From John Dorgan: “As I’m sure you know, your advice regarding mutual funds is in stark contrast with the folks at the Motley Fool who say that mutual funds rarely keep up with index funds. They suggest buying numbers 2 through 5 of the top five dividend paying Dow Jones Industrials has yielded an annual growth of 22.23% over the past 25 years. Your comments would be appreciated.”

As long as you have some way of going back 25 years to start investing that way, you will definitely earn 22.3% compounded on your money. Whether this will work going forward is less clear.

Certainly, the idea of buying the highest dividend-paying Dow stocks each year has some appeal. The notion is that these companies, having made it into the Dow, are not, by and large, the type to go broke. So if you buy those with the highest dividends, you will (a) get the highest dividends, which can’t hurt, and (b) generally be selecting stocks that are out of favor (their prices have fallen to the point that the dividend, as a percentage thereof, has become relatively high). Things that go out of fashion have a way of coming back into fashion.

So there’s some logic to it, but I think there are lots of holes one could poke in it going forward. One is simply a tax problem (if you’re doing this in a taxable account). Index funds generate little by way of taxable gains. Rebalancing a “dogs of the Dow” portfolio each year, on the other hand, exposes much of the gain to tax. Say you could earn 20% a year taxably with this strategy going forward (which I doubt), but you’re in the 40% bracket, between federal and local taxes, given some blend of long- and short-term gains. That means you’re not getting 20% a year but more like 12%. After 25 years, the $1,000 you started with (say) would be worth $17,000. But earning “just” 15% in an index fund, and assuming for simplicity sake that none of it would have been taxed along the way (although the dividend portion, at least, would have been), your $1,000 would have grown to $33,000 — subject to capital gains tax if you sold the fund. How does a potentially-taxable $33,000 compare with $17,000 on which taxes have been fully paid? Well, at today’s 28% rate, plus say another 7% for state and local tax, you’d get to keep north of $21,000. So 20% with the “Dow dogs” might be less good, in a taxable account, than 15% with an index fund.

Of course, numbers like these — 20% and 15% — are extremely aggressive and optimistic. It’s much more likely both the Index funds and the Dow dogs will revert to much more modest returns. But however well they do, taxes are one item to consider.

Aside from taxes, what else might go wrong with the Dow dogs? Perhaps nothing. Or perhaps relationships will just change going forward. For the next few years, perhaps the Dow dog with the highest dividend, which the Motley Fools would exclude — it’s Philip Morris for 1997 — will really rock and roll, while the second through fifth, which the Fool suggests you favor, will do worse than the sixth through tenth — or worse than Berkshire Hathaway, say, which has also outperformed most mutual funds for the last 25 years (and without your having to pay taxes along the way).

As for your/their comment that most mutual funds rarely keep up with index funds — this is absolutely true, and a point I frequently make myself. That’s why I think super-low-expense index funds are a good choice for most people who want to put some of their money in the market.

But I’d also agree with those who think the big “index stocks” may have been pumped up even more than the rest of the market because so much money has been going into these index funds. I’m not sure we’re anywhere near the end of that, but would suggest looking at index funds that invest more broadly — or that invest abroad.

 

 

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