Summary
- I am a habitual self indexer, using different value metrics and cloning strategies to build parts of my portfolio.
- I have all together avoided ETFs for the past 3 years, only indexing myself rather than buying ETFs.
- After arguing the virtues of self-indexing with members on a popular SCHD article, after charting and reviewing performance and cost, I am now using this as my "capital gains capture".
The virtues of dividend investing
Sublimation of hubris can be cathartic.
Index funds are a topic that I often come to loggerheads over when discussing it with other friends and investors on Seeking Alpha. In my earlier days of investing, I was almost 100% in VOO , SPY and DIA . All of those investments have done well, have lots of unrealized gains that I do not intend to realize, and are excellent, logical investments. My biggest regret was putting so much into DIA. Not only is State Street's ( STT ) DJIA fund the easiest to replicate, but it is also one of the highest expense ratios at .16%. Personally matching that has been easy, I buy all 30 stocks over and over in a price-weighted manner the same way the index is put together. Benjamin Graham originally recommended using the DOW 30 as your index fund when index funds weren't a thing.
For half of my portfolio I had gone on a cloning spree, buying this and that index personally rather than handing the keys to an ETF driver. While I still do this, I have begun to use a new ETF as a capital gains capture mechanism. That ETF would be SCHD . I would like to thank the community here for turning me on to it. The performance is amazing and combines the best of growth and dividends to outperform the market. Let's explore its virtues to see why this fund shows that for the majority of stocks, making sure they have a dividend yield and an increasing one is important for buy and hold investors over time.
Capital gains capture
When I say that I have gotten over my hubris, this hubris was solely based on easily being able to match the DJIA. With the DJIA virtually matching the S&P 500 over long periods, I no longer saw a reason to buy VOO, SPY, or DIA at all. I could also control my fund flows, going into beaten-down stocks first and buying current market favorites last as my dollar cost averaged. However, it does seem that SCHD over 10 years on a total return basis has been able to trump them all. I would gladly recommend it as the index fund of choice and now use it as my capital gains capture.
When I say capital gains capture, I mean moving excessive gains from my single holdings into SCHD to hold for the long run. I'm not the sort to double down and take my winnings to try to roll into another winning bet. I like to take my winnings and secure them in a vehicle or store of value that I can let marinate on the sidelines into eternity. Last year I would self index those winnings into the DJIA, but it presented one issue in that a lot of my capital gains could not buy a full round of all 30 DJIA stocks which left the money slightly un-diversified. Now by using SCHD, I not only capture those gains but often increase my yields as many beaten-down dividend stocks I bought may now have a lower yield than SCHD after an ascension.
The other usage is to capture dividends of companies I no longer consider a value but intend to hold indefinitely due to the high quality of the company itself. One example would be my largest position, Exxon ( XOM ). I bought quite a bit when the yield was near 10%, now it's down to 3.05% as the price moved upwards. Using an individual share strategy to sell only the shares that I dripped into at a very high-cost basis, I moved that capital into SCHD at the end of the year, virtually avoiding any capital gains and diversifying some of my position. This also increased my dividend yield as SCHD is slightly higher at 3.32%
My favorite self indexing strategies
In addition to dollar cost averaging the DJIA, I also love to index Joel Greenblatt's magic formula. This is a screener based on a score-based system where the stock market is ranked on an earnings yield plus ROIC score system. The yield percentage is added to the ROIC percentage to get an overall score, the higher the better. An example would be a company with a P/E of 15 that would have an earnings yield of 6.6%, if it also had an ROIC of 10% then the overall score would be 16.6. You can set the screener at different market cap levels to determine the volatility you can endure. The screener starts at micro caps as low as $50 million in value.
A lot of gains I end up with are also a result of using this screener. The earnings yield plus ROIC are meant to give the investor a breadth of stocks that are both "good" and "cheap". This is another area where I have been taking gains from Magic Formula stocks I don't intend to hold forever and bought as an index strategy rather than a top-down analysis strategy, moving those into SCHD recently as well.
A highly diversified portfolio yielding over 3%
There are not many quality, diversified equity funds out there that can get you a yield of 3% after expenses. This is currently one of them. Here are the top 10 of the funds nearly 100 holdings :
Many of these names I own as single holdings, however I have to admit it would be inefficient to reallocate in a way to maintain a certain dividend yield/target. I would incur lots of capital gains to cycle gainers with decreasing yields to under-performers with larger yields.
