VYM - Dividend Investing Made Easy: Building Wealth With ETFs

2023-03-23 08:00:00 ET

Summary

• After a number of requests, I decided to write an article covering an easy-to-manage dividend portfolio able to outperform the market on a risk/adjusted basis.
• The portfolio is based on dividend growth, high yield, growth, and government bonds, providing a basis for high total returns and subdued volatility.
• While multiple paths lead to Rome, I believe that this portfolio is suitable for a wide range of investors looking to build wealth with a subdued risk profile.

Introduction

One of the reasons why I enjoy investing so much is that portfolio management is basically working on a fascinating puzzle. Every piece (company) is unique, which means we can build portfolios that perfectly suit our needs. Hence, in the past few months, we have discussed a wide number of portfolio strategies and the theories behind effective diversification methods. Last week, I wrote an article focused on an all-weather dividend ETF portfolio, which included dividend growth stocks, aggregate bonds, high-yield investments, real estate, and gold. That article triggered a number of discussions I had with readers. Especially investors who just got into investing and are interested in ETFs, as it reduces risks tremendously. Hence, my Twitter and Seeking Alpha inboxes were filled with special requests to construct portfolios that would suit their needs.

That's what this article is for. I worked on a model ETF portfolio that truly has it all.

• A decent dividend yield.
• Consistent dividend growth.
• Low volatility.
• High (expected) capital gains.
• A market-beating risk/reward.

I believe that the portfolio I'm about to show you is not only perfect for starters but also for experienced investors who want to manage a low-maintenance portfolio that still allows them to reach their financial goals.

So, let's get to it!

ETFs Are Boring, But So Useful

Depending on your expertise and/or financial goals, ETFs can be perfect financial tools to get the job done.

I don't own any ETFs. I am a big fan of doing the work myself instead of paying an asset manager to do it for me. Also, given my job, it would be a bit weird if I didn't pick my own stocks. That said, I'm also very skeptical of the power major asset managers hold over companies, given that the big guys like Vanguard hold massive positions in major stock-listed companies. While they are passive holdings, they can (technically) use proxy battles to (indirectly) gain influence.

That said, there are too many good reasons to ignore ETFs. The biggest reason is that ETFs allow millions of investors to passively invest their money. It keeps them from encountering single-stock and related risks and allows them to focus on what they are good at (their jobs), to make even more money for passive investing. In other words, excel at your job and let passive ETFs do the accumulation.

Actually, minutes before I started writing this article, I had a somewhat fierce discussion with someone who completely nuked his portfolio with ultra-high-yielding investments. Most of them had cut their dividends, leaving him with a deep negative total return after years of investing.

Based on this context, there are a number of things to keep in mind. After all, buying ETFs still comes with picking the right one.

As I wrote in my prior ETF-focused article, there are four major things to keep in mind when buying ETFs.

1. Asset allocation : Determine the asset classes you want to invest in and the percentage of your portfolio that should be allocated to each asset class. This one is the trickiest and the reason why I like writing articles like the one you're currently reading.

2. Risk tolerance : Understand your risk tolerance and construct a portfolio that aligns with it. This sounds easy, but it's very tough. One reason is that most (inexperienced) investors underestimate risks. They buy assets they don't fully understand and do not know what to do when the market turns against them. In 2020 and 2021, for example, investors went overweight in growth stocks. A lot of these picks fell more than 70% in the decline that followed.

3. Cost : Choose ETFs with low expense ratios to minimize costs and maximize returns. Expense ratios are often underestimated. While most major ETFs have low expense ratios, some smaller ETFs come with expense ratios of up to 1%. That adds up over time.

4. Liquidity : Choose ETFs that have sufficient liquidity, so you can easily buy and sell them in the market without incurring significant bid-ask spreads. This issue isn't extremely important when managing your personal portfolio. However, major funds need to take this into account. The reason why I still kept it in is that I don't want people to buy ETFs with low liquidity. Often there's a reason why liquidity is low.

Needless to say, multiple paths lead to Rome. There are many ways to build a good portfolio. Even the ETFs I'm using in this article can be replaced by other ETFs with slightly different holdings. So, please take everything with a grain of salt. I always want to make this a learning experience for everyone, even if you're not interested in ETFs.

With that said, let's dive into the portfolio.

The Diversified Dividend (Growth) Portfolio

Buying the perfect mix between growth and safety.

** Before we begin, it's crucial to note that in this article, I have used the VYM ETF as a representation of high-yield dividend stocks. However, I personally favor the Schwab U.S. Dividend Equity ETF ( SCHD ), which has a higher long-term dividend growth rate and yield. Unfortunately, since the SCHD ETF is relatively new to the market, I had to use an ETF that allowed me to conduct a more extended backtest. Therefore, please keep this in mind while reading this article. I discussed the benefits of SCHD in these two articles ( here and here ). **

As I'm all about dividends, I wanted to construct a portfolio around dividend ETFs. I wanted to create a portfolio that comes with both income growth and income. This way, the portfolio is suitable for a very wide range of investors.

This is the final portfolio I came up with:

• Average dividend yield: 2.2%

As you can see, I went with an 80/20 mix between stocks and bonds. 30% are dividend-paying stocks. Half of that exposure is focused on dividend growth. The other half is aimed at providing income. I added long-term (duration) government bonds, as they add safety and yield.

