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In Part One of this series we began our examination of whether a Dividend ETF like Vanguard's VYM would make a suitable investment vehicle for those who are retired in the Distribution Phase of Investment. While the ETF holds over 380 dividend paying stocks, nearly 70% invested in the top 40. Roughly 6% is invested in Exxon Mobile alone. In 2008, VYM suffered losses in capital of over 32%, nearly equal to those of the S&P 500 Index. Another concern for those in the distribution phase of investing has been inconsistency in the income from dividends distributed by VYM on a quarterly basis. Such inconsistency while not necessarily problematic for investors in the accumulation phase of investing is more likely to be a concern for seniors looking for a more reliable and consistent flow of income.

As an investor in, or about to enter, the Distribution stage there are two basic approaches you can choose for drawing income from your portfolio: The traditional approach is to withdraw 4% of your capital plus there is an additional withdraw of capital made each year equal to the rate of inflation. With this approach the focus remains on a gain in investment capital to support withdraws lasting the lifetime of the investor. Investors favoring ETFs like VYM will make capital withdraws including the sale of shares on a quarterly or yearly basis. If inflation is projected at 3%, investors need to to withdraw 4% from their accounts over and above the dividends received.

A second approach would be to establish a Dividend Growth Distribution Portfolio for the equity portion of your total portfolio. Ideally the portfolio would be comprised of equal weight Dividend Champions, Challengers and Contenders with a portfolio yield at the time of purchase or time of distribution equal to 4-5%. Dividend Champions, Challengers and Contenders are used exclusively by risk-averse investors due to their record of sustained dividend payments during down markets like 2008. Equities selected should be those with recent dividend growth exceeding inflation by 2% or more. Under this approach necessary retirement income of 7% is obtained exclusively by dividends and dividend growth. The biggest risk under this approach is due to any cuts in the dividends received. Many investors preferring this approach have 50 or more equal weight positions, reducing the effect of any cuts.

There remains the question of performance. How does VYM stack up against the S&P 500 Index (SPY) and typical Dividend Growth Distribution Portfolios.

ETF

2008

2009

2010

2011

2012

VYN

-32.10

17.17

14.22

10.54

12.69

SPY

-36.81

26.37

15.06

1.89

15.99

The five-year average return for the VYM is 8.80 vs. 8.29 for the S&P 500 index. Of the two VYM would appear to be the better choice for a distribution portfolio particularly since its yield is roughly 1% higher.

Let's see how it does against two typical Dividend Growth portfolios by two Seeking Alpha contributors: chowder and Jeff Paul. Both have their portfolios posted here and here. Let's see how they back tested for the same five-year period.

2008

2009

2010

2011

2012

VYN

-32.10

17.17

14.22

10.54

12.69

SPY

-36.81

26.37

15.06

1.89

15.99

chowder

-15.10

18.9

15.15

13.85

8.73

J.Paul

-18.50

28.5

20.20

11.15

10.23

The five-year average for each portfolio is as follows:

Jeff Paul - 10.23%

VYM - 8.80%

Chowder - 8.73%

SPY - 8.29%

What really stands out when you look at the last chart is how well the Dividend Champions, Challengers and Contenders held up in 2008. Unfortunately VYM doesn't go back to 2002 to capture performance during another bear market but let's see how chowder and Jeff did against SPY in that year.

Jeff Paul - 3.4%

Chowder- 8.2%

SPY - 21.59%

Finally let's put it all together and see the average performance for each from the 11 years 2002 - 2012. This period was selected in order to contain performance during two bear markets.

Chowder - 12.49%

Jeff Paul - 11.64%

SPY - 5.96%

It is important to note that each of the stocks represented in Jeff's and chowder's portfolios maintained sustained and growing dividend distribution for the entire period. If purchased today each would have a total yield of over 4% and 5-year histories of dividend growth more than twice the rate of inflation. Were chowder and Jeff Paul just lucky with the stocks in their portfolios? A recent article by contributor Eli Inkrot suggests not. He looked at the performance history of the current 102 Dividend Champions each with 25 years or more sustained dividends and dividend growth. What he found was looking back 15 years, 94 of the 102 stocks that make up the Champions beat the S&P 500 Index.

In Part Three of our study we will use the current VYM holdings to construct a 35-stock Dividend Growth Distribution Portfolio. We will be selecting the first 35 that hold the distinction of being Dividend Champions, Challengers and Contenders. We will then give each equal weight and back test performance for the same period of 2002-2012. Should be interesting so stay tuned.

Now let's hear from you.

Source: Do Retirees Need A Dividend ETF Or A Portfolio Of Individual Stocks - Part Two