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Sep 09 2014

Why I Invest in ETFs

post008_600x200I’m often asked by those who know about my dividend investing “Why ETFs?” It’s a good question. In the world of dividend investing, there are two two fundamental methodologies or schools of thought. The first approach is to invest in positions with proven dividend growth. For loooong term investing (10+ years), this method can produce excellent returns. The second approach is to invest in positions with high yields that handily beat inflation. The downside is that risk is higher (dividends may be cut, even when the economy is doing well), but the upside is that with higher yields one can build a good income stream with less capital and less time (and being in my forties, time is more valued than it was in my twenties).

Driven by near-zero interest rates and wanting to make up for lost time as I entered my forties, I looked beyond corporate stocks that paid out dividends in the 2-4% range, which puts them at or barely ahead of inflation. Thus I opted for the second dividend investment approach of seeking higher yields and I was willing to accept greater risks.

In Robert Kiyosaki’s “Cash Flow Quadrant” book, Kiyosaki assigned level numbers to the different skill levels of investors. In his advice to Level 4 (Long Term) investors, Kiyosaki briefly mentioned in passing closed-end mutual funds. This was where I first heard of CEFs, and only later did I learn of ETFs. ETFs and CEFs are similar to mutual funds, except that they can be bought and sold as easily as stocks, and their prices fluctuate just like stocks. Like common stocks, some ETF/CEF stocks can produce regular dividend payouts.

One benefit of ETF/CEF stocks is that you can select how dividend income is taxed. Want a high yield, but taxable dividend? There are ETF/CEF stocks that do it. Want a lower yield, but tax-free dividend? Again, there are ETF/CEF stocks that can do that. Like mutual funds and ice cream, ETFs come in an enormous variety of flavors. You can buy ETF stocks that focus on such sectors as healthcare, energy/resources, biotech, utilities, emerging markets, mortgage backed securities, specific countries, US municipalities, etc. To borrow the old Burger King ad slogan: Have it your way.

ETF/CEF stocks *seem* pretty damn awesome in theory, but how have they been in practice? Based on my journey so far, it’s been a mixed bag. On the positive side, I get yields that are higher (sometimes *much* higher) than what corporate stock dividends typically offer and totally blow away CDs (What? Lock up my money for 6-12 months just to eke out a wretched 1% annual yield? Yeah, right.).

On the negative side, dividend cuts have reduced my dividend payouts, so it’s been a six steps forward, two steps back experience. If not for the cuts, I would be earning more than $600/month now. And it has been something of a challenge just to break $400/month (which I finally did late last year). Still, even with the dividend cuts I’m still holding on to most of my stocks (I’ve only sold one stock due to severe dividend cuts) and just let the (now diminished) dividends from other positions continue to roll in every month.

However, the ETF/CEF stocks I hold aren’t without risk. Most are heavily leveraged, which means that the fund’s earnings are magnified (hence the larger yields), but losses are also magnified as well (yikes!). So far so good, but I realize that a severe drop in the stocks’ prices and slashed dividends are a very real possibility. It has taken time for me to learn this, but one way to mitigate the damage of dividend cuts is to diversify. A cut to a dividend that makes up just 5% of one’s dividend income is far less damaging then when the dividend makes up 30% of one’s dividend income.

Over the past few years, I’ve made my share of investing mistakes, and my methodology has evolved over time (more selective of positions, diversification to minimize risks, self-restraint, and more tax-free investing).

My journey in building dividend income from ETF/CEF investments has been fascinating, educational, and monetarily rewarding and I look forward to what your views are about my general approach to investing.

Image Credit: geralt (pixabay.com)