VYM - These 4 High-Quality Dividend ETFs Form The Foundation Of My Portfolio

2023-06-05 09:00:00 ET

Summary

• The author argues that the combination of Schwab US Dividend Equity ETF, iShares Core High Dividend ETF, Vanguard International High Dividend Yield ETF, and Global X MLP & Energy Infrastructure ETF provides a solid foundation for a dividend portfolio.
• These ETFs offer diversification across sectors, geographies, yields, growth rates, and types of companies, while mostly avoiding yield traps and high-risk companies.
• The goal of this strategy is to maximize dividend income and growth, rather than outperforming the S&P 500 in total returns.

About 15% of my investment portfolio is in dividend stock ETFs.

I always find interesting the split among dividend investors between those who are pro -ETF and those who are anti -ETF.

Those in favor of using ETFs say:

• Buying a broad-based index prevents overtrading.
• Since most investors don't beat the index anyway, you might as well get returns equal to the index.
• Investors with limited funds get instant diversification with an ETF.
• Properly analyzing enough stocks to feel confident about even a 20-25 stock diversified portfolio takes more time than many investors have.
• Management fees for many diversified dividend ETFs have fallen to such low levels as to be negligible.

On the other side, those against using ETFs say:

• Buying a broad-based index gives investors no control over stock selection or weighting.
• With a diversified fund, you have to accept the bad performers as well as the good ones.
• Most dividend ETFs, even "high dividend" or "high yield" ones, end up having yields between 2.5% and 4%, despite many of their constituents offering much higher yields.
• Some investors want to have more concentrated portfolios, while ETFs tend to have dozens, hundreds, or thousands of holdings.
• Management fees, while typically small, do add up and incrementally eat into long-term returns.

As for me, I don't see ETFs as an either/or but a both/and. Even for most stock-pickers, I think it's a good idea to have 10-50% of your portfolio invested in diversified ETFs, depending on your risk tolerance and time available to research companies. That's as true for dividend investors as anyone else.

In my estimation, the for/against ETF debate is more about personality differences and personal preferences than aptness of achieving one's investing goals.

In what follows, I'll go through the four dividend ETFs that make up the foundation of my dividend growth portfolio and talk about how they collectively work together to provide a stable bedrock of diversification, moderately high yield, and steady dividend growth.

The Four Horsemen of Dividends

Here are the four dividend ETFs in my portfolio in order of their respective weighting:

• Schwab US Dividend Equity ETF ( SCHD )
• iShares Core High Dividend ETF ( HDV )
• Vanguard International High Dividend Yield ETF ( VYMI )
• Global X MLP & Energy Infrastructure ETF ( MLPX )

In a November 2022 article, I explained " Why SCHD Is A Dividend Growth Investor's Dream ETF ," highlighting its unique blend of quality factors, relatively high yield, and strong dividend growth (12%+ over the last decade).

Candidly, SCHD is so well designed, I think it would be irresponsible of me not to recommend it to dividend growth investors and income investors alike. Of course, each investor should use discretion to discern how much of their portfolio it should be. But it's the gold standard of dividend ETFs, and I think it deserves a place even in the stock-picker's portfolio.

Fellow stock-pickers, think of SCHD as insurance against hubris.

Meanwhile, HDV offers a slightly higher yield in exchange for slower dividend growth, while VYMI offers extensive international exposure (to both developed and emerging markets) and MLPX concentrates on the largest and strongest midstream oil & gas companies.

Appropriately, my two largest dividend ETFs are US-based, which means that earnings and dividend growth doesn't fluctuate with foreign currency exchange. Also, they have extraordinarily low expense ratios that only barely nibble into the returns.

VYMI offers massive diversification across the rest of the planet outside of the US and yields a little more in exchange for a slightly higher (but still quite low) expense ratio.

Lastly, MLPX's 6.6% yield may not be as high as that of many midstream MLPs, but it boasts growth and diversification. Some names, like Williams Companies ( WMB ), Enbridge ( ENB ), and Cheniere Energy ( LNG ) provide the growth while others like Enterprise Products Partners ( EPD ) and Energy Transfer ( ET ) bring up the yield.

Each of these ETFs has negligible exposure to real estate, or none at all, which suits my portfolio quite well since about 40% of my invested dollars are in individual real estate investment trusts ("REITs"). This may sound high, but real estate is my core competency. I believe in concentration when you really know what you're doing.

