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The Benefits of Investing in More Than Index Funds

The battle for investors’ savings is over, and index funds have won. According to mutual fund research firm Morningstar, passively managed index funds took in a record $504.8 billion in 2016. This figure is on the heels of inflows of $418.5 billion in 2015. In contrast, actively managed mutual funds experienced net outflows of $340.1 billion in 2016 and $230 billion in 2015. Although the migration rate from active to passive management appears to be accelerating, the phenomenon is hardly new. The last year in which active U.S. equity funds experienced net inflows was 2005!

The empirical underpinnings for the exodus have been in place for decades, as a mountain of academic research has shown that professional fund managers consistently underperform their unmanaged benchmark indices. Even among the few fund managers who do manage to beat the markets over certain periods of time, research suggests that such outperformance is fleeting and that low expenses are a much better indicator of future returns than past performance. As legendary investment guru Warren Buffett said in his 2016 letter to Berkshire Hathaway shareholders, "When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.”

As the fund flow statistics prove, investors are heeding this advice in droves. However, while the superiority of passively managed index funds over active fund management is well-established, a question that rarely arises in personal finance discourse is, “Does this mean index funds (and/or ETFs) are really the only investments American consumers need?” (For related reading, see: Active vs. Passive Investing.)

For all the hoopla over the ultra-low internal fees and expenses of most index funds, a fact that is often overlooked is there is a broad universe of investments that have absolutely no internal costs, specifically, the individual securities in which all mutual funds invest. This essay presents a range of scenarios in which individual investor interests may be best served by considering individual fixed income securities and/or stocks in lieu of or in addition to index funds.

Individual Bonds vs. Bond Mutual Funds

A fundamental concept in bond investing is that the value of an existing bond rises when interest rates fall and falls when interest rates rise. For the better part of 30 years investors have seen interest rates go in only one direction—down. The long-term secular decline in interest rates has been an enjoyable ride for bond mutual fund investors, as evidenced by the fact that the Merill Lynch Corporate Bond Index has experienced just one down year  (a 0.7% decline in 2008) in the past 30 years. With interest rates hovering near historic lows, it is extraordinarily unlikely that the next 30 years will be equally rosy. In fact, there are some who argue the threat of rising interest rates makes investing in bond mutual funds a risky proposition

Of course, the value of bonds falls when interest rates rise whether the bonds are held in bond funds or in an individual investor portfolio. However, a fundamental advantage of owning an individual bond vs. investing in a bond fund is that, if held to maturity, the bond will repay its face value, regardless of how much interest rates have risen since the bond was purchased. In contrast, bond mutual funds have no maturity date and there is no assurance that investors who purchase bond funds will ever receive their principle back if they have the misfortune of investing at the start of a long period of rising interest rates. (For related reading, see: Key Strategies to Avoid Negative Bond Returns.)

A counter-argument can be made that bond mutual funds offer diversification benefits, but default risk, especially in AA or AAA-rated corporate or municipal bonds, is low and such risk can be mitigated entirely by investing in individual treasury securities or FDIC-insured CDs. On this score, a popular strategy among conservative investors to is to invest in a CD ladder in which the maturities are staggered over a three to five year period to hedge against future interest rate increases.

Rising Dividend Stocks

On the surface, the suggestion that consumers should purchase individual stocks instead of broadly diversified stock index funds seems shaky at best and blasphemous at worst. Behavioral finance research has consistently found that investors overestimate their stock picking ability and consistently make bonehead timing decisions. Nonetheless, as with bonds, individual stocks may possess certain characteristics and advantages that are not afforded by investing in stock mutual funds. One such strategy involves investing in companies that have a demonstrated history or policy of increasing their dividends each and every year.

At the outset, readers should understand that the objective of the rising dividend strategy is not necessarily to outperform the stock market, and its success has little to do with stock picking beyond the fact that companies that are able to increase their dividends each year tend to be healthy. Instead, the attraction to the rising dividend strategy is it offers a means of building an income generating portfolio that rises at a rate faster than the cost of living. Assuming a buy-and-hold approach and proper diversification (15-20+ companies in different industries), the basic approach can work in any economic environment, but has been particularly appealing over the past 10-15 years because of the historically low yields on traditional income generating investments (e.g., bonds and CDs). (For related reading, see: Proof that Buy-and-Hold Investing Works.)

Passively Managed Rising Dividend ETFs

Again a counter-argument can be made that investors' interests might be better served by investing in passively managed rising dividend ETFs, such as Vanguard’s Dividend Appreciation Index ETF (VIG), comprised of companies that have increased dividends for at least 10 consecutive years, or State Street Global’s S&P Dividend ETF (SDY), which invests in the Dividend Aristocrats Index (comprised of companies that have increased dividends for at least 25 consecutive years). However, a fundamental problem with the ETF portfolios is that, because they are capital-weighted, there is no assurance the dividend will increase each year, even if all of the companies in the portfolio raise their dividends from one year to the next. 