Now, with that said, I spent many hours playing with different compositions. My initial goal wasn't to include all of these ETFs. As you can see below, I experimented with a number of portfolios. Please click on the image to enlarge it, as there's quite a lot of data to digest. Note that I included the Vanguard 500 Index twice, as I used two different data sets (it's two combined screenshots). Also, the VIG/QQQ/TLT portfolio is included twice. Again, because I copied and pasted two tests.

What you're looking at above is a breakdown of four versions of the final portfolio you just saw.

• A 70/30 portfolio consisting of dividend growth and long-term bonds.
• A three-ETF version excluding high-yield dividend stocks.
• A 50/50 portfolio consisting of technology and dividend growth.
• The winning four-ETF portfolio.

We can backtest these ETFs going back to January 2007. While I had preferred to backtest it multiple decades, we do have a sample that includes the Great Financial Crisis, the commodity-backed rebound until 2011, the low-inflation period that followed until 2021, a brief commodity/industrial recession in 2015, trade wars, a pandemic, and the QE-fueled recovery until 2022. In other words, we have plenty of data to work with.

That said, the best risk-adjusted returns (Sharpe Ratio) were generated by the portfolio that consisted of VIG (50%), QQQ (25%), and TLT (25%). This portfolio returned 9.6% per year, beating the market by roughly 100 basis points per year. This portfolio came with a standard deviation of 11.3%, which is 430 basis points below the market's standard deviation. That is a fantastic performance with a 91% market correlation. This portfolio has a 1.8% dividend yield.

I believe this portfolio is great. However, some investors want a slightly higher yield, which makes sense. After all, both dividend growth and dividend stocks tend to outperform the market with subdued volatility.

Hence, I added VYM to the mix as a proxy for high-yield stocks (as explained, I prefer SCHD). By adding VYM to the mix (30%), the annual compounding return since 2007 falls from 9.6% to 9.3%. The standard deviation rises from 11.3% to 11.7%. After all, high-yield stocks tend to be more volatile than dividend growers. Yet, the Sharpe Ratio falls to 0.74, indicating that investors do not give up the great mix between risks and potential returns for the sake of 40 basis points of additional yield.

Moreover, income growth is more consistent. After all, when buying bonds, investors aren't buying dividend growth. Government bonds aren't subject to dividend growth, as they are not equities and are not driven by traditional company fundamentals.

Hence, when comparing the VIG/QQQ/TLT portfolio to the VIG/VYM/QQQ/TLT portfolio, we see that the latter comes with more consistent and higher growth.

Investors who bought both portfolios in 2007 with $10,000 (no additional investments) received $916 in dividends in 2022 in the portfolio which includes VYM. That's a 9.2% yield on cost. That's not too bad!

Furthermore, in recent years, the portfolio that includes VYM has begun to outperform the portfolio that excludes it. This trend was observed even prior to the pandemic, as the former started to close the performance gap with the latter. Notably, the portfolio containing VYM also exhibited lower volatility.

Moreover, during major sell-offs, (both) dividend portfolios outperformed the market.

• Great Financial Crisis (-51% S&P 500): VIG/QQQ/TLT (-29%), VIG/VYM/QQQ/TLT (-35%).
• COVID-19 (-20% S&P 500): VIG/QQQ/TLT (-8%), VIG/VYM/QQQ/TLT (-11%).

So, to summarize, we can say that this portfolio (including VYM) has a number of benefits.

• Volatility is limited . This is caused by the inclusion of dividend (growth) stocks and government bonds. Both tend to be less volatile than the market. It helps to stabilize the portfolio, and it lowers the risk of major prolonged drawdowns.
• Income . The portfolio comes with a 2.2% yield. This isn't a high yield, yet it finds a great balance between high (expected) long-term total returns and income. A shift toward income would have caused the risk/reward to become less favorable.
• Growth . By adding the Nasdaq, we add the aspect of growth. While this is also provided by dividend growth stocks, the Nasdaq comes with faster price appreciation in times of falling rates and inflation. This balances the portfolio.
• Outperformance potential . While past performance is not a guarantee of future results, this portfolio has the potential to outperform the broader market on a risk-adjusted basis. The inclusion of dividend-paying stocks and bonds can help reduce volatility while still offering the potential for growth.
• Survivor bias . While backtesting single-stock portfolios comes with survivor biases, we're now dealing with diversified ETFs. Hence, this risk is reduced tremendously.

However, there are also some cons.

• Overlap . Both VYM and VIG focus on dividend-paying stocks. While that is the purpose of including both, it does not necessarily boost diversification a lot.
• Concentration . QQQ is highly concentrated in the tech industry. Its top-5 holdings have close to 40% exposure.
• USA-heavy . The entire portfolio is focused on the US. While I like that strategy and apply it to my own portfolio, it does mean that the portfolio could underperform emerging markets in certain economic environments.

Closing Remarks

The tricky thing when discussing portfolio ideas is that I don't know the personal situation of my readers. Hence, I try to give readers a wide variety of strategies and the ideas behind them to give everyone the opportunity to find something that suits their goals.

I have to say that this article has become one of my favorites this year, as I believe that I am presenting a portfolio that suits a huge range of investors. It's suitable for starting investors looking to build wealth and seasoned investors looking to protect their money. While there are certainly safer investments, this portfolio comes with a terrific risk/reward based on subdued volatility and an expected total return that has a high likelihood of beating the market on a prolonged basis - thanks to downside protection.

It also comes with a decent yield and consistent dividend growth.

Therefore, if you are seeking conservative investment options without compromising on high total returns, I believe that this portfolio is suitable for you.

Please let me know what you think of this portfolio in the comment section down below!

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