The Dividend Dilemma

I recently saw a quote come across in social media that went something like "If your only source of income is a paycheck, you are one step away from being broke."  Certainly, the pandemic and recession last year, causing so many people to join the ranks of the unemployed and now dependent on government payments (unemployment benefits, stimulus checks), was and still is a stark reminder of this.  I have written about the benefits of passive income for a while and one component of passive income is having a portfolio of dividend paying stocks.  For today's post, I set out to answer the question:  "If you wanted to keep things simple and get reliable dividend income, what is the one thing (presumably an ETF) that you would invest in for the long haul?"  While doing the research, I came up with a few good ideas that I will share below.  

I also came across an article on Seeking Alpha that I shared on my Twitter feed called "Confessions of a Recovering Income Investor" that highlighted the tax burden associated with dividend income (even qualified dividends, although taxed at a lower rate, are still taxed).  If your strategy is to use the dividends to buy more stocks and grow the portfolio (or if you plan on spending the money you earn), you quickly learn that when it's time to pay the tax bill, you may not have the money!  This forces you to set aside some portion of your income for the tax man, cutting into the benefit of having the passive income.  As such, sometimes it may make sense to forego some dividends for higher growth stocks that pay a lower yield to get the best, long term and most tax efficient returns (majority of tax paid when you sell).  That would be a contrarian move in today's market that is running away from growth / tech stocks toward cyclicals like industrial and financial stocks - buy FAANG on the dip?  

Anyway, back to the focus of today's post.  Some key considerations for a dividend ETF are 1) the yield, 2) the expense ratio (it's very important for this to be as low as possible, especially if you are looking at a long term hold) 3) the relative risk and level of diversification (for example if the fund is invested 50% in energy and that sector crashes, so does your investment in the ETF - if you have "diamond hands" that's not a problem, but the temptation to sell will be strong if / when that happens) and 4) the types of stocks that are included in the top holdings and how those relate to your macro views and personal preferences.  While there are many international dividend ETF's and many that pay high yields, the expense ratios are high and I focused more on US ETF's for this research.  As Warren Buffett says "Don't bet against the US." 

Here are a few of the ETF's that seemed to rise to the top of the lists after a survey of Motley Fool, The Street, ETF.com, Nerd Wallet and Investors' Business Daily:

• Vanguard High Dividend Yield Index ETF (VYM) - expense ratio 0.06%, yield 3.09%; The Fund seeks to track the performance of a benchmark index that measures the investment return of common stocks of companies that are characterized by high dividend yield. The Fund attempts to replicate the FTSE High Dividend Yield Index by investing substantially all of its assets in the stocks that make up the Index.

• iShares Core Dividend Growth ETF (DGRO) - expense ratio 0.08%, yield 2.26%; The Fund seeks to track the investment results of an index composed of U.S. equities with a history of consistently growing dividends. The Underlying Index may include large-, mid- or small-capitalization companies, and components primarily include consumer staples, industrials and information technology companies.

• Schwab US Dividend Equity ETF (SCHD) - expense ratio 0.06%, yield 3.09%; The Fund seeks to track the total return of the Dow Jones U.S. Dividend 100 Index. The Index is designed to measure the stock performance of high dividend yielding U.S. companies with a record of consistently paying dividends, selected for fundamental strength relative to their peers, based on financial ratios.

• SPDR Portfolio S&P 500 High Dividend ETF (SPYD) - expense ratio 0.07%, yield 4.74%; The Fund seeks to provide investment results that correspond generally to the total return performance of S&P 500 High Dividend Index. The Fund invests at least 80% of its assets in the securities comprising the Index, designed to measure the performance of 80 high dividend-yielding companies within the S&P 500 Index.

• Vanguard Dividend Appreciation ETF (VIG) - expense ratio 0.06%, yield 1.63%; The Fund seeks to track the performance of a benchmark index that measures the investment return of common stocks of companies that have a record of increasing dividends over time. The Fund attempts to replicate the Nasdaq US Dividend Achievers Select Index by investing its assets in the stocks that make up the Index.

Of these five, the Schwab fund looks like it has a lot of recent inflows and overall good current and long term return, low expenses and a reasonable risk profile.  It is also well situated for the "reflation trade" since its two largest sector holdings are financials and industrials - 44% of the portfolio.  My only concerns about this fund are 1)  concentration in financials (26% of portfolio), 2) largest holdings include Exxon (5%) and Altria (4%) - Exxon while doing well recently with the spike in oil prices is in secular decline, owning Altria is an issue if you don't like big tobacco and both stocks are not favored by the ESG crowd.  If you can get past those issues, this is a pretty good ETF to own right now and for the long term but be prepared when there is a rotation out of cyclicals into growth again as the share value could take a big hit.  

If you are looking for a bit more diversity, the Vanguard Dividend Appreciation ETF looks better, although the yield is not as good, but expenses are low; the low yield should be offset by dividend and share price growth upside - top holdings include Microsoft, Walmart, Johnson & Johnson, Proctor & Gamble, United Health Group, Walt Disney, Home Depot, Visa, Comcast and Abbott Labs.  I actually like this one better for tax efficiency, diversification and growth potential.  

The Vanguard High Dividend Yield Index ETF lands somewhere in the middle with a similar yield and expense ratio to the Schwab fund, but more exposure to financials; top holdings include:  Johnson & Johnson, JPMorgan Chase, Proctor & Gamble, Bank of America, Intel, Verizon, Comcast, AT&T, Pfizer and Walmart.

In conclusion, as with most ETF's, there are many to choose from but for long term dividend investors choosing one dividend ETF can be a simple, diversified solution to create passive income.

I hope you find this post useful as you chart your personal financial course and Build a Financial Fortress in 2021.  To see all my books on investing and leadership, click here. 

Stay safe, healthy and positive.