Dear Readers,
Due to the current bear market environment that we are in, a lot of previously popular growth stocks have been decimated. This has lured a lot of investors towards the “safety” of dividend stocks. Rather than jeering, I am actually very happy for these investors. This is a great entry point, with dividend yields at all-time highs and also attractive valuations for several popular dividend growth stocks.
Another popular entry option is that of owning a dividend growth Exchange Traded Fund (ETF) and there are several options available here as well. For those of you who are unfamiliar with what an ETF is, Investopedia defines an ETF as follows:

So essentially by owning a single ETF security, you are effectively owning a basket of stocks. And what type of stocks? Well that depends on the type of ETF. For example, a dividend growth ETF like SCHD would comprise of dividend growth companies through which the fund promises to yield some dividend income for its investor. And since the fund manager does the leg work of choosing the dividend growth stocks for the investor, the investor is charged some fees typically called the expense ratio.
At first glance, it is easy to see the attractiveness of the ETF option for dividend growth investing. After all, if the investor is hard-pressed for time and simply does not have the mental bandwidth or the interest to track individual companies, the investor can simply choose to own an ETF instead. As the saying goes, such investors simply choose to “ETF and chill”.
I ran into a question from a fellow investor on Twitter on this subject:

Great question. And as someone who owns a dividend growth ETF like SCHD in addition to several individual stocks, I wanted to pen down my thoughts on some potential drawbacks with a pure dividend growth ETF-based investing strategy. I will use the beloved and everyone’s favorite SCHD as an example.
That Dreaded Expense ratio
There is no free beer in this party. With SCHD, per the fund’s fact sheet, the expense ratio is 0.06% i.e. 0.06% of total investment in the fund are deducted annually. This might not seem like a lot initially, but when compounded over a long period of time, the same can account for a significant portion of the total investment returns. Ironically, while we as dividend growth investors rely on compounding to generate a stable cash flow, in this case, the expense ratio can cause compounding to work against us.
Choice in the basket of stocks
So the investor relies on the fund manager to choose high-quality dividend growth stocks. But do their definitions of “high-quality” align completely? What if the fund manager chooses some stocks that the investor believes to have dodgy fundamentals. This is yet another drawback with ETF i.e. the investor has little say in the basket of stocks that are contained with the ETF.
With SCHD, its top 3 holdings are Merck (ticker: MRK), Pepsi Co. (ticker: PEP) and IBM (ticker: IBM). While I do not have any particular issues with MRK and PEP (I hold PEP separately in my portfolio), I am not particularly comfortable with IBM. Having tracked the company for a few years now, I am not sure about the management and the business’s long-term growth prospects.

Weightings
Let us assume that the investor chooses an ETF that has exactly the funds that he/she is interested in. Then there is the question of weight distribution among the various stocks and sector weightings within the fund. With SCHD, at the time of writing this, it owns 20.8 in Information Technology sector, 19.6% in Finance and 14.7 in Consumer Staples. Personally, I am not as comfortable with the allocations to Finance and Consumer Staples. In fact, I would have been more comfortable if the allocations were swapped.
Predictability
The next issue is with regards to predictability of stocks contained in the fund. The fund manager can choose to trade in and out of different positions, while maintaining the overall objective of the fund performance i.e. in the case of SCHD, match the total returns of the Dow Jones US Dividend 100 Index. It becomes quite a challenge to track when and where these turnovers are happening. The whole aspect of tracking these changes defeats the objective of maintaining a “hands-off” investing strategy for the investor.
As an aside, since income obtained through a dividend growth ETF is due to the holdings contained in the ETF itself, it becomes a little harder to track the potential dividend growth rate of the ETF especially considering that the fund manager can trade in and out of positions. This makes retirement planning that much harder.
So why own an ETF then?
For me, there are two primary reasons:
- Diversification: As a part of a diversified portfolio, an ETF can provide necessary diversification to the investor. In my case, I hold ETFs in separate accounts that are tied to retirement (HSA, IRA etc.)
- With individual stocks held across different accounts, it becomes quite tedious (for me atleast) to keep track of my cost basis, last transaction date, weighting etc. for individual positions. The effort required to track these is non-trivial. Compare that with holding an ETF in these other accounts, I can save a lot of energy and time by going that route.
Let me know in the comments below if you agree/disagree with the above thoughts. Are there any popular dividend growth ETFs that you own in your portfolio?
Until the next post. Cheers!
LWD