When should you replace an index fund with a stock portfolio?

[soupcxan]

Right or wrong, I like dividend paying stocks. I have a vanguard dividend-focused index fund yielding 3% with a 0.2% expense ratio. With a hypothetical $1M in there, I'm getting $30k/year dividends and paying $2k in ER.

I could replicate the portfolio with individual stocks, maybe with 50 stocks, and pay $2/trade. If I buy every quarter, that's $400/year versus $2k. Plus I would have more control over recognizing capital gains (no mandatory capital gains distributions). Obviously the downside is more administrative work for myself.

Does this make sense or not worth the effort?

 

[Dash man]

There are a lot of good stocks out there paying a better dividend than 3% right now. I keep about 35 stocks in my taxable account with all but one paying dividends. My 15 largest holdings are ABC, MAIN, T, SBUX, KMB, JNJ, LLY, RPM, DUK, AEP, O, PEP, RCL, XOM and WFC. They're not all over 3%, but a mix of growth is important too. Only one stock I own, LCI, doesn't pay a dividend. My 401k is all in mutual funds for now, including half of it in a stable value fund since May. I pay $5.95 a trade, but don't trade often and usually only to buy. Selling is only to take advantage of a tax loss or a change in the fundamentals of a company. I also prefer CDs and cash over bonds right now.

 

[MBAustin]

I'm not an expert, but in my book the advantage of the fund is that it adjusts to the relative market positions of each stock in the portfolio based on their relative values, which would require a lot more trading and analysis to maintain even if you only did it quarterly.

 

[samclem]

Does this make sense or not worth the effort?

Considerations:
-- Any cap gains to pay if you sell the fund? That could add a lot to the costs of switching.
-- How much time are you going to want to spend tracking companies, making decisions, buying/selling? How about 20 years from now? Can you explain the process to any spouse/heirs so they can keep doing it?
--Some would argue 50 stocks aren't enough to be well diversified across sectors/industries. The need for lots of stocks to match the performance of an index is largely driven by a few stocks sometimes having huge price appreciation, so it's less significant if you'll be counting primarily on dividends.
-- The fund buys and sells as needed to keep things cap weighted. Failure to do this on a frequent basis results in overweighting "winners" and a higher overall stock valuations. So, that's something that would require semi-frequent attention.


Personally, I don't think I'd ever get to the point where it would be worth it to go to individual stocks vs a very low-cost fund. As the balance of my portfolio grew (together with the annual allowable withdrawals), the importance of each dollar in the growing amount paid in ER would be reduced.

 

[Cobra9777]

Too much work for such a small reduction in ER. I own VYM (Vanguard High Dividend Yield ETF) which currently pays 3.2%, and since it's an ETF, I rarely if ever get CG distributions. Plus, the ER is 0.10%. So, with your hypothetical $1M in VYM, you'd get $32K dividends, only $1K ER, and no CG distributions. There might be something out there more appropriate for your situation, but I'd be more inclined to stay with a large, diversified, low-ER index ETF, rather than building a portfolio of individual dividend-paying stocks. Just my perspective.

 

[enjoyinglife102]

I also focus on low cost dividend mutual funds with a regular income distribution as it's a lot easier for me to ride out a declining market when I have no intention of selling anything that a total return approach may require. The convenience, simplicity, hassle-free and I'd bet out performance of low cost funds works great for me; do what will work best for you. A good financial plan is the one that an individual can successfully implement. Vanguard Equity Income Adm & Dividend Growth make up the bulk of my stock portfolio.

 

[Senator]

You can probably find a dividend ETF that will produce the same yield as your 50 stocks. And it will be less effort. DVY being one of them. Even the S&P returns 2% now.

Tracking 50 stocks, and keeping any sort of allocation across sectors, or ??, will be a nightmare.

I would not think it is worth the effort.

 

[LOL!]

Why not ditch the fund and get a fund with a lower expense ratio and lower dividend yield? That will lower one's taxes in most situations, too.

VFIAX has a yield over 2% and a million dollars in it will cost just $500 in the expense ratio. If you really need the missing $10K, sell some shares.

