Investing, Mutual Funds

Should you buy index funds or ETFs?

By Kanwal Sarai
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bombardier-crj700-2Should you buy index funds or ETFs? Is it better than dividend investing?

Here’s my take on it….

I bought my first mutual fund 27 years ago, then moved to index funds, then ETFs. I’m now 100% in dividend paying stocks and have been for the last 17 years. The return on my dividend stocks has far outpaced my first 10 years as a mutual fund investor. I don’t consider myself an active investor; I’ve owned most of my stocks for more than a decade. Last year I executed just one trade.

I'm not trying to beat the market. My goal is to build a stream of growing passive income (via dividends) each year. Since I started investing in stocks my dividend income has increased consecutively each year for the last 17 years.

Dividend Growth Investor recently wrote, “Financial advisers love index funds, because they do not have to spend any effort picking good investments, so they can focus their time on gathering client assets. The more assets they can gather, the more fees they can charge. Plus, if their clients lose money, the advisers can blame it all on the index they picked not doing too well.”

Indexing might work for some people. People who don’t have the time, confidence, or desire to select dividend stocks. But I would argue it’s easier to pick dividend stocks than to pick from the multitude of available index funds. If you are going to index be aware of the following 4 things:

1. Index funds inadvertently buy overvalued stocks: On any given day some stocks are undervalued and some are overvalued. When you buy an index fund your money goes to buying both undervalued and overvalued stocks. As a dividend investor in the last 17 years I have only bought undervalued stocks.

A stock is undervalued when it’s current dividend yield is higher than its average (10 yr) dividend yield:
current dividend yield > average dividend yield = undervalued stock
current dividend yield < average dividend yield = overvalued stock

2. Index funds inadvertently buy lousy stocks: At any given time some stocks are quality stocks and some are not. When you buy an index fund your money goes to buying all stocks in the index, some of which are quality stocks and some are not. As a dividend investor in the last 17 years I have only bought quality stocks, and defined by my 12 Rules of Simply Investing.

3. You’re still paying fees: Fees are much lower for index funds than managed mutual funds, but a fee is still a fee. Using an online calculator I compared the cost of owning an index fund versus owning individual stocks:

Index Fund A
Amount invested: $100,000
Index Fund Fee: 0.83%
Index Fund: TD US Index Fund-e
Total fees paid after 25 years: $28,095.90

Index Fund B
Amount invested: $100,000
Index Fund Fee: 0.08%
Index Fund: Vanguard Value Index (VVIAX)
Total fees paid after 25 years: $2,000.80

Individual Stocks
Amount invested: $100,000
Trading Fee: $9.99 per trade
Number of stocks held: 20
Total fees paid after 25 years: $199.80

4. Index funds buy non-dividend stocks: Without dividends the yield on index funds (and ETFs) is very low. With a low yield, you won't receive enough in dividend income, and when you need the money you'll be forced to sell your equity thereby reducing your nest egg.

In my opinion an index fund is not the greatest investment strategy, but it works for some people. The same way you could fly from Toronto to Chicago on the Bombardier Q300 or the CRJ700, they’ll both get you there but one is the better option.

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Kanwal Sarai

With more than 27 years of investing experience and a passion for investing and teaching, I demystify the world of investing. My goal is to help you grow your net worth by investing in quality dividend paying stocks. Build your own stream of increasing income today.

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