No Truly Passive Approach to Dividends

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. It's Active/Passive Investing Week here at Morningstar.com, and I'm today with Josh Peters. He is editor of Morningstar DividendInvestor. We'll see how dividends can play into both active and passive investment strategies.

Josh, thanks so much for joining me today.

Josh Peters: Good to be here, Jeremy.

Glaser: There has been ton of interest in dividend-paying stocks with yields so low in the bond market, but a lot of investors are somewhat perplexed, if they should go out and buy individual high-yielding securities, individual stocks, or if they should be looking at some of the indexes that track a broad basket of dividend-paying stocks. Can you walk us through some of the pros and cons of those active or passive strategies there?

Peters: Yeah, I think the place that you have to start is really with "know thy self" and understand what it is that you're trying to accomplish as an investor because there are always trade-offs. There is no escaping the fact that either you or somebody is going to have to do some hard thinking, going to have do some research, going to have to do some homework, and going to have to formulate an opinion as to what types of stocks, asset classes, or different industries are actually attractive on a risk/reward basis. The same thing goes for styles, such as higher-yielding stocks versus stocks that don't pay dividends or only pay very small ones.

Once you realize that somebody has to do the hard thinking then the question is, "Should I do it, or should somebody else do it?" If you do it yourself, you have the opportunity to improve your returns somewhat by reducing the fees that you pay for passive management of one kind or another or somebody else's active management. You tend to put it in context of the dividend yield itself. I mean the whole stock market, right now, only yields are little bit more than 2%.

When you consider that your mass of actively managed mutual funds might be charging about 100 basis points, or 1 percentage point a year in expenses, that comes right out of the dividend income that an investor is going to receive. Now that might be a worthwhile price to pay to have somebody else doing the stock-picking, and certainly you can pay a lot less if you go with the passive product of one kind or another, such as an index fund. But it still comes out of the dividend income and the total return that you stand to get.

So, you can improve your returns somewhat in exchange for labor value added, actually going in and helping pick some of the stocks yourself. That said, you have to be prepared to do it. You have to feel like you know what you're doing. It's going to require some homework as I mentioned. But I think, in general, for individual investors, if you're looking at stocks that pay good dividend yields that are generally your more stable companies, such as utilities, food companies, and things like that, these are not whiz-bang financial instruments that take a Ph.D. to even begin to understand. They are, I think, accessible for lots of individual investors to help put to work in their portfolios.

Glaser: So, let's take a look at some passive funds then. If investors decide they don't want to do that work, and they really want to be in that passive index instrument, what are some of the features they should look for to make sure they're really getting that dividend exposure that they're looking for?

Peters: Well, a lot of the funds tend to be pretty similar. A good place to start with any of them is the amount of fees that you're going to pay. If you're paying more than 0.5% a year even out of a high-yield portfolio and expenses, then I think you have to start wondering whether or not you're getting enough value out of that relationship in exchange for what you're paying for it. Other things that you'd want to look are some of the details. How are the stocks actually selected for the index? There are dividend indexes that are focused on trying to maximize current yield, but perhaps they're owning stocks whose dividends might be cut at some point in the future. That's something that as an active investor, perhaps you can do a better job of avoiding those if they're being selected just on the basis of yield.

In some other cases, there are funds that are oriented around trying to find companies that have the fastest dividend-growth rates or that raise their dividends every year or have for many, many years in the past. These funds will tend to have lower current yields because their holdings are more growth-oriented and they may not be providing a big dividend yield from the get-go. So, it comes down very much like owning an individual stock. You have to be willing to open up the prospectus and the marketing documents and understand how the stocks are being selected for the portfolio and what they're trying to accomplish. And you do that with the same level of rigor, frankly that you'd do if you are looking at Johnson & Johnson, General Electric, or any other individual stock.

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Glaser: So, if you want to be a passive investor, you can't truly be passive.

Peters: No. If you're a truly passive investor and you're not putting anything into your portfolio other than money, then you may not be able to get a whole lot of return out. I think there is no way to walk away from the fact that work has to be done. So, you can choose to outsource the picking of individual stocks by going with a mutual fund or going with an index product with an ETF, but you still have to think about what kinds of businesses those funds are going in. Sometimes, they can actually be more complicated. You have to look at all of the companies that are in a fund to really understand how that product is being put together, whether or not it makes sense for you.

For me, I actually find it easier to look at individual businesses, and if it comes to a point where I don't feel like I understand the business, I can just move on.

Glaser: Can you tell us a little bit more about your active strategy then and exactly how it works?

Peters: Well, the idea is really to emphasize the dividend and make it a touchpoint for all the other aspects that we look at in the course of evaluating a business. It starts with laying out goals, specifically for the two model portfolios in DividendInvestor, we say, we actually want to earn a certain amount of dividend yield off of the portfolio. Now the yield is going to fluctuate somewhat with the stock price, but we want to get that big income component coming in. Then we also want that income stream to grow over time. So, we look for companies that we think can raise their dividends consistently by at least as fast as inflation, but preferably much faster if it's a lower-yielding stock, a stock that yields 3% should grow its dividend a lot faster than one whose dividend yield is 7%.

We put this together with some diversification in mind. We'll typically look to own perhaps 15-20 stocks in each of the two model portfolios. There is something of a trade-off there. The more stocks you own, the better diversification you'll have and the less risk vulnerability that you'd have to one particular dividend being cut or one particular company going on the rocks. But the more companies you own, it also diminishes the impact of your really good decisions. So, you want to be able to have perhaps some more capital behind the companies that you have the highest degree of confidence in, and it's more work.

I think for average investors, the idea of having a portfolio that would own 50 or 100 stocks just creates more work than they're likely able to handle. So, I look at that sort of 15-20 number as being a good number to work with when you're looking at individual stocks. It splits the difference between a good amount of diversification but not forcing you to work so hard to have really an extra full-time job just managing your portfolio.

Glaser: Josh, I appreciate your take on active and passive investing today. Thanks for joining me.

Peters: Happy to be here.

Glaser: For Morningstar, I am Jeremy Glaser.