But, who pays commissions anymore anyways? There are so many free brokers, it is a shame not to have 3 or 4 of them ready to trade at.

 

[target2019]

Right or wrong, I like dividend paying stocks. I have a vanguard dividend-focused index fund yielding 3% with a 0.2% expense ratio. With a hypothetical $1M in there, I'm getting $30k/year dividends and paying $2k in ER.

I could replicate the portfolio with individual stocks, maybe with 50 stocks, and pay $2/trade. If I buy every quarter, that's $400/year versus $2k. Plus I would have more control over recognizing capital gains (no mandatory capital gains distributions). Obviously the downside is more administrative work for myself.

Does this make sense or not worth the effort?

It sounds like you would sell off MFs and slowly purchase stocks, maybe a few purchases at good value periodically. I think a basket of 25-30 companies would be much easier to manage.

 

[gcgang]

I think 50 stocks, if selected properly, are more than sufficient to replace something like an S&P 500 index.

Like you said, you've got lower expenses, and much more tax efficiency, if that's important to you.

Heirs can simply sell with stepped up basis and do whatever.

I'd say, go for it!


Sent from my iPhone using Early Retirement Forum

 

[ESRwannabe]

Right or wrong, I like dividend paying stocks. I have a vanguard dividend-focused index fund yielding 3% with a 0.2% expense ratio. With a hypothetical $1M in there, I'm getting $30k/year dividends and paying $2k in ER.

I could replicate the portfolio with individual stocks, maybe with 50 stocks, and pay $2/trade. If I buy every quarter, that's $400/year versus $2k. Plus I would have more control over recognizing capital gains (no mandatory capital gains distributions). Obviously the downside is more administrative work for myself.

Does this make sense or not worth the effort?

I wouldn't bother for the cost savings.

I have and do use individual stocks but its been primarily a way to boost my income. You can add at least one or two percent yield easily going with individual stocks without skewing that far away from whatever index you are bench marking.

I'm primarily in index etfs because I'm lazy. When I own individual stocks at a minimum I follow the quarterly analyst calls for the company and its competitors. I also find out what the trade publications are for that industry and follow them. Its a lot of reading and listening to webcasts.

 

[Totoro]

Not relevant for most here, but a re-investing ETF (that doesn't pay out dividends) can be tax beneficial.

In Belgium (where my mom lives) you pay 25% tax on dividends paid out. If it stays in the fund, it is avoided.

Similar things can play a role with dividends from foreign companies (non-US).

 

[hnzw_rui]

In Belgium (where my mom lives) you pay 25% tax on dividends paid out. If it stays in the fund, it is avoided.

Unfortunately not the case in the US. While qualified dividends get preferential tax treatment, you still have to pay taxes whether you spend or reinvest.

Hence, I do reinvest in retirement accounts (no tax consequences) but have it directed to the sweep/money market for taxable accounts (for use in AA rebalance after end of year). Makes keeping track of basis easier, too.

 

[Danmar]

I have taken the approach you have considered, eg no funds just individual equities. I have about 12 positions and would not be diversified enough for most here. The tax efficiency is great except I have several positions with huge gains. Hard to sell these in order to rebalance. My yield is in the 3.5-4% range (4% now).

Don't like paying fees. Even 10BPs would be a fairly big $ amount. Cheap, I guess. Total return over 18 years about 12.5% handily beating indexes in Canada. Obviously, wouldn't recommend this for most people though.

 

[stephenson]

You might get more responses if you didn't start with, "Right or wrong, I like dividend paying stocks.."

Seems sort of illogical to ask for advice if you start this way? Still scratching my head ...

The responses you got are pretty darn thoughtful! Most seemed to indicate a preference for far less work for very nearly the same net ... unless I misread the general tone?

 

[Texas Proud]

Considerations:
-- Any cap gains to pay if you sell the fund? That could add a lot to the costs of switching.
-- How much time are you going to want to spend tracking companies, making decisions, buying/selling? How about 20 years from now? Can you explain the process to any spouse/heirs so they can keep doing it?
--Some would argue 50 stocks aren't enough to be well diversified across sectors/industries. The need for lots of stocks to match the performance of an index is largely driven by a few stocks sometimes having huge price appreciation, so it's less significant if you'll be counting primarily on dividends.
-- The fund buys and sells as needed to keep things cap weighted. Failure to do this on a frequent basis results in overweighting "winners" and a higher overall stock valuations. So, that's something that would require semi-frequent attention.


