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Dividend Growth and Asset Allocation have found each other. It's kind of like that Reese's moment when peanut butter and chocolate came together in a wonderful collision and in perfect harmony. In the television commercial that introduced Reese's Peanut Butter Cups, we saw a man walking along the street not paying attention. He has a very large piece of chocolate. He then bumps into a woman who is conveniently not paying attention, and who is even more conveniently carrying a large jar of peanut butter. We know that, because on the side of the jar we see the words written in very large type "Peanut Butter." They bump into each other. He claims that "hey, you got peanut butter on my chocolate." She claims "you got chocolate on my peanut butter." Not sure who won that argument. All we know is that peanut butter and chocolate go together very well.

You can see this very memorable vintage commercial here.

And now defensive asset allocation can go together with the more aggressive and more volatile dividend growth strategy. I'm about to get some dividend growth on my asset allocation. Or is that asset allocation on my peanut butter? And I think it's going to work out pretty sweet. I'd say the equity dividend growth part is the chocolate. It's sweet and gives you lots of energy. The peanut butter's kind of sticky and a little slower moving. The asset allocation component - you're the peanut butter.

As I stated in this article, "Investing and the cost of playing defense," I'm looking to ramp up the equity component and hence long-term gains of "me and the Mrs." retirement portfolios. I made some nice gains of 85% from 2007 to 2011 and I started to play more defense to protect those gains. But the cost of playing defense is reduced returns compared to what the equity markets are offering. Last year, when the markets were delivering 10-14%, our accounts delivered 5%. And most of the gains were from income generated by the holdings. My asset allocation is currently 65% bond ETFs (mostly on the shorter side) and 35% equities, both ETFs (of the higher income variety) plus three individual company holdings.

I'm still the Scaredy Cat Investor, see this article here. But at the same time, I want to participate a wee bit more if the equity markets continue with the central bank fueled "extend and pretend" rally. Given that, my strategy is to reinvest some of our investment income (nearly 5% yield) into equities. And the strategy that many Seeking Alpha writers have sold me on is the Dividend Growth model of investing. There is a very real and incredible compounding magic when your investments pay you every three months, and then give you a nice 10% or more raise every year - year in and year out.

And given that I am going to use income already generated by the account, it feels like playing with the house money. A little emotional trickery if you will.

That said, the portfolio will still offer a very low beta (volatility) while delivering increasing and accelerating returns on the income and capital gains fronts.

The funds will be directed into an ETF or two. One for U.S. companies, and one for Canadian dividend payers. I will use my personal registered retirement account as an example of how this will play out. There is currently $24,400 already in a dividend ETF. It yields 5%. It has a P/E ratio of 14.3. It's a fund with a short history, but it did raise its yield by 10% last year. For the sake of this income projection, I will use an 8% dividend growth rate. Here's what happens if I feed this dividend ETF with $9,000 of annual income (currently being generated by the account). The starting point of this ETF is $1,220 of annual income. The ETF's dividends will also be reinvested in the fund.

Here's 15 years of dividend growth adding $9,000 of investment income into an iShares ETF (XEI on the Toronto Stock Exchange) that has a 5% yield and a dividend growth rate of 8%. Thanks to the charting service at buyupside.com that allows you to track dividend growth with the addition of new monies.

XEI Dividend Income - Initial Fund Value $24,400

Year

Dividends Paid Without Dividend Reinvestment

Portfolio Value Without Dividend Reinvestment

Dividends Paid With Dividend Reinvestment

Portfolio Value With Dividend Reinvestment

1

$1,805

$33,428

$1,805

$35,233

2

$2,476

$42,456

$2,581

$46,842

3

$3,243

$51,484

$3,519

$59,389

4

$4,116

$60,512

$4,654

$73,072

5

$5,109

$69,540

$6,032

$88,131

6

$6,234

$78,568

$7,709

$104,868

7

$7,506

$87,596

$9,760

$123,656

8

$8,942

$96,624

$12,279

$144,963

9

$10,560

$105,652

$15,391

$169,383

10

$12,379

$114,680

$19,259

$197,670

11

$14,422

$123,708

$24,097

$230,795

12

$16,713

$132,736

$30,196

$270,019

13

$19,277

$141,764

$37,945

$316,992

14

$22,145

$150,792

$47,879

$373,899

15

$25,349

$159,820

$60,735

$443,662

Total

$160,277

$283,842

And here's another option, an ETF that's more of a pure Dividend Growth fund - iShares Canadian Dividend Aristocrats Fund (CDZ on the [[TSX]]). The Fund includes companies that have increased ordinary cash dividends for at least 5 consecutive years and have a minimum $300 million market cap. The aristocrats fund, CDZ, has a yield of 3.63% and has raised its dividend an average 12.4% over the last 5 years. That of course is the compound average growth rate or CAGR.

Here's 15 years of dividend growth adding $9,000 of investment income into a fund that has a 3.63% yield and a dividend growth rate of 12.4%.

