Welcome to the fifth chapter in a successful series where we explore the question: Do Retirees Need a Dividend ETF or a Portfolio of Individual Stocks? Let's start by summarizing what we learned. First, no true Dividend Growth ETF currently exists, which exclusively tracks Dividend Champions, Contenders and Challengers and provides consistent dividend distribution. In order for such an ETF to exist the first step would be the creation of a Dividend Growth Index. Many have suggested that the "chowder rule" serve as the foundation for such an Index. The "chowder rule" named after a Seeking Alpha contributor, requires that a stock have a combination of yield and a 5-year Dividend Growth rate of 12% or 8% for higher-yielding but slower dividend growers like utilities, MLPs, REITs and telcom.There was considerable discussion as to position weight. Some favored equal weight while others favored higher weight for Champions and progressively lower weights for Contenders and even lower weights for Challengers. While I suspect the industry will create such an Index sometime in the future I don't suspect such an action anytime soon.
What this will mean is that 401Ks will continue to offer few if any choices for investors favoring the Dividend Growth model. It would be interesting to learn what percentage of company plans even offer their employees the option of ETF or Index Funds. Clearly a mandated requirement that 401Ks and 529 Plans offer ETF and Index Funds would be an important step forward. Again I don't expect such a requirement any time soon.
What about options for retired investors favoring a Dividend Growth investment approach concerned about their investments should they or their spouse be unable to managed their portfolios?
Some spoke of a willingness to pay for the management of their portfolio in accordance with the guidelines spelled out in their portfolio business plan but cited the lack of portfolio managers who had a real understanding of the Dividend Growth Investment Model.
In the discussions that followed we learned of a new managed portfolio offered by Morningstar to subscribers of Josh Peter's Dividend Investor newsletter. With fees of just .55% and a yield of more than 4% on the surface this appears to be an option that invites a closer look.
Last time around we met "Buy and Hold" investor Dave and his friend Bob. Bob had helped set up a portfolio for Dave in January of 2008 based on Dividend Champions that yielded over 2% and met the requirement of the "chowder rule." This metric requires that stocks only be selected when yield plus dividend growth equals 12 percent for most stocks and 8 percent for utilities including telecom, MLPs and REITs. Thirty-two holdings were purchased with $10,000 each. We learned that even with huge losses in two of his positions, Bank of America - BAC and General Electric - GE, his investment as of September 12, of this year would be valued at $464,734 vs. $366,960 if held in the S&P 500.
Let's change the scenario just a bit. On New Year's Eve 2008, Dave and Bob have a conversation about his retirement investments. Dave tells Bob that he's happy because the monthly dividend payments have continued to be deposited into his account each month in spite of what's been happening in the market. Bob had just taken a closer look at Dave's portfolio and shares what he learned with Dave. The first thing he discovered is that Dave's portfolio dividend growth has been just over 12%. He also learned that only one stock in the portfolio, Bank of America, had cut its dividend. The cut, which had occurred in October, reduced the dividend income by 50%. Dave decided to sell Bank of America and purchase Century Link, which now qualified under the "chowder rule" with a yield of 8.23%.
Dave had learned an important lesson his first year of investing. Buy and monitor is a better approach than pure Buy and Hold. He decided to make a habit of downloading a copy of the Dividend Champions when they are released the first of each month and noticed if any of his positions had cut their dividend. If so he would sell and purchase another stock that qualifies under the "chowder rule."
By expanding on these scenarios, a custom ETF of sorts could be constructed in accordance with what I am calling the Dividend Growth Income Index. The Dividend Growth Income Index constructed and maintained by Dividend Growth contributors of Seeking Alpha, targets companies that are currently members of the S&P 500®, have increased dividend payments each year for at least 5 years, and meet certain market capitalization and liquidity requirements. The index contains a minimum of 50 stocks, which are equally weighted, and yield a minimum of 2.7% at the time of purchase. The 5-year Dividend Growth Rate for the portfolio shall equal 10% or more at all times. Any holding announcing a dividend cut shall be removed from the index. The index is rebalanced each January, April, July and October, with an annual reconstitution during the January rebalance.
Let's see how this might play out by selecting appropriate Dividend Champions Contenders and Challengers (CCC) that meet the "chowder rule" matrix. This month's list of CCCS shows a total of 469, 298 of these stocks yield 2% or more. Next I eliminated banks since I prefer not to invest in them reducing the number to 253. After applying the "chowder rule" 207 stocks remain.
Many performing this exercise would chose not to invest in MLPs due to the extra paperwork at tax time. This action if taken would reduce the number to 165. Those favoring the Index I described earlier would require higher yield and would reduce accordingly. Still others would only select those stocks currently fairly or undervalued. The point is since you are building your own customized ETF you control how your positions are selected and weighted.
Once established your "ETF" can be monitored with ease.
Monthly - Download a fresh copy of the CCC lists the first of the month. Check for any stocks removed due to Dividend cuts or freezes. Sell and redeploy using Fast-graphs or Morningstar to establish value.
Annually - Rebalance portfolio by removing stocks that no longer qualify under the "chowder rule" or no longer yield 2%. Replace with newly qualified stocks from the CCCs.
Here's how I managed the exercise: First since I have decided to follow the Dividend Growth Income Index, I further eliminated stocks yielding less than 2.7%. That left me with 98 stocks - 19 Champions, 44 Contenders and 35 Challengers. These stocks at an equal weight portfolio would have a yield of 4.01% at cost on 10/7. The average 5-year Dividend Growth rate for this portfolio is over 12%. The estimated 5-year earnings growth for the portfolio is 6.8%.
There are 33 MLPs among the CCCs and each qualifies under the "chowder rule." Those willing to accept addition tax complexities may wish to consider MLPs and expand their ETF to include such holdings since they are likely to increase overall yield.
I hope you enjoyed your first look at the Dividend Growth Income Index. Now it's time for your comments, suggestions and questions.