Retirement: Dividend Yield vs. Dividend Growth [iShares Trust, Vanguard High Dividend Yield ETF]

retirement 401KMichael Fabian: There are many schools of thought when it comes to constructing a portfolio of dividend paying equities, but one topic of debate is whether investors should focus more on total return or dividend yield in retirement.

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.

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