Topic: How To Invest
Dividend vs. Index Investing, or Both?
What are the key differences between dividend and index investing?
Dividend investing focuses on stocks that pay regular cash distributions to shareholders, while index investing aims to replicate the performance of a broad market index by holding a diversified portfolio of securities.
One big advantage of index funds when weighing dividend vs index investing is that they can help you avoid the risk of choosing a mutual fund with a management style that virtually guarantees below-average long-term performance. When considering dividend vs index investing, a common question is “do index funds pay dividends?” The answer is that some index funds do pay dividends, depending on the holdings of the fund.
Another advantage of index funds is that they can give investors with limited funds a low-cost way to get some stock-market exposure. They can also be a good starting point for a registered education savings plan (RESP), or a child’s in-trust account. Many investors also consider them when they invest funds in their tax-free savings accounts (TFSAs). So when asking “do index funds pay dividends,” it’s important to consider your overall investment goals and account types.
How to find the best Canadian index funds?
To find the best Canadian index funds, compare expense ratios, tracking error, and asset coverage of funds that mirror major Canadian indices like the S&P/TSX Composite Index.
The MERs (Management Expense Ratios) are generally lower on ETFs than on conventional mutual funds. That’s because most ETFs take a much simpler approach to investing. Instead of actively managing clients’ investments, ETF providers invest so as to mirror the holdings and performance of a particular stock-market index. This leads back to the question, “do index funds pay dividends?” If the underlying index includes dividend-paying stocks, then the index fund will likely pay dividends as well.
ETFs practice this “passive” fund management, in contrast to the “active” management that conventional mutual funds provide at much higher costs. Traditional ETFs stick with this passive management—they follow the lead of the sponsor of the index (for example, Standard & Poors). Sponsors of stock indexes do from time to time change the stocks that make up the index, but generally only when the market weighting of stocks changes. They don’t attempt to pick and choose which stocks they think have the best prospects.
This traditional, passive style also keeps turnover very low, and that in turn keeps trading costs for your ETF investment down.
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How to find the best Canadian dividend stocks?
To find the best Canadian dividend stock, research companies with consistent dividend growth, sustainable payout ratios, and strong financials in stable sectors of the Canadian economy, such as banks, utilities, and telecommunications.
Should I buy dividend stocks? It’s a question many new investors ask. Our answer is always “yes.” We look for Canadian dividend stocks that have industry prominence, if not dominance. Our reasoning, besides brand recognition, is that major companies can influence legislation and industry trends to suit themselves. Minor firms can’t do that.
Are dividend stocks less risky than index funds?
Dividend stocks are not necessarily less risky than index funds. Index funds typically offer broader diversification, which can reduce overall portfolio risk, while individual dividend stocks may carry company-specific risks.
For Canadians asking “should I buy dividend stocks?”, it’s important to remember that Canadian dividend stocks are an important contributor to your long-term gains, and dividend-paying stocks tend to expose you to less risk than non-dividend-payers. That’s why the majority of your stocks should be dividend-payers at all times. As you get older and closer to retirement, you should raise the proportion of dividend-paying stocks in your portfolio, to cut risk and improve the stability of your investment results. When considering dividend vs index investing, the question “do index funds pay dividends” becomes particularly relevant for those nearing retirement.
Should I buy dividend stocks?
Yes, dividend-paying investments can be among your best holdings. We’ve always placed a high value on a record of dividends, mainly because it provides something of a pedigree for stocks we recommend. That’s another reason why we always answer “yes” to the question, “should I buy dividend stocks?” After all, you can’t fake a record of dividends. It takes a lot of success and high-quality management for a company to have the cash and the determination to declare and pay a dividend every year for five or 10 years. It’s not something you can create at the spur of the moment.
If you stick with top-quality, high dividend-paying stocks, the income you earn can supply a significant percentage of your total return—as much as a third of your gains. And at the same time, dividends are more dependable than capital gains as a source of investment income.
We think Canadian dividend stocks are some of the best investments you can own. That’s another way of answering the question, should I buy dividend stocks?
