Forget Dividend-Paying Mutual Funds, Buy These Instead

It’s not breaking news that dividends are hot. With bonds paying next to nothing, income-starved investors are increasingly pouring money into dividend-paying stocks.

Last year, while $178.2 billion was removed from equity products, $26.8 billion were invested into dividend-focused funds.

And mutual funds that specialized in dividends saw net inflows (more money invested in than taken out) every week for 44 weeks, according to EPFR Global.

[ad#Google Adsense 336×280-IA]I’m not a huge fan of mutual funds in general, and especially not those that are dedicated to dividends.

You can do much better yourself.

For example, Columbia Dividend Opportunity I (RSOIX) is rated five stars by Morningstar.

It has a current yield of 3.79% and an expense ratio of 0.75%.

Since March of 2004, $10,000 invested turned into $16,915 versus $13,426 for the S&P 500.

Those are some pretty solid stats. If I were looking for a mutual fund that invested in dividend payers, this one would be near or at the top of my list. It’s beaten the S&P 500 and its peers since its inception, the yield is solid and the expense ratio is reasonable.

Its largest holdings are Lorillard (NYSE: LO), J.P. Morgan Chase (NYSE: JPM) and Pfizer (NYSE: PFE) – not exactly a low-risk group. Most of the rest of the portfolio are large cap names like Microsoft (NYSE: MSFT), AT&T (NYSE: T) and General Electric (NYSE: GE).

That’s because a $3.9-billion fund has to buy a lot of stock in order for any one position to be meaningful. A large fund is able to go into the market and purchase two million shares of AT&T or Microsoft.

But if there are better opportunities in smaller names, a mutual fund is going to have a tough time buying enough shares to make a difference.

For example, if you invested in some of the smaller-cap names that are in The Ultimate Income Letter’s Perpetual Income Portfolio, you could do significantly better at an even lower cost.

For instance, let’s say you invested $2,500 each into Community Bank System (NYSE: CBU), Omega Health Investors (NYSE: OHI), Main Street Capital (NYSE: MAIN) and Genuine Parts (NYSE: GPC). During the same eight-year period as the mutual fund’s 69% increase, your $10,000 would have become $19,862 – a significant difference over the $16,915 this very good mutual fund returned.

Community Bank System is not a stock that a mutual fund manager would likely buy. It’s a great little bank with a 3.9% yield, but it only trades 200,000 shares a day. It would be hard for a fund to accumulate enough shares to make a difference in the fund’s returns. Perhaps more importantly, it would also be tough to sell a lot of shares if the fund manager no longer wanted to hold the stock. Omega Health and Main Street have yields approaching 8% and Genuine Parts’ yield is 3.2%, but the company has raised its dividend every year for 56 years.

All of the stocks mentioned above trade less than one million shares per day, although Genuine Parts has a market cap of over $9 billion.

And don’t forget that 0.75% expense ratio. While that is on the low side for mutual fund fees, your return is still being impacted by that 0.75% every year.

If you bought the four stocks listed above with a discount broker, it would cost you about $10 per trade or $40. That comes out to 0.4% of your initial investment. However, that’s a one-time cost, not an annual expense. The only time you’ll incur another fee is when you go to sell. So if you sold it today, you’d have incurred a total expense of 0.8% ($80/$10,000) over eight years rather than 0.75% every year. When you pay that 0.75% every year for eight years, you end up impacting your return by 6%.

I don’t know about you, but I prefer to keep the 6% for me, rather than pay it to a mutual fund manager who can’t do as good a job as I can.

It’s not that the fund managers aren’t smart. They are. But the size of their funds limits their flexibility. As an individual investor, you can use that flexibility to your advantage by owning smaller cap stocks that have higher yields and better growth potential.

Stay invested in dividend paying stocks. They’re the best way that I know of to grow your wealth and generate increasing amounts of income over the long term. But do it yourself. With just a little bit of work, you’ll make more money and pay less in fees than you would with even the best mutual funds.

Because this is one area where the little guy has the advantage.

Good Investing,

Marc Lichtenfeld

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Source: Investment U