Q: Frequently on the radio, I hear financial advisers recommend index funds for investors. While that may work reasonably in a rising market, it has not done too well in a falling or even a static market. If you examine the performance of dividend stocks data sources such as Value Line and Big Charts, in recent years you can see the advantage of dividend stocks over the index. While this may look like hindsight, the performance of my wife’s portfolio — composed entirely of dividend-paying stocks — outperformed the Dow Jones industrial average and the Standard & Poor’s 500 index last year, in the previous five years and in the previous 10 years in spite of the dot-com crash and real estate slump. Because of that, we recently moved a small account that my wife had (about 25 percent in an index fund) from Vanguard to Schwab where it, too, can be invested in dividend-paying stocks. Shouldn’t people be warned that the index funds are hazardous?
A: Any index fund is subject to the hazards of its asset class. A stock index fund will go up and down with the stock market. A bond index fund will go up and down with the vagaries of interest rates. So, yes, an index fund can be hazardous.
That does not mean that it is more hazardous than other ways of investing in the same asset class.
More important, history shows that investing in low-cost index funds is a better way to invest in whatever asset class is chosen. It provides greater diversification, greater tax efficiency, and it eliminates “manager risk” — the risk that the fund manager chooses the “wrong” stocks rather than the “right” stocks. One bit of evidence is the Vanguard Balanced Index fund: It has consistently provided a higher return at greater tax efficiency than the majority of its managed competition.
That a group of hand-picked, dividend-paying stocks may have done better in a particular period does not make a compelling case for owning dividend stocks versus owning a stock index fund. It does open a question about whether it is possible that an index of dividend stocks might produce superior results to an index that included all stocks, and there is evidence to support the idea of preferring dividend stocks. One obvious factor is that studies have shown that a significant part of the total return from investing in common stocks is from dividends.
Dividends, however, can also be a trap. I haven’t seen your list of high-dividend stocks, but if it had included such stocks as Bank of America, Citibank or GE, the results of your selection over the last five years would be very different and far less pleasing.
Q: What is your opinion of GNMA mutual funds? They seem to produce about 5 percent and bounce around from $10 to $11.50 per share (Vanguard) year in and year out. And the U.S. government guarantees them.
A: GNMA funds generally offer a higher yield than conventional bond funds. That added income is attractive to many retirees. Recently, for instance, the Vanguard GNMA Fund (ticker: VFIIX) was yielding 3.15 percent while the Vanguard Total Bond Market Index Fund (ticker VBMFX) was yielding 3.01 percent. So there is a small yield advantage in this and other funds that focus on mortgage-backed securities. (The yield advantage, by the way, has been larger in more normal markets.) That said, it has been quite a while since this fund provided a 5 percent yield.
The extra income, moreover, is not a free lunch. When interest rates decline, people tend to refinance to lower interest rates. This means you don’t get the nice capital gain that you get holding long-term bonds. Similarly, when interest rates rise, people tend to hang on to their low-interest-rate mortgages, and you are stuck with a lower yield longer.
Compensating for this is one of the reasons GNMA funds have higher yields than conventional bond funds. Even so, I have been a fan of the Vanguard GNMA Fund for many years — precisely because it produces a slightly higher yield than conventional fixed-term coupon securities.