How do dividend ETFs compare to individual dividend stocks?
Dividend ETFs offer greater diversification and easier management than individual dividend stocks, but typically come with ongoing fees and less control over specific holdings.
Overall, we recommend looking for dividend-paying ETFs that hold companies with records of long-term success and a long history of payouts. These companies are the most likely to keep paying and increasing their dividends.
How can I choose the best dividend-paying ETFs?
To choose the best dividend-paying ETFs, consider factors such as yield, expense ratio, diversification, track record, sector allocation, and dividend growth history.
Here are three key tips to finding the best of those income providing stocks.
- Know the economic stability of countries when investing in international dividend ETFs. It’s also worth mentioning that foreign leaders may not be your ally when it comes to passing legislation that can affect your investments.
- Know how broad the dividend ETF is, so you can determine its volatility. The broader the ETF, the less volatility it may have. A sector-based ETF, like one that tracks resource stocks, may be more volatile.
- Know the current financial health of each company in the ETF. If a company is doing well, has done so consistently, and shows signs of growth, these factors are indicative of stocks that will keep paying a dividend.
What are DRIPs?
Dividend reinvestment plans, or DRIPs, are plans some companies offer to allow shareholders to receive additional shares in lieu of cash dividends. DRIPs bypass brokers, so shareholders save on commissions.
DRIPs also eliminate the nuisance effect of receiving small cash dividend payments. Second, some DRIPs let you reinvest your dividends in additional shares at a 5% discount to current prices. Third, many DRIPs also allow optional commission-free share purchases on a monthly or quarterly basis.
Generally, investors must first own and register at least one share before they can participate in a DRIP. Registration will generally cost $40-$50 per company. The investor must then notify the company that they wish to participate in the company’s DRIP.
In summary, when comparing dividend vs index investing, a common question is “do index funds pay dividends?” The answer is that some index funds do pay dividends, depending on the holdings of the underlying index. Index funds offer advantages such as lower management expense ratios and broad market exposure. However, dividend-paying stocks can provide reliable income and lower risk, making them attractive for investors nearing retirement.
Dividend-focused index funds can offer the benefits of both approaches. When selecting dividend ETFs, investors should consider factors such as the economic stability of the countries represented, the breadth of the fund’s holdings, and the financial health of the underlying companies. Dividend reinvestment plans (DRIPs) can provide an additional benefit for dividend stock investors by allowing them to reinvest their dividends in additional shares, often at a discount and without brokerage commissions. Ultimately, the choice between dividend vs index investing depends on an investor’s individual goals and circumstances, but understanding the role of dividends in index funds is crucial for making informed decisions.
What are the different dividend ETF strategies (e.g., high dividend, dividend growth, covered call)?
There are several dividend ETF strategies, each with its own approach to generating income for investors. Here are the main types:
- High Dividend Yield ETFs: These focus on stocks with above-average dividend yields. They aim to provide higher current income but may have less potential for dividend growth.
- Dividend Growth ETFs: These target companies with a history of consistently increasing their dividends. They may offer lower initial yields but potentially higher total returns over time.
- Covered Call ETFs: We don’t recommend these as they use options strategies to generate additional income on top of dividends. They sell call options on their holdings to collect premiums, potentially boosting yields but limiting upside potential.
- Quality Dividend ETFs: These focus on companies with strong financials and sustainable dividend policies, aiming for a balance between yield and growth.
- International Dividend ETFs: These invest in dividend-paying stocks from outside the investor’s home country, offering geographic diversification.
- Sector-Specific Dividend ETFs: These concentrate on dividend-paying stocks within specific sectors, like utilities or real estate.
- Total Return Dividend ETFs: These aim to balance dividend income with capital appreciation for overall returns.
An extremely high dividend yield can be a sign of danger. Have you chased a high dividend before, and if so, what led you to take the risk?
If you had to choose between investing in an index fund or dividend stocks, what would factor into your decision?
This post was originally published in February 2010 and is regularly updated.
