Fundamentally weighted indexes have recently allowed investors to begin to shape their income portfolios to not only target the highest dividend yields, but also the up-and-coming dividend payers that are just establishing a track record. Yet with over 70 different exchange-traded funds available for dividend equity investing, how should one go about selecting and commingling the correct mix? Furthermore, how should investors view dividend-growth strategies in relation to high-dividend strategies in the prevailing market environment?
For clients in our Strategic Income portfolio, we attempt to narrow the choices down to a rough watch list using traditional means of analysis that includes a comparison of fees, performance, sector distribution, dividend yield, and capitalization style. Then we take on the more arduous task selecting an index that aligns itself with our client’s tolerance for volatility and expectations for return. I believe it’s that relationship alone that investors should prioritize most when balancing the holdings within their equity sleeve.
Analyzing your allocations and then viewing them alongside various market scenarios should give you additional insight as to how your portfolio will perform in future.
High dividend yield
In the early stages of ETF development, nearly all equity income funds were designed to use a screening methodology whereby stocks are selected for inclusion based on the size of their dividends alone. There are typically sector limitations built in, insuring the basket of stocks doesn’t become overly tilted toward one area of the market. The predominant sectors where dividends are typically found are in large utilities, consumer staples, and health-care stocks.
The crux of the problem with allocating strictly to high dividend yield ETF’s is the disproportionate allocations to aforementioned sectors that are already trading at elevated valuations or generate revenue from mature business models. There isn’t much meat left on the bone at current levels unless the constituent companies post higher than expected earnings growth, or increased net margins for the remainder of 2014. Although it’s a safe bet to say they will sometime in the future given the strength in the underlying economy, it simply takes time.
Yet the fact remains that the value stocks held in high-dividend indexes will present less volatility over time. So for retirees that are at the latter stages of their life cycle, carrying a larger allocation to high dividend yielding stocks is a prudent bet that you won’t be forced to draw down your principal during the next bear market. In addition, inflation concerns begin to diminish and the reliability of the income stream becomes more paramount to supporting a comfortable retirement.
More recently, several ETFs have come to market that offer a cheap and easy way to gain access to a portfolio of companies that are establishing, or have already established a track record of growing their dividends. These funds typically target mid and mid/large-cap companies that are increasing payouts to shareholders on a year over year basis. However, the yields are much smaller when compared with high-dividend companies. For example, a typical high dividend ETF might carry a yield of 3.5% compared with a much smaller yield of only 2.2% for a dividend growth ETF.
Yet, there are still many attractive qualities to investing in these types of companies, the first being that an investor can establish a holding that may eventually graduate to a high-dividend-yield stock during their lifetime. This is a great way to secure a future income stream from a company that is at its infancy when developing a long-term dividend payment policy.
Another great feature is that they typically have great coverage ratios, and still retain a good amount of earnings to invest in new revenue streams to grow the bottom line. In turn, dividend growth indexes should stand a better chance to keep pace with broad market indexes for investors that are still in their accumulation phase. Those that are able to make these key investments in the earlier stages of their life cycle and then reinvest over time will stand to benefit from a significant yield on cost. This could ultimately make for a more robust income stream when the time comes to draw form the investment in retirement.
For late stage planners or new retirees that are just beginning to draw from their nest egg, I recommend a slightly larger allocation to dividend growth than dividend yield to keep pace with inflation and the markets over the next several decades. These allocations should then strategically taper off into high dividend yield if more stability or income is desired.
Balancing your individual income needs with your desire for capital appreciation should be the single largest factor when sizing an allocation to each strategy. Finally, identifying where you are at in your life cycle and how much volatility you feel comfortable assuming should be a secondary consideration when determining the amount of dividend growth versus dividend yield.
A hypothetical mix within a diversified equity sleeve for someone nearing retirement or just entering retirement could be 60% dividend growth versus 40% dividend yield. Conversely, an investor in retirement currently drawing from their portfolio could allocate just 20% dividend growth, while reserving the remaining 80% for dividend yield.
From a strategy perspective, for clients in our Strategic Income portfolio, we are waiting to add additional positions in high-dividend-yield and dividend-growth ETFs during the next pullback greater than the 1%-2% dips we’ve witnessed over the last several months.
Two of our favorite funds for high income include the iShares High Dividend ETF (NYSEARCA:HDV) and the Vanguard High Dividend Yield ETF (NYSEARCA:VYM). For dividend growth, we favor the WisdomTree U.S. Dividend Growth (DGRW) and the Vanguard Dividend Appreciation (NYSEARCA:VIG).
This article is brought to you courtesy of Michael Fabian from FMD Capital Management.