Index investing has always been a hassle free way to invest in the total returns on the stock market. Index investors argue that so few actively managed mutual funds beat the S&P 500 and similar indexes so why not just invest in the index? You’ll not only see lower management fees but also less stress as investing simply becomes choosing an appropriate index and funneling your investing dollars there.
One of the key points in this argument is that index investing offers higher annual returns than actively managed mutual funds. Even when you don’t factor in the extra expenses that owning an actively managed mutual fund entail, less then half of the funds are able to beat the S&P 500 two years in a row and less than ten percent are able to beat the index three years in a row (source).
But what about dividend paying stocks? How do they perform against the S&P 500 index?
According to an analysis done by Motley Fool, over the ten years from 1999 to 2009 which was the worst decade in stock market history for the corporations in the U.S. stock market that the S&P 500 tracks, the index returned -2.7% annually. But, adding in income from dividends lowers that annual loss by two-thirds to -0.9%. Still not an impressive return by any standard but income from dividends did serve to cushion the loss substantially.
But, when you compare the S&P 500 to two mutual funds from Morningstar that offer an index concentrated on dividend paying stocks, the returns look much better.
Morningstar Dividend Composite & Dividend Leaders Index
The S&P 500 is a market cap weighted index of the 500 leading large cap public companies trading on U.S stock exchanges. The higher a corporation’s market cap the more impact it has on the value of the index. The Morningstar Dividend Composite Index offers the same weighting but for dividend paying stocks where the stock paying the highest dividend instead of having the highest market cap is weighted to have more impact over the value of the index.
Over the decade where the S&P 500 returned -0.9% this dividend index returns 3.4%. Not -3.4% but a three and a half point gain. And the Morningstar Dividend Leaders Index which focuses only on 100 stocks with the highest dividend yields returned a 5.5% gain!
Those are still relatively small gains but when you compare the value of $1,000 invested in 1999 with its value in 2009, an index investor would be left with a $91 loss and $909 while an investor in the dividend composite index would have $1,439 and an investor in the dividend leaders index would have $1,925. Those are gains of 60% and 100% for those dividend funds over the S&P 500.
That’s not to say that you should rush out and invest in these indexes (which you can’t right now anyway although dividend focused exchange traded funds (ETFs) are an option), the point is that over the worst stock market decade in U.S history, a portfolio focused on dividend paying stocks would have substantially outperformed the leading market index in total return.
Of course dividend investing takes more research and a little more oversight than straight index investing but not nearly as much as investing in equities or in actively managed mutual funds. Not to mention the fact that expense ratios are non-existent and dividend stocks provide income that can be reinvested to grow capital over time.
Considering the performance of dividend stocks vs. the S&P 500, I’d think index investors would be well served in giving them an honest look.