Personally, I don't think I'd ever get to the point where it would be worth it to go to individual stocks vs a very low-cost fund. As the balance of my portfolio grew (together with the annual allowable withdrawals), the importance of each dollar in the growing amount paid in ER would be reduced.

If you do the math, 30 stocks are diversified enough.... adding one more stock does not move the diversification needle much....

Also, if you look at stock funds, they give you a percent of the fund in the top 10 stocks... many are in the 30% range... even the S&P 500 has almost 18% from the top 10... the little stocks do not add much to the mix...

PS... looked at the dividend appreciation fund and its top 10 is 35%...
Primecap is 43%....
Windsor is even 19% and it has a big chuck of bonds....

 

[soupcxan]

You might get more responses if you didn't start with, "Right or wrong, I like dividend paying stocks.."

Seems sort of illogical to ask for advice if you start this way? Still scratching my head ...

What's illogical about asking for the best way to run a portfolio of a particular asset class (in this case, value equities)?

Is my question any different if I asked about buying individual high-yield bonds versus a high-yield bond fund for that portion of my portfolio?

I too am scratching my head as to why my question is illegitimate from your point of view.

 

[samclem]

If you do the math, 30 stocks are diversified enough.... adding one more stock does not move the diversification needle much....

As I tried to communicate, it probably matters less with dividend stocks, but with growth stocks a very disproportionate amount of the gains during some time periods have come from a very few stocks that came from nowhere to go to many, many multiples of their initial share prices. Owning just a few stocks instead of a much larger universe increases the chance that you'll get an uneven distribution of these winning lottery tickets (either more or fewer than average).

Per William Bernstein:

. . .the scatter of returns was quite high, with more than a few [sample portfolios drawn at random from the S&P 500] underperforming "the market" by 5%-10% per annum.
The reason is simple: a grossly disproportionate fraction of the total return came from a very few "superstocks" like Dell Computer, which increased in value over 550 times. If you didn’t have one of the half-dozen or so of these in your portfolio, then you badly lagged the market. (The odds of owing one of the 10 superstocks are approximately one in six.) Of course, by owning only 15 stocks you also increase your chances of becoming fabulously rich. But unfortunately, in investing, it is all too often true that the same things that maximize your chances of getting rich also maximize your chances of getting poor.
If the O’Neal data are generalizable to stocks, and I believe that they are, then even 100 stocks are not nearly enough to eliminate this very important source of financial risk.
So, yes, Virginia, you can eliminate nonsytematic portfolio risk, as defined by Modern Portfolio Theory, with a relatively few stocks. It’s just that nonsystematic risk is only a small part of the puzzle. Fifteen stocks is not enough. Thirty is not enough. Even 200 is not enough. The only way to truly minimize the risks of stock ownership is by owning the whole market.

Our own Running Man also offered a thoughtful rebuttal to Bernstein's idea, you can find it here.

 

[ETFs_Rule]

Does this make sense or not worth the effort?

Stock picking is old school. Stick with index funds. Don't pretend to be a stock picking expert. And really the so-called "experts" are really just professional guessers.

 

[kcowan]

If you want to dabble, start simple selling enough funds to finance a few picks. Measure you returns on each side. Continue the process until you are comfortable. Lower fees and control over capital gains are the main advantages. After a few years, you should see the accelerating effects of the sheltered capital gains improving your yield. So if you have a ten year runway or more, and you enjoy analysis, it may be worth it.

OTOH, the capital gains liability will eventually become an issue as you approach old age. So then you might choose to go the other way at that time.

I have a mixture of direct holdings and funds. The funds are to balance off sectors that I don't study. I also carry a large insurance policy to finance the deferred capital gains hit.

 

[eta2020]

Not worth it!
Then you have to rebalance such portfolio and cough out taxes.

Though it is OK to have few hight quality stocks that you really believe in.