ETF’s Vs Dividend Stocks? What Is Better?

As an Investor, I am a huge believer in keeping an open mind to learn as much I can. Since starting this blog at the beginning of 2020, I have met some amazing people who have helped me improve as an Investor. I never claim to be always correct and when challenged or asked a question, I take it as a time to learn. That is why I’m always happy when someone takes the time to read my content and posts a comment.

One of the many questions that pop up is around my common screening process. Screening companies is a good way to weed out some bad companies, but it can also disregard some really good companies.   There are both Pros and Cons to this which I may discuss at a later time but one way to solve this would be to invest in ETF’s instead of dividend stocks.

Advantage of ETF’s over Dividend Stocks

Diversification

Diversification seems like a good place to start.

ETFs allow an investor to own a tiny fraction in many different companies for a fraction of the cost it would take to buy 1 single share in each of the companies within an index.

This reduces the amount of capital needed to invest in all these companies. For example, ISHARES CORE MSCI WORLD UCITS ETF has exposure to over 1600 global companies within 23 developed countries.  It also provides good diversification across each sector as shown below.

You can have access to all these companies and different sectors for as little as $71.36 a share. If you were trying to achieve this level of diversification by stock picking than it would cost you a lot more than 70 bucks.

This level of diversification also affords the “Lazy Investor” more time as you don’t need to be following individual companies checking their financials to see if they fit your profile. This will all be taking care of for you.

Of course Brokers like Trading 212 offer the chance to buy fractional stocks and create your own ETF’s. The only issue is you still have to manage which companies input into your own ‘Pie’

Low Fees

The fees associated with ETF’s are historically low. John over at the Dividend Growth Investor wrote an excellent article on why keeping your fees low matters. Just as compounding can work for you, it can also work against you so you should always try to keep fees as low as possible. The good news for Investors with DEGIRO they have a list of commission-free ETF’s that you can invest in each month.

Disadvantage of ETF’s over Dividend Stocks

I must caution here that these disadvantages will be from an Irish perspective. As you will see below, we will have different laws and Taxes on our investments that may not apply to you. That said any Irish resident with a better understanding of ETF's please fell free to comment if i have misunderstood anything

There are three main reasons why I have avoided ETFs thus far. The taxes from the outset appear unfair. In Ireland, we are Taxed 41% on gains and 41% on any dividends received on ETFs. That is a hell of a lot of money to give away when you are taking all the risk.

Before I landed in the world of investing, Irish investors used to be able to invest in US ETFs which were taxed similar to stocks and were more favorable. However much to my annoyance, these types of investments are not easily available to your average retail investor on these shores.

PRIIPS

An EU directive called PRIIPS came into effect in 2017 which disallowed EU brokerages to sell any non-EU domiciled fund which didn’t comply with the PRIIPs rules.

One of these rules is that each investment fund needed to produce a key investor information document (KIID). Without KIID documents, the fund could not be sold to retail investors.in Europe. Vanguard, Ishares, and SPDR confirmed that they would not produce KIID documents. I believe it is still possible to invest in these funds, but it is not easy and too much hassle for a small investor like me.

Taxation

Taxation is something I usually leave to my accountant. I suppose that is why I pay him. But it is important to understand the different rates for each of your investments.

ETF’s are taxed differently depending on where they are domiciled.

ETF’s Domiciled in the EU carry an exit tax of 41% on gains. This is higher than the 33% CGT on individual stocks. Dividends are also taxed at 41%. You also cannot offset your losses on ETF’s. For me, this is a huge disadvantage.

eg. For individual shares If I make a loss on company A of €1000, and a profit on company B of €2000. I only pay tax on the net of the two which is €1000. For ETF’s I would pay tax on €2000 as the loss on company a does not offset any gains.

ETFs domiciled outside of the EU are treated like shares which means that Gains are taxed at 33%, Dividends are taxed at your marginal income tax rate and loss relief is also available. (Note that there is capital gains tax relief of €1250 per year)

Dividends from individual shares are taxed at your marginal rate + USC and PRSI. Depending on your income this could be as high as 51%. In my personal situation, I pay a maximum of 27%

This site offers a good income Tax calculator for Ireland

Deemed Disposal

In Ireland we have a rule called deemed disposal. I can forgive you if you never heard of this rule before. But in 2006 the people in charge decided it was a good idea to pretend to sell your investment on its 8th anniversary.

Exit tax is then payable on these shares which you haven’t sold at the market share price. Honestly don’t understand this rule and in my opinion, it’s just a massive compound interest blocker.

To be fair, this tax does act as a credit which you will use against your actual sale of the ETFs. If the market value is worth more when you sell than it was when you paid your deemed disposal, you will pay the difference. If the fund is worthless when you sell, you will get a refund on the tax paid.

There is no deemed disposal on individual shares.

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Why Should I consider ETF’s over Dividend Stocks?

The Sunday Investor wrote a nice article titled Is your Stock Portfolio Strategy Working which I highly recommend reading. This posed a question for me on if my portfolio is designed robust enough to beat both the S&P 500 and EFT’s that fit into my desired portfolio sector allocation.

I had some discussions with the Sunday Investor who was kind enough to send me a spreadsheet to perform portfolio attribution. This allowed to me compare my portfolio against my desired portfolio in ETF’s and compare my individual stock selection and my sector allocation.

On analysing my portfolio, the Sunday Investor made this comment –

“I got the sense right away that you don’t really have an asset allocation problem. but you may have a security selection problem”

At that time (April 2020) I was actually underperforming the market by 0.27%. This is not a lot but it got steadily worse as the markets bounced backed after March. My issue with this was that I could tweak my desired portfolio such as reducing the tech allocation. This would allow me to beat the market.

As a second check, I compared my returns against the S&P 500 since I began investing in 2017.

My portfolio wasn’t actually performing too badly compared to the index up until March 2020. Since March I have completely under-performed. I am not surprised with this since I did not have any of the main tech stocks that have been driving this growth.

While my time weighted annualised return is 3.8% compared to 11.7% I am not overly disappointing in my returns. This is because part of of strategy is finding stocks that may be undervalued by the market that I believe have potential for future growth.

Why dividend stocks over ETF’s.

I can not sit here and tell you which one is better for you. Your goals will be different from mine. To find out why I use a dividend strategy than you can read Why I choose a dividend reinvestment strategy here.

How do EFT’s returns compare to dividend stocks

For this I needed to make some assumptions.

1. €12000 Invested a year.
2. EFT fees are free ( from the DEGIRO list)
3. Dividend Stocks fees are €1.00 per €1000 invested
4. ETF Returns is assumed to be 6.52%, (based on the 10yr return from the ISHARES CORE MSCI WORLD UCITS ETF Distributing)
5. Assume the same return for dividend stocks.
6. The dividend Yield for the ETF is assumed to be 2%.
7. The dividend yield for the stock portfolio is assumed to be 4%. (current portfolio yield)

	ETF’s	Dividend Stocks
Total Invested	€240,000.00	€240,000.00
Total gains	€165,394.02	€241,364.62
Total Tax on Gains	€67,811.55	€79,650.33
Total Dividends	€70,163.28	€77,553.48
Total Tax on Dividends	€28,766.95	€20,939.44
Total after 20 years	€378,978.81	€458,328.34

After selling all Investments in year 20, I calculate that I would be €79,350 better off with dividend investing rather than ETF’s. I would be particularly interested in the point of view of Irish Investors who prefer investing in ETF’s and if i am missing anything important.

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For those who are interested, Myself and my buddy European DGI spoke about ETF’s of one of our earlier podcasts. Have a listen below.

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