Bonds have been yielding almost nothing for years and stocks have been rip roaring for the past decade, which has made high yielding dividend stocks very attractive. People have been looking for high-yield and high-growth investments for years, and dividend stocks have delivered. Would you rather earn 2% per year investing in U.S. treasury bonds, or 4% in dividend stocks, while also getting double digit growth year-after-year? As money has rushed into dividend stocks for years making them expensive, and as interest rates have been increasing, will dividend stocks continue to grow at a torrid pace? This article discuss the pros and cons of a dividend stock strategy for retirees and some of the best dividend stock ETFs.
Companies have decisions to make with their income. Newer companies will typically reinvest the income back into the company. Many mature companies give their income back to investors in the form of a dividend. This is why dividend paying stocks are typically large and well-established companies. Here in the U.S., companies will typically pay dividends four times a year, while in Europe, they may only pay one or two times a year. Many companies will try to grow their annual dividend each year, and companies that increase their dividend for 25 years in a row are call dividend aristocrats. You have the choice to either reinvest the dividends into more shares of the company (or ETF), or take the dividend in cash. Dividend stock ETFs are investments which hold many dividend paying companies.
High Yield: As interest rates have come down, people have been searching for other ways to supplement income. Higher dividend paying stocks will pay 3 to 4% annually, which is still quite a bit higher than most bonds.
Principal keeps growing: One strategy many people implement is to live off of their dividends and therefore don’t need to touch the principal. For example, take a $500,000 portfolio of dividend stocks which is each yielding 4% per year, or $20,000. You receive the $20,000 of income and this allows your principal continue to grow.
Yearly raise: Many dividend stocks have a goal to raise their dividend each year, and therefore your income should increase. That $20,000 of income that first year, hopefully will be closer to $20,500 the next year. Stock prices may go up or down, but dividends should be more consistent.
Lower volatility: Dividend stocks are certainly going to be more risky than bonds, but they are typically less risky than non-dividend paying stocks. As I mentioned before, dividend stocks are typically larger companies with steady cash flow. As a result, dividend paying stocks tend to be less volatile and typically will do better in a market downturn.
Market: The biggest risk with dividend stocks is market risk. I mentioned that many people implement the strategy to live on the dividends and not touch the principal. That is fine, until the principal drops by 20% and you are potentially dealing with huge losses. Dividend stocks tend to be less volatile than the stock market, but there is still risk.
Potential Dividend Cuts: Dividends are certainly not guaranteed and unfortunately, companies can cut their dividend at just the wrong time. For example, in 2008 during the recession, many companies reduced or eliminated their dividend when stock prices were plunging. At that point, you have to decide to keep a lower dividend, or sell it and take a potential big loss on the position.
Diversification Risks: One of the biggest drawbacks of only investing in higher dividend paying companies, is that you are limited in which stocks you can pick. For example, many financial,energy, and utility companies pay a high dividend, but very few tech and growth companies pay a high dividend. Therefore, dividend strategies are skewed towards certain high dividend sectors, while completely forgetting other sectors.
Dividend Stock ETF Options
Comparing three of the larger dividend stock ETFs
|iShares Select Dividend ETF||DVY||0.39%||16.7 B||3.19%|
|Vanguard High Dividend Yield ETF||VYM||0.08%||20.2 B||2.97%|
|SPDR S&P 500 Dividend ETF||SDY||0.35%||15.4 B||2.36%|
Source: Morningstar as of 4.10.18
|Benchmark: S&P 500||-0.1%||15.0%||10.4%||13.2%||9.3%|
Source: Morningstar as of 4.10.18
A quick note, the Sharpe ratio is a measure of the risk-adjusted (standard deviation) performance and the higher the better. The Sortino ratio is the measure of how well an investment performs when the market goes down and like the Sharpe ratio, the higher the better.
|Ticker||Standard Deviation||Sharpe Ratio||Sortino Ratio|
|Benchmark: S&P 500||9.87||1.28||2.42|
Source: Morningstar as of 4.10.18 (5-years)
iShares Select Dividend ETF (DVY): iShares Select Dividend ETF is one of the highest yielding dividend ETF but it also has one of the strangest portfolios. DVY holds over 30% in utility stocks, which is much higher than the other dividend ETFs. Utility stocks tend to have high yields and low volatility. This is the reason DVY has such a high yield and low volatility compared to the other dividend ETFs. Still, having this much concentrated in one sector subjects DVY to risks. Mainly, utilities tend to be very leveraged (have a lot of debt) which makes them very susceptible to rising interest rates. Even with the risks, if you are looking for a high yielding, lower risk investment, it is hard to beat iShares Select Dividend ETF.
Vanguard High Dividend Yield ETF (VYM): As expected, Vanguard has one of the lowest cost dividend ETFs out there. VYM is a very diversified ETF of over 300 dividend stocks, but what makes VYM unique is its technology exposure. Many dividend ETFs have low exposure to the tech sector because technology stocks tend to pay little or no dividends. However, VYMs largest sector holding is actually technology. Still, VYM is very diversified over all sectors, and technology still only represents 17% of the index. Vanguard’s low expenses and great long track record makes the Vanguard High Dividend Yield ETF a very attractive part of a retirement income portfolio.
SPDR S&P 500 Dividend ETF (SDY) – One of the biggest benefits of dividend payers is not just current yield, but also the potential for rising income each year. SDY focuses not only on dividend yield but also dividend growth. SDY requires that its holdings have raised their dividend for at least 20 straight years. This doesn’t mean that the dividend yield is necessarily high, as it is one of the lower yielding Dividend ETF. SDY also has the highest standard deviation of the three ETFs that we are comparing, and will have pretty close to the same amount of risk as the S&P 500 index. The big benefit of SDY is that you are purchasing stocks with a history of increasing dividend payments, which means the income should be consistent, even when market conditions are volatile.
So, should I use dividend ETFs as part of my retirement strategy?
I’ve always been a big fan of dividend stocks as part of a retirement income portfolio. The high income and typically lower volatility, makes dividend stocks a great investment for retirees. Still, I am cautious to allocate too much to dividend stocks, as they are still volatile and the dividend is never guaranteed and can be cut at the worst time. Dividend ETFs are a great way to own dividend stocks as their low cost and diversification helps with a consistent income stream. I do use low cost dividend ETFs as a core part of my retirement income strategy, but they are certainly not without their risks and shouldn’t consist of your full retirement portfolio.
Disclaimer: This article is for education purposes only and does not imply a recommendation to buy or sell any securities. I, or my clients, do not hold any of the previous securities mentioned and do not intend to initiate a new position.