Why Not Simply Invest in ETFs?

 

This question comes up often. Why not simply invest in ETFs? After all, they offer instant diversification and convenience. However, as a firm believer in the power of dividend growth investing, I stay away from ETFs, and I’ll explain why.

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I truly believe there are multiple ways for investors to be successful on the market. Investing in ETFs is a perfectly valid strategy that has serious advantages over any stock picking strategy. It’s much easier and requires less time. There are myriads of ETFs to choose from.

You can buy index ETFs that aim to replicate the performance of a specific index, such as the S&P 500, Nasdaq 100, or FTSE 100. There are non-index ETFs that focus on specific sectors (e.g., technology, healthcare), regions (e.g., emerging markets), or investment strategies (e.g., dividend, covered calls). Fund managers actively make investment decisions for non-index ETFs with the goal of outperforming a benchmark or achieving a specific investment goal.

However, ETFs come with drawbacks that don’t suit me. I believe that investing directly in dividend growing equities provides me with better total returns. Here’s why…

Lack of control on stock selection

Wooden boat helmBy buying an ETF, I relinquish the ability to handpick individual stocks. I can choose which index or sector I want to replicate, even choose an investing goal, be it growth or dividends, but not the individual stocks. I’m basically buying a basket of stocks picked for me based on metrics or a philosophy that may not be entirely mine. In other words; I’m not investing according to my strategy but according to someone else’s.

Buying undesirable companies

When I look at the composition of ETFs, most of them include stocks that I really don’t like and that I would never pick. ETFs often include high and low-quality stocks within a particular index or sector, diluting the overall quality of the portfolio.

For example, over 15% of the BMO equal weight banks Index ETF (ZEB.TO) is invested in Scotia Bank, my least favorite of the big Canadian banks. The top ten holdings of its US Dividend ETF (ZDY.TO) include IBM and Verizon, two companies that are less than thriving, and for which there are much better alternatives. I chose BMO ETFs as examples here, but I would find similar problems in BlackRock’s iShares ETFs and others.

Investing in dividend growers helps me to limit my stock basket so that it includes only companies that show favorable factors. Why would I bother investing in index ETFs that takes all the great businesses and all the weak ones at the same time?

Hidden cost of ETFs eroding returns

Eroded coastal rocks in Gaspésie, QC, CanadaWhile ETFs are often praised for their low expense ratios, even a seemingly modest fee can significantly erode the compounding effect of dividend reinvestment over the long term.

The popular notion that index ETFs are an easy avenue for beating the market is, in my view, somewhat misleading. Mirroring the market’s performance becomes much more difficult when you factor in these fees. In essence, by investing in an index ETF, I’m willingly sacrificing a portion of my returns. Therefore, it’s virtually impossible to beat a benchmark with index investing; investors are eternally behind it by a small margin.

Insufficient management and adjustments

Another drawback I find with many ETFs is a lack of active management. Some ETFs merely replicate the composition of an index without adjusting for changing market conditions or individual company performance.

As a dividend growth investor, my quarterly reviews of my portfolio reveal when earnings are slowing in their growth or falling, or when there isn’t any dividend growth. This active management allows me to make informed decisions about when to dig for more information, buy, hold, or sell a stock based on the company’s fundamental health and ability to sustain dividend growth. ETFs often hold on to positions despite worsening company fundamentals.

See some of our dividend stock selection for 2024, download our Top Stocks booklet now!

What about dividend ETFs?

Investors might want to adopt a simplified dividend growth investing strategy by choosing dividend ETFs, rather than individual equities. From what I can see, most dividend-focused ETFs are built based on stocks of companies that are dividend aristocrats, or on a specific yield or dividend growth target.

There’s more to dividend growth investing than yield and dividend growth metrics. Metrics only tell us about the company’s past, not much about what is coming. To assess a company’s ability to keep growing its dividend, you must look at graphs to see trends, read quarterly earnings and annual reports to see where the company’s going and how it can sustain its growth. You’ll only find this level of scrutiny in very actively managed ETFs.

The takeaway

You can spend a lot of time reading research that tells you index investing is better than dividend growth investing, or the opposite.

  • Does ETF investing work? Yes
  • Does index investing work? Yes.
  • Does dividend growth investing work? Definitely YES

What you really must do is build your own investing process. Find out what really works for you and stick to it.

ETFs offer diversification and are the best vehicle if you want a simple way to invest in the stock market. Simply buy something that tracks the S&P 500, the TSX, and the MCSI and you’ll do just fine. Things get more complicated if you try to track specific sectors or investment strategies with ETFs, which is why I will continue my journey with dividend growth investing.

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