Sunday, April 5, 2015

Dividend Growth Investing vs Indexing

Two weeks ago, Mark at myownadvisor.ca had a thought provoking piece on the merits of indexing vs dividend growth investing ("DGI"). A couple days ago, a friend of mine posted a link to this Wall Street Journal story questioning whether Benjamin Graham would have hated index funds (spoiler alert: No, Mr. Graham was an early proponent). Both links seemed timely, as I had just finished re-reading Andrew Hallam's Millionaire Teacher book, which is a great introduction to index investing.

Over the last year, as I dedicate more time to researching investments, executing portfolio strategies, and ultimately managing my money, I've asked myself several times if indexing wouldn't make more sense for me. The big selling points of indexing are it's easy (maybe a couple hours a month) and in theory, you should get the market returns of the indexes you buy (less transaction costs). Having an eight month old at home, I can assure you that the idea of more sleep at night and less hassle during the day is extremely tempting. However, despite my growing interest in the concept of indexing, I stick to DGI for a couple key reasons.

1. Show Me The Money
A quick peak at Google Finance shows me that the TSX 60 IShares index fund (TSX: XIU) yields a respectable 2.6%. In contrast, my unregistered trading account, which consists of shares in eleven large Canadian public companies with a history of dividend growth yields 4.4%. If history is any indicator of the future, I'm also willing to guarantee that the growth of distributions I realize in any year is at least double that of the index distribution growth. Simply put, my portfolio throws off more more now, and its distributions will grow at a higher rate for years to come.

2. My Return is Higher, More Certain, and Less Variable
At the risk of sounding boastful, I believe the return I'll realize over time will be higher, more certain, and will show less volatility than any index out there. Although studies tend to come up with slightly different numerical results, most academic studies indicate that dividends account for the bulk of total stock market return over long periods of time. If I'm investing in an index, my underlying belief is likely that the basket of companies in the index will become more profitable over time, thus increasing their attractiveness, and demanding higher price multiples in the market. In a sense, I'm betting on a capital gain in the underlying securities. Instead, a DGI investor assumes the companies they invest in will increase profits over time, and pay them out as even higher dividends. Dividends are sticky, and management that has a history of raising distributions over time, is only likely to cut them in extreme emergencies. Dividend stocks, where payouts account for a higher percentage of total return, will be less volatile in trying economic times, and their companies should be around for the long haul.

3. Index Problems
At its peak, Nortel accounted for about 30% of the TSX 60 index. Before March 2015, Apple, the largest company in the world by market capitalization, accounted for 0% of the famous Dow index. Simply put, I think buyers should beware that not all indexes are created equal, and that research has to be taken in order to ensure you're receiving what you expected. Academics continue to debate the merits of value weighted vs price weighted vs equal weighted indexes. With the explosion of index investors, it seems there are all kinds of country/commodity/sector/region/you-name it indexes, none of whose contents are entirely well known. Another index problem is that the funds who create them choose not to act in the best interest of shareholders, and instead vote with current management recommendations via their proxies.  If index owners truly want to own a piece of multiple businesses, shouldn't they encourage index managers to vote like owners, and not lap dogs?

Contrary to what might be implied from the above, I'm not anti-indexing. I think indexing, when done correctly, can be an incredible low effort activity that generates good results. I continue to practice DGI since I simply love the flexibility that fresh cash in my investment accounts brings to me each day. I also see DGI as better path toward my ultimate goal (retirement by way of passive income from dividends/distributions) than indexing, in which I'd likely have to convert my portfolio to a annuity in order to ensure that my income needs are met until I die.

Sadly, I've lost the source of one of my favourite DGI quotes, that went something along the lines of:
"There are very few former income investors."

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