Bogleheads live and breathe "FIRE"
As an older millennial, any readers on here in a similar age group probably resonate with the "FIRE" movement. Financial independence retire early is a mantra for many of us and the topic fills the airwaves of our household daily podcast listening. It is also almost exclusively an index and mutual fund movement with little in the way of single stock picking. Although I am part of this movement, I am also a single stock picker and adore financial analysis. The fire movement favorite is the Vanguard Total Stock Market Fund ( VTI ). While it performs well, it still lost to VOO and SCHD has now trumped it by 30% over 10 years.
That's quite a lot. While people on the Mr. Money Mustache forums may point out that the excess dividends will create excessive taxes or what have you, I still believe the fund will win out because of the drip model that helps accelerate the total return. Everyone's tax basis and deductions are different, but since most of these bloggers only buy in tax-advantaged accounts anyways, this should take over as the ETF of choice. I've read all the John Bogle books and love them, but he might even agree to switch to SCHD were he here today. Vanguard has an edge over Schwab in this sense due to the cult following of Bogle by my generation, but that may change in the not-too-distant future.
Compound dividend model
Below are two examples of an ETF model where one yields a 3.3% dividend like SCHD and one yields 1.59% like VOO. First, the SCHD model with a $10000 investment over 10 years with an assumption of an annual 3% dividend increase and an annual 10% appreciation, and a starting 3.3% dividend:
Second, the VOO model with a $10000 investment over 10 years with an assumption of an annual 3% dividend increase and an annual 10% appreciation, and a 1.59% starting dividend:
This is a vacuum where the SCHD manager can match the passive market, which they have more or less been able to do so. The kicker of the much larger dividend results in a quite larger total return as evidenced by the calculators, not taking into account taxes. Accounting for taxes and assuming a 15% qualified dividend tax rate, would result in about $3,300 more in net dividend income. The main bump to the return using DRIP instead of receiving cash payments is being able to buy more shares on DRIP at depressed prices versus the lower-yielding index fund. Dividend power.
Creation and redemption
Being that I mainly invested in index funds for the passive indexing quality that resulted in lower costs, I ignorantly never paid attention to the creation and redemption process and how it differs from a mutual fund.
The best description I have found of the creation redemption process comes from Investopedia :
Tax Implications
We can see these tax implications best by comparing the ETF redemption to that of a mutual fund redemption. When mutual fund investors redeem shares from a fund, all shareholders in the fund are affected by the tax burden.
This is because to redeem the shares, the mutual fund may have to sell the securities that it holds, realizing the capital gain, which is subject to tax. Also, all mutual funds are required to pay out all dividends and capital gains on a yearly basis.
Therefore, even if the portfolio has lost value that is unrealized, there is still a tax liability on the capital gains that had to be realized because of the requirement to pay out dividends and capital gains. ETFs minimize this scenario by paying large redemptions with stock shares. When such redemptions are made, the shares with the lowest cost basis in the trust are given to the redeemer.
This increases the cost basis of the ETF's overall holdings, minimizing its capital gains. It doesn't matter to the redeemer that the shares it receives have the lowest cost basis because the redeemer's tax liability is based on the purchase price that it paid for the ETF shares, not the fund's cost basis.
Redeeming shares to the AP versus selling into the market for the redemption process like a mutual fund does, actually helps to protect the investor against tax implications should a position change. As SCHD is always trying to maintain a certain yield target combined with appreciation, some exchanging of shares is necessary to reallocate positions and buy new ones if necessary. The John Bogle argument against selling and being in passive mutual funds loses steam when you encounter the ETF system.
For those that have caught onto the above for quite some time, please forgive us brainwashed Bogleheads, we are just now getting up to snuff on the new system of ETFs versus mutual fund redemption processes. Yet another hubris evaporated.
Summary
While I don't buy ETFs as a home for my new money going into the market, I have once again begun using this ETF to capture my old money capital gains. The total stock market and S&P 500 index fund buyers would do well to learn about some conservatively managed ETFs that focus on both dividends and appreciation. One particular factor I like would be having the ability to turn off DRIP and live off the dividends all the while seeing my portfolio appreciate in retirement. I don't plan to ever be all in fixed income any more than I would need to satisfy short-term cash requirements. Equities and equity funds of dividend stocks are certainly the way to go in retirement. As Peter Lynch once said, the US Government will never increase your interest payment as a company does with a dividend, and neither would they invite you to the party to include you in their decision-making process.
SCHD is the best ETF I've seen thus far with too many holdings to mimic. The fund is a buy and I hope my FIRE community catches on soon.
For further details see:
SCHD: I Concede, This Dividend ETF Is The King