For example, if one of the lower-yielding companies in the ETF sees its stock price rise significantly during the year, while another company with a higher dividend yield falls, the ETF may add shares of the former and sell shares of the latter to maintain the proper weighting. Additionally, there may be companies in these indices an investor may not wish to own based on dividend yield or current valuation. Building a rising dividend portfolio from scratch gives the individual investor the ability to cherry-pick from these indices. 

Investing in individual rising dividend stocks has been a popular investment strategy over the years. The ability of a portfolio to produce predictably rising income over time is something that neither bonds nor mutual funds do terribly well. The ability of investors to implement it successfully often hinges on staying disciplined in continuing to hold the companies through inevitable market downturns. On this score, investors may do well to again pay heed to Warren Buffett’s oft-quoted adage, “My favorite holding period is forever.” Common sell disciplines include selling only if a company reduces its dividend or if it fails to increase it from one year to the next.

Investors may also wish to keep in mind that a rising dividend strategy does not necessarily involve investing in companies that have high current dividend yields, but rather with companies that have demonstrated high dividend growth rates. For example, a company with a relatively low current dividend yield, but which has a history of increasing its dividends by 8-10% per year for a number of years, may have more long-term income generating potential than a higher yielding stock that has been increasing its dividend by just 1-2% per year.

Tax Efficiency

Broad investment diversification, liquidity and the ability to easily buy and sell in small or odd dollar amounts are among the benefits of investing in index funds. However, tax efficiency is one area in which index funds may be at a fundamental disadvantage to individual stocks. Each year, index funds, like all open-end mutual funds, are required to distribute to shareholders the income paid into the fund from the securities in the portfolio and the capital gains attributable to market capitalization rebalancing, meeting fund redemptions, and/or the replacement of any companies that may be been removed from the benchmark index. 

These distributions are taxable and are inherently unpredictable from one year to the next. As a result, investors may receive an unwelcome 1099 for the previous tax year that may be disruptive to their tax planning. For example, the additional income may cause the investor to be bumped into a higher marginal bracket or impact the taxability of Social Security income. (For related reading, see: Understanding Taxes on Mutual Funds Dividends.) 

Although the structure of ETFs may make them marginally more tax efficient than open-end mutual funds, the same basic problem of this unpredictable annual gains distribution may cause investors headaches in taxable investment accounts. (The tax impact of distributions is irrelevant in retirement accounts such as traditional and Roth IRAs, 401(k)s, etc.)

In contrast, holders of individual stocks only realize a capital gain (or loss) when they choose to sell. They can control the timing of the sale and may even choose to offset capital gains with the sale of securities that may be at a loss. This ability to control the taxes due may offer a significant advantage in annual tax planning, as taxes saved represent additional dollars in investors’ pockets.

Along the same lines, a concept that has received scant attention in personal finance forums is the impact of accumulated gains from decades of investing in mutual funds that pay little or no income (e.g., small cap or international equity funds) in taxable accounts. When the investor retires, he or she may wish to convert these holdings to income producing investments, and the only way to do that may be to give back a sizeable portion of the portfolio to the IRS as capital gains tax. In contrast, an investor who purchased dividend stocks in a taxable account (while investing in non-income-oriented mutual funds in tax sheltered accounts) may have a ready-made income producing portfolio without the need to make costly taxable reallocation decisions. 

The Importance of Account Spending Order

This discussion has shown there may be instances in which individual securities may be more appropriate and more tax efficient than merely investing in index funds. This does not imply that index funds have no place in investor portfolios, but it does suggest that individual securities may play an important role in complementing and rounding out an efficiently diversified nest egg. (For related reading, see: The Importance of Diversification.)

On this score, one of the hottest topics in financial planning these days is the idea of achieving portfolio optimization by carefully controlling both the mix of securities that are owned and the order in which the accounts are spent.    

For instance, it may be wise for an investor to own tax-exempt municipal bonds and individual U.S. stocks that pay qualified dividends in taxable accounts and certificates of deposit and index funds in Roth accounts and/or traditional IRAs and qualified plans, while balancing distributions from tax-free and tax-deferred accounts so as to enable the investor to keep as much as possible and to give as little as possible to Uncle Sam.

Financial planning industry thought leader and prolific "Nerd’s Eye View" blogger, Michael Kitces, has addressed this topic in a number of posts. The following articles provide excellent practical insight for planners and lay investors alike:

In sum, while the rise of index fund investing undoubtedly benefits investors, developing a sound, tax-efficient retirement portfolio may require the inclusion of individual securities and careful planning across multiple types of accounts. There is indeed much more to investing than just index funds.

(For more from this author, see: How to Make Your Nest Egg Last? Don't Sell Stocks When They're Down.)