ETFs and mutual funds are great for total-return investing, but for a flow of dividend income that grows, stocks look better, writes Rob Carrick, reporter and columnist for The Globe and Mail.

There's a problem with what is supposedly one of the best all-around investing strategies for all kinds of investors.

Dividend-growth investing provides a steady, rising income, it offers good capital-gains potential, and it offers very competitive returns in all kinds of markets. But it's tough to harness dividend growth if you're an investor who has a small account, and is thus better served by mutual funds or exchange-traded funds than individual stocks.

Do you use ETFs to build your portfolio? There are lots of dividend ETFs listed on Canadian and US markets, most of them focusing to some extent on companies that increase their dividends. And yet, many dividend ETFs were up and down in the amount of cash they paid to unitholders in the past couple of years.

Are mutual funds better suited to your needs? A search for dividend-growth mutual funds uncovered a bunch of names with "dividend growth" in the title, but no apparent priority placed on companies that regularly increase quarterly cash payouts to shareholders.

Elite Canadian dividend-growth stocks were covered in last week's Portfolio Strategy column, which you can read here. The column prompted some readers to ask whether there was a way to pursue dividend growth if you have a portfolio too small to make it economical to buy individual stocks.

It's worth noting that you can buy any number of shares you want—forget about having to buy "board lots" of 100 shares.

The fund approach gives you instant diversification for whatever amount you invest. But this benefit didn't help investors much in the past three years of stock-market turbulence.

In the Canadian market, where the vast majority of classic dividend-growth stocks either held the line on their cash payouts or increased them, dividend ETFs ended up paying less.

Consider the Claymore S&P/TSX Canadian Dividend ETF (Toronto: CDZ), which tracks the S&P/TSX Canadian Dividend Aristocrats Index. One of the key conditions for inclusion in this index is that a company must have increased ordinary cash dividends every year for at least the past five years.

That sounds like a sound basis for dividend-growth investing—yet CDZ's current monthly dividend distribution is 5.5 cents per share, down from 6.95 cents earlier this year and 7.4 cents for much of 2009.

The issue here is that the pool of steady dividend growers shrank in the difficult economic environment of 2008 to 2010, explained Dan Rubin, vice-president of marketing at Claymore Investments.

"As an example, in December 2010 the index added five securities which established a five-year track record of increasing their dividend, and removed 22 securities which failed to increase their dividend over the past 12 months," he wrote in an e-mail.

Fewer companies in the index can mean a smaller flow of dividends. Rubin noted that many of the deleted companies were income trusts that churned out lots of cash. They were replaced by stocks that don't pay quite as generously, even if they have a history of steadily increasing their dividends.

Another example of a dividend ETF with zig-zagging payouts is the iShares Dow Jones Canada Select Dividend Index Fund (Toronto: XDV), which tracks the Dow Jones Canada Select Dividend Index. This index is made up of 30 stocks selected according to rules based on dividend growth, as well as yield and average payout ratio.

XDV paid just about 74 cents through its distributions of dividend income last year, which compares to 73 cents in 2009, and almost 79 cents in 2008.

Oliver McMahon, director of product development for iShares Canada, said dividend fluctuation in XDV has come as a result of strong inflows of money into the fund. In very simple terms, this has required the fund to temporarily spread its dividend payments out to more unitholders, and thus pay less.

Unitholders aren't losing anything, because the loss of income is compensated by a rise in the price of XDV shares, McMahon added.

In the US market, dividend cuts were more common in the stock market downturn than in Canada. That's reflected in the dividend distributions of dividend ETFs holding US stocks.

The Vanguard Dividend Appreciation ETF (VIG) tracks the Dividend Achievers Select Index, which includes stocks chosen on criteria that includes ten straight years of dividend growth. VIG's annualized dividend payout fell to 98 cents in 2009 from $1.03 in 2008. before climbing back to $1.05 last year.

"Dividend cuts from 2008 and 2009 certainly impacted the payouts," Vanguard's Rebecca Katz said in an e-mail.

One of the oldest US dividend ETFs is the iShares Dow Jones Select Dividend Index Fund (DVY), which also uses dividend growth as a criteria for including stocks. DVY's annualized payout last year was $1.70, up from $1.66 in 2009—but well off the $2.20 to $2.40 paid in the previous few years.

The lesson here seems to be that ETFs aren't ideal for generating a steadily growing stream of dividend income. You can get more dividends from year to year, but you can also get less.

Forget about using mutual funds for dividend growth. Undoubtedly, there are managers who evaluate stocks for their funds using dividend growth as part of their analysis. But just try and find a fund with an explicit mission of investing in dividend-growth companies.

One fund that does this is Franklin US Rising Dividends, which has attracted just C$15 million in assets. The mission statement for this fund is to focus primarily on "US companies with a history of consistent and substantial dividend increases."

Returns from this fund have fluctuated above and below the average for the US equity category, but the 11.1% loss in 2008 looks outstanding in comparison to the 21.9% drop in the S&P 500 index in Canadian dollars.

The drawback with this fund is that it's not designed for income seekers. It pays distributions only annually.

Don't get the wrong idea about dividend mutual funds and ETFs. They're still a great way to benefit from total-return investing, which means dividends tacked onto share-price gains. But if you want to build a flow of dividend income that grows year by year, individual stocks look better.