to pay or even increase its dividend. However, just because a stock does not pay a dividend does not mean that the company is not profitable or not a good investment.
Investors can gain access to dividends several ways, with the two most popular being through the purchase of individual stocks that pay dividends or through a dividend mutual fund. Dividend mutual funds are funds that are focused on both capital appreciation and income as their long-term goal. The funds invest in a variety of stocks, of which most pay a dividend.
Individuals looking for the best investment option should look at the benefits and risks of each and determine how either fits into their investment goals.
Key Points of Differences
In order to invest in dividends, one needs to understand the key differences between an individual dividend-paying stock and a dividend-paying mutual fund. Let’s look into these 5 important differences.
1. Investment Decisions
The largest difference between investing in dividend stocks versus dividend funds is the decisions the individual makes during the process.
Using a dividend fund allows the investor access to a team of professional money managers who analyze stocks on a daily basis. The manager also watches over the performance and allocation and makes changes as they see fit to the fund.
On the contrary, choosing individual stocks takes a lot more research on behalf of the investor, to ensure that the stock is a good fit for their own portfolio. Plus buying individual stocks also requires the investor to monitor the performance and allocation on their own, while also continually researching each stock on a regular basis. So, for simplicity purposes, dividend funds are more practical.
2. Risk vs. Reward
Another major difference between dividend funds and individual dividend stocks is the risk-to-reward ratio. Mutual funds consist of a group of stocks that allow the investor to be diversified. If one stock misses earnings and rapidly declines, a portfolio with many other holdings will be less affected than a more concentrated portfolio. For example, if one stock massively drops by 50% in a portfolio that only holds ten stocks, it would make the overall portfolio drop by 5% in total. Now suppose another mutual fund has 100 holdings. If a single stock dropped by 50%, the overall portfolio would only be down by 0.5%. This way, a mutual fund might have overall lower risk than buying individual stocks due to the level of diversification.
However, the same philosophy that lowers the risk for mutual funds also hurts them in terms of performance. If a single stock increased by 50% in a ten-stock portfolio, the overall return would be 5%. In the case of the dividend fund with 100 holdings, a stock that increased by 50% would only equal a 0.5% gain. Having more stocks in the portfolio may lower the risk level on the downside but it limits the upside potential.
For more investment concepts, visit our Dividend Investing Ideas Center.
3. Investment Yield
Along the same lines with risk versus reward are the yield factors that go into investing in dividend funds versus dividend stocks.
Consider the Vanguard High Dividend Yield Index Fund Investor Shares (VHDYX), a fund that is dedicated to investing in U.S. companies that pay larger-than-average dividends. The fund has 384 individual stocks and currently has a yield of 3.02%. This represents the weighted average yield of the individual constituents of the fund.
When purchasing individual dividend-paying stocks, an investor can create a portfolio of higher-yielding stocks. For instance, by using Dividend.com’s Screening tool one can see that there are 73 mid-cap and large-cap U.S.-based companies that pay dividends higher than 4%. In this scenario, an investor could create a portfolio that could yield higher than the 3.02% of the Vanguard fund.
For another list of high dividend stocks, click here.
When it comes to investing outside of a tax-deferred account, taxation is a very important issue and has a great effect on performance. Dividends that are considered “qualified” by the IRS have the same taxation as long-term capital gains, which is 15% for most investors. Also, regular capital gains rules apply in both cases between stocks and funds. However, dividend funds have an extra layer of taxation that individual stocks do not. Mutual funds are required to distribute their capital gains to shareholders once a year, whether the fund is up or not. The American Funds Investment Company of America (AIVSX) is a fund that has 80% of its current holdings predominately in dividend-paying stocks. Last December, the fund paid out $2.26 per share in long-term capital gains to every shareholder. The fund’s NAV at the time was at $40.35, so the capital gains distribution was 5.6% of the fund’s total net asset.
Individual stocks give investors more freedom, especially when it comes to taxation. Since the investors manage their own portfolios and capital gains recorded during the year can be offset by any losses. This flexibility is simply something that mutual fund managers cannot provide for their customers.
For more resources on dividend tax, click here.
Finally, one of the largest differences between dividend funds and dividend stocks is the fees. Mutual funds have different fees, depending on the share class. However, on an ongoing basis, mutual funds have an expense ratio, which covers the day-to-day trading costs for the money manager. These expense ratios can vary from fund to fund, like the VHDYX fund having a low expense ratio of 0.15% or the AIVSX fund having a more industry average expense ratio of 0.57%. If an investor is looking to compare dividend funds, looking at the expense ratio is a must.
Stocks, on the other hand, do not have any internal fees like mutual funds do. However, the issue with owning a stock portfolio is more about the cost of trading. Buying and selling a stock might incur a commission, so the more frequently trades occur, the higher the commissions are. Active investors could also buy and sell stock through a brokerage advisory account but typically these accounts run at 1% per year in advisory fees.
The Bottom Line
When comparing dividend funds and dividend stocks, investors need to do their research to determine which method is better for them. Factors like their level of investment decision, risk versus reward, yield, taxes and fees are all important when making this determination. Each strategy has its own advantages and disadvantages, so making the decision should not be taken lightly.