CDZ Dividend Aristocrats -Initial Fund Value $24,400

Year

Dividends Paid Without Dividend Reinvestment

Portfolio Value Without Dividend Reinvestment

Dividends Paid With Dividend Reinvestment

Portfolio Value With Dividend Reinvestment

1

$1,364

$33,428

$1,364

$34,792

2

$1,947

$42,456

$2,010

$45,830

3

$2,654

$51,484

$2,828

$57,685

4

$3,506

$60,512

$3,865

$70,579

5

$4,529

$69,540

$5,184

$84,791

6

$5,751

$78,568

$6,867

$100,686

7

$7,207

$87,596

$9,027

$118,741

8

$8,936

$96,624

$11,816

$139,585

9

$10,982

$105,652

$15,448

$164,060

10

$13,399

$114,680

$20,223

$193,311

11

$16,246

$123,708

$26,571

$228,911

12

$19,593

$132,736

$35,121

$273,060

13

$23,520

$141,764

$46,801

$328,888

14

$28,120

$150,792

$63,015

$400,931

15

$33,499

$159,820

$85,929

$495,889

Total

$181,251

$336,069

As we can see, they both deliver, well at least in this hypothetical test modeling. The aristocrats take 10 years to pass the income level of the Dividend Income Fund.

Here's what will happen (again hypothetically) if I were to put that $9k into the Dow Jones Industrial Average ETF (NYSEARCA:DIA). As this article outlined, I am currently using the DIA for my U.S. equity allocation. It also offers a yield of 2.8% and modest dividend growth of 6.55%. I will use the same $24,400 starting point.

DIA - Initial Investment $24,400

Year

Dividends Paid Without Dividend Reinvestment

Portfolio Value Without Dividend Reinvestment

Dividends Paid With Dividend Reinvestment

Portfolio Value With Dividend Reinvestment

1

$997

$33,428

$997

$34,425

2

$1,350

$42,456

$1,381

$44,835

3

$1,744

$51,484

$1,824

$55,687

4

$2,184

$60,512

$2,335

$67,050

5

$2,674

$69,540

$2,925

$79,004

6

$3,219

$78,568

$3,607

$91,639

7

$3,824

$87,596

$4,395

$105,061

8

$4,494

$96,624

$5,307

$119,396

9

$5,236

$105,652

$6,365

$134,789

10

$6,056

$114,680

$7,595

$151,411

11

$6,961

$123,708

$9,027

$169,467

12

$7,958

$132,736

$10,701

$189,196

13

$9,056

$141,764

$12,662

$210,886

14

$10,263

$150,792

$14,968

$234,882

15

$11,590

$159,820

$17,688

$261,598

Total

$77,605

$101,778

Obviously, DIA does not work that well as a Dividend Growth proxy. It's likely that I would have some very significant capital gains over 15 years, but I certainly would not be able to rely on the safety of dividend growth. So let's consider a more pure Dividend Growth ETF by design.

I could use the iShares Dividend Aristocrats ETF (CUD on the TSX). It selects companies with a 25-year history of increasing dividends. It offers a current yield of 2% with a dividend CAGR of 9.49%. This fund is essentially the S&P 500 Dividend Aristocrats ETF (NYSEARCA:SDY). For some reason, the Canuck version offers a very small yield. SDY will deliver a yield in the area of 3.2%.

iShares U.S. Dividend Aristocrats Initial Investment $24,400

Year

Dividends Paid Without Dividend Reinvestment

Portfolio Value Without Dividend Reinvestment

Dividends Paid With Dividend Reinvestment

Portfolio Value With Dividend Reinvestment

1

$732

$33,428

$732

$34,160

2

$1,018

$42,456

$1,035

$44,223

3

$1,352

$51,484

$1,398

$54,649

4

$1,739

$60,512

$1,830

$65,508

5

$2,188

$69,540

$2,346

$76,881

6

$2,707

$78,568

$2,960

$88,870

7

$3,305

$87,596

$3,693

$101,591

8

$3,991

$96,624

$4,569

$115,188

9

$4,778

$105,652

$5,618

$129,834

10

$5,679

$114,680

$6,876

$145,739

11

$6,707

$123,708

$8,391

$163,158

12

$7,880

$132,736

$10,222

$182,407

13

$9,214

$141,764

$12,443

$203,878

14

$10,731

$150,792

$15,152

$228,058

15

$12,453

$159,820

$18,474

$255,560

Total

$74,475

$95,740

As you can see, there is some incredible dividend growth magic at work, especially in the higher initial-yielding ETFs. There have been many articles on SA that have demonstrated the importance of a generous initial yield, combined with a "generous enough" dividend growth rate.

CONCLUSION

Asset Allocation (a mix of bonds, equities and cash) can work incredibly well with a Dividend Growth strategy, even with the use of ETFs. For those who are concerned with the state of the economy, sovereign debt, black swans - there is a reasonable and measured method for increasing your equity exposure by dollar cost averaging with existing portfolio income. Income from existing holdings combined with the magic of dividend growth can deliver some pretty sweet income and capital gains.

The one problem with the above strategy and the use of ETFs is that the fees will eventually become quite considerable. The total portfolio values listed above do not include capital gains (yes it gets even better). Embedded ETF fees even by year 10 could reach $1200 a year, or more. There will be a time to switch out of ETFs and into individual stocks. Also, I may consider removing the currency hedge of my U.S. holdings and hope that the dividend growth can outpace the decline of the U.S. dollar against the Canuck bucks.

OK, now just like the ending to the Reese's peanut butter cups commercial linked to above - everybody dance.

Source: Dividend Growth And Asset Allocation - Together At Last