But when you lack that confidence and conviction, diversification is the better bet, in my view.

The four dividend ETFs above provide just such diversification.

As you can see, the top five sectors based on their weighted average weight in my portfolio, together make up ~74% of the ETFs' collective dollar value. They are:

• Energy: 25.0%
• Healthcare: 14.4%
• Financials: 14.0%
• Industrials: 10.9%
• Technology: 9.6%

I am stricken by energy's weight at 25% across the weighted average of the four ETFs. Perhaps I shouldn't be, since MLPX is 100% energy.

However, over time, energy's share should gradually drop, as I am only adding to my position in SCHD right now. SCHD's energy exposure is the lowest of the four ETFs, so as I accumulate more SCHD shares, the overall energy weighting should go down.

Total Returns -- Do They Matter?

I hesitate to bring up total returns, because to me and many other dividend growth investors, they really don't matter. The goal for many dividend investors to create a dividend income stream large enough to live off of without needing to sell shares, so do total returns really matter?

Well, negative total returns over a long time period are certainly a red flag. They can indicate that the constituent holdings have poor fundamental performance as well as poor stock price performance.

Fortunately, each of my four ETFs has put up positive total returns over the last five years, which of course includes COVID-19.

On a weighted average basis, these four ETFs have generated a 5-year total return of 50.8%, compared to the S&P 500's ( SPY ) 70.3%.

On an average annual basis, that's 10.2% for the weighted average of the four dividend ETFs and 14.1% for the SPY.

Of course, my goal as a dividend growth investor is to generate maximum dividend income and dividend growth, not to beat the SPY in total returns. For those whose goal it is to beat the SPY, dividend strategies may not be the most suitable to attain that goal.

Why? Because for over a decade now, the SPY's surge in price has been fueled primarily by the huge outperformance of a small group of names, mostly in tech, most of which pay little to no dividends.

Unless the breadth of market performance widens out in the future, dividend investors on the hunt for ETFs to match the total return performance of the SPY should therefore look to dividend ETFs with most or a plurality of their holdings in tech names. Two examples would be:

• First Trust NASDAQ Technology Dividend ETF ( TDIV )
• Siren DIVCON Leaders Dividend ETF ( LEAD )

Anything given the label "high yield" or "high dividend," though, has been slapped with that label for one of two (or both) reasons:

• The stock pays out most of its earnings as dividends, leaving little retained cash for reinvestment and therefore less earnings growth.
• The market has pushed the stock price and valuation lower, reflecting a perception of lower growth prospects.

The market is not always right, which is why stock-pickers find it worthwhile to hunt for diamonds in the rough. But, generally speaking, when either of the two points above are true of a stock, earnings growth and stock price appreciation will underperform the market.

Hence we find, for instance, that the Vanguard High Dividend Yield ETF ( VYM ), underperforms the SPY over virtually any multi-year period of time. Here's just the last five years:

The reason one would want to own a dividend ETF like VYM is not the total returns but the combination of dividend yield and dividend growth .

Admittedly, VYM's dividend growth has roughly matched that of the SPY over time...

...but VYM's dividend yield of ~3.2% is slightly over double the SPY's ~1.5%.

I think the combination of the four dividend ETFs I've discussed above (SCHD, HDV, VYMI, and MLPX) work much better for the combination of yield and dividend growth that I and other dividend investors want. That's why I don't own VYM.

It's not that VYM is a bad dividend ETF. It's just mediocre -- in terms of total returns, yield, and dividend growth. It doesn't excel in any of those categories.

Bottom Line

I would argue that the combination of SCHD, HDV, VYMI, and MLPX, weighted in that order, provides a solid foundation for a dividend portfolio. It provides diversification across sectors, geographies, yields, growth rates, and types of companies while mostly avoiding yield traps and high-risk companies.

If international stocks (and their respective currencies) start to outperform the US, then VYMI gives one exposure to that outperformance. Otherwise, the heavier emphasis on US-based companies keeps the dividend income stream stable and growing.

Admittedly, the combination of these four ETFs hasn't outperformed the SPY in the past and probably won't in the future. But who cares? If the goal is maximal dividend income and growth, then these four ETFs, taken together, are a much better option than the SPY.

That's why I chose them and weighted them as I did.

But I am always open to learning and adjusting my strategy as new information becomes available. If you believe other dividend ETFs are better options than these four, let me know!

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