Many dividend investors choose to invest in dividend exchange-traded funds ("ETFs"), closed-end funds ("CEFs"), and mutual funds instead of selecting individual dividend stocks. There are several compelling reasons for this, and we agree that for some investors, this path makes the most sense. However, we also believe that for investors who are willing to roll up their sleeves and do their due diligence on individual stocks, the rewards can definitely be worthwhile.
In this article, we will discuss the pros and cons of both approaches and share why we believe that investing in individual high-yield dividend stocks is a great way to compound wealth over time. We will also share some of the best stocks for implementing our approach.
Why Dividend ETFs and CEFs Make Sense For Some Investors
One of the reasons for investing in dividend ETFs and CEFs is instant diversification across many stocks, which helps mitigate the risk associated with any single company and leads to less volatility in portfolio positions.
Another advantage is the ease and passive nature of this approach, as opposed to the extensive research required for individual stocks, such as analyzing company balance sheets, reviewing earnings calls, scrutinizing investor presentations, and performing valuation or industry analysis. In contrast, investing in broadly diversified dividend ETFs can be as simple as a few mouse clicks, allowing the active or passive management strategy to run its course over time while investors simply relax and let the dividends fund their lifestyle.
Furthermore, many dividend ETFs, such as the Schwab U.S. Dividend Equity ETF (SCHD) and the Vanguard Dividend Appreciation Index Fund ETF (VIG), charge very low expense ratios, making them efficient vehicles for achieving a diversified and passive investment strategy.
Other ETFs, like the iShares International Select Dividend ETF (IDV), offer exposure to international markets without the tax complexities associated with investing directly in stocks overseas. Additionally, popular CEFs such as the Cohen & Steers Quality Income Realty Fund (RQI), the Cohen & Steers Infrastructure Fund (UTF), and the Reaves Utility Income Trust (UTG), as well as some ETFs like the Virtus InfraCap U.S. Preferred Stock ETF (PFFA), provide access to relatively low-cost margin on investments, which can enhance yields and potentially increase total returns during bull markets.
Some ETFs like the Neos S&P 500(R) High Income ETF (SPYI) and the JPMorgan Equity Premium Income ETF (JEPI) also employ covered call strategies, paying out monthly dividends, which leads to enhanced yields and more frequent distributions.
Why We Prefer Picking Individual Dividend Stocks Over ETFs and CEFs
While these benefits certainly make ETFs and CEFs the right choice for some investors, others, including myself, have chosen this approach in the past out of ignorance, without fully understanding the advantages of investing in individual stocks.
One of the key benefits of selecting individual stocks includes the potential for higher yields. Since ETFs and CEFs typically must invest in a certain minimum number of holdings, and there are only so many quality high-yield stocks available, these funds' average dividend yields often end up being much lower than what can be achieved by selectively investing in individual stocks, particularly a select few within sectors like midstream (AMLP), business development companies aka BDCs (BIZD), real estate investment trusts aka REITs (VNQ), and utilities (XLU), which offer very high, sustainable, and even growing yields.
Another major advantage of individual stock selection is the ability to exert greater control over portfolio holdings and avoid the problem of over-diversification. Many ETFs and CEFs are required to maintain a minimum number of holdings at all times, which can lead to the inclusion of a sizable number of low-quality or significantly overvalued stocks, potentially leading to suboptimal performance compared to a more intelligently selected, concentrated portfolio.
Choosing individual stocks can also be a powerful way to generate income and compound total returns over time through intelligent capital recycling. This is particularly effective in the high-yield space because these stocks are generally easier to value than low-yield or no-yield stocks due to their focus on current income over long-term growth. This makes it easier to predict their long-term growth rates, facilitating a more straightforward application of discounted cash flow valuation analysis.
As a result, with high-yield stocks it is generally simpler to determine when stocks are overvalued or undervalued than with low-yield and no-yield stocks, enabling the implementation of an effective opportunistic capital recycling strategy of selling high and buying low. Moreover, we can overlay a covered call and put selling strategy to further optimize our risk-adjusted returns and income generation potential, an approach that very few funds employ to the extent that we can individually. Even when they do attempt to, they generally charge elevated management fees and also tend to employ broad diversification, which can dilute their risk-adjusted total returns over time.
Investor Takeaway
While ETFs and CEFs certainly have their advantages and are probably the best option for investors who prefer to be as passive as possible, being an active investor also has many benefits. With stocks like Energy Transfer (ET), Realty Income (O), Ares Capital (ARCC), and many others that offer very high and well-covered current dividend yields along with significant options liquidity, investors can generate very attractive current income yields, have a strong sense of when their stock is overvalued, undervalued, or fairly valued, and thereby employ an intelligent capital recycling program.
They also have the opportunity to sell calls and puts as part of their strategy for entering and exiting positions to maximize risk-adjusted total returns and achieve far higher income yields than they could by simply investing in CEFs or ETFs. By implementing this approach, we believe that we can generate outsized risk-adjusted returns over time relative to dividend ETFs and CEFs.
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