Can The Balanced Portfolio Do The Job Of Dividend Growth?

Includes: AGG, LQD, VIG, VYM
by: Dale Roberts

Some investors want it all. Count me in. We want the income in our portfolio to be growing consistently and hopefully well above inflation. We also want lower volatility. We no longer want to see the portfolio value swinging wildly on a weekly or monthly basis.

We want income growth. We want low volatility. Is that possible?

The classic balanced portfolio consists of a mix of stocks and bonds. Typically, an investor of the balanced variety will hold a mix of 60% stocks and 40% bonds. For the purposes of this article, I've gone with a 50/50 split between two dividend or dividend growth ETFs and two bond funds. In this corner representing the stocks, we have the ever popular Dividend Appreciation Fund (NYSEARCA:VIG) from Vanguard. It's tag team partner also wears the Vanguard colours, the Vanguard High Dividend Yield ETF (NYSEARCA:VYM). VIG tracks the Dividend Achievers Select Index. It's a dividend growth ETF that only includes companies that have raised their dividends every year for an extended period. It also includes various quality filters that screen for company value. VYM as per its name is a 'high' yielder.

In the bond corner, we have the broadbased bond ETF (NYSEARCA:AGG) and the corporate bond ETF (NYSEARCA:LQD).

The goal of the Balanced Income Portfolio is to create a reliable (and hopefully growing) income stream. One of the main benefits of Dividend Growth Investing is that the income stream will grow at a rate that is typically above the inflation rate. That is important when one is in the accumulation phase of investing - of course, your income has to outpace inflation or you're going backwards and losing that race. It's also crucially important for those who are in the retirement or drawdown phase of the investment cycle. If the income stream from your portfolio is not keeping pace with inflation, you're losing spending power and your quality of life may suffer. The bogey man in retirement is inflation, and that's why it's important for investors who need to protect their income from inflation to hold stocks - they are the best protection from inflation. Of course, the best protection from inflation might also be acquiring $3 million in investments when you only need $1 million - but that's another article.

OK, back to our income test. To tell you the truth, I was not that hopeful when I set out on this research. Buying bonds and bond funds for income has been somewhat of a losing battle lately. With interest rates very low and falling further in many periods, the income created by most bond funds has been falling. In fact, in my article Bonds: A Dividend Growth Investors Best Friend, I pleaded for some higher rates, I welcome some modestly rising rates.

Here's a quick look at the income history of a broadbased bond fund that I hold in my accounts, it's also the bond index that we use in our index-based portfolios at ING Direct Canada. On the Toronto Stock Exchange, it goes by the ticker XBB.

That income stream has been falling steadily. It's been cut by a third over a decade. Factor in inflation and that income history looks even more disconcerting. I'll take the price hit on the bond side with my goal now being for rising income. As you'll soon see, the two popular bond ETFs used for this article have experienced the same declining income trend.

Without further ado, let's get to the numbers. I started the portfolio from January 2007, as VYM and VIG became available in late and mid 2006. This first examination of this portfolio income considers that the investor is now retired and is supplementing their pensions or other income with this income source. That is, there is no reinvestment of the income, they are simply withdrawing the income out of their portfolios to cash accounts - to spend.

Here is the income stream from the two bond offerings. For the purposes of this back test, I allocated $10,000 each to the four ETFs. The income is calculated quarterly.

Start Date of January of 2007

03/07 125.56 114.65 240.21
Dist 137.77 114.65 252.42
Dist 135.86 119.64 255.50
Dist 133.05 119.93 242.98
TOT 07 991.11
Dist 132.21 116.18 248.39
Dist 134.49 113.37 247.86
Dist 127.43 106.81 234.24
Dist 121.81 116.64 238.45
TOT 08 968.94
Dist 130.24 101.12 231.36
Dist 138.67 92.76 231.34
Dist 133.05 99.70 232.75
Dist 132.21 100.07 232.28
TOT 09 927.73
Dist 124.62 94.47 219.09
Dist 127.43 94.47 221.90
Dist 121.81 89.73 211.54
Dist 120.87 109.67 230.54
TOT 10 883.07
Dist 120.87 94.47 215.34
Dist 120.87 93.71 214.58
Dist 118.06 82.75 200.81
Dist 113.37 108.67 222.04
TOT 11 852.77
Dist 110.56 58.82 169.38
Dist 111.50 70.78 182.28
Dist 109.62 65.80 175.42
Dist 104.94 111.17 216.11
TOT 12 743.19
Dist 103.07 64.80 167.87
Dist 102.13 65.80 167.93
Dist 101.20 60.81 162.01
Dist ? ? ?
TOT 13 ?

As we can see the initial income stream was quite generous at close to a 5% yield. And as expected, the income stream did fall right on queue. That said, the yields available with dividend stocks was typically not that generous in 2007. That 5% looks pretty good.

Here's the income stream from combined VYM and VIG.

Start Date of January of 2007

Dist 51.92 32.94 84.64
Dist 57.60 34.77 92.37
Dist 67.30 40.26 107.56
Dist 86.53 51.24 137.77
TOT 07 422.34
Dist 71.15 40.26 122.39
Dist 71.15 51.24 111.41
Dist 71.15 49.41 120.56
Dist 63.46 47.58 111.04
TOT 08 465.40
Dist 59.61 51.24 110.87
Dist 00.00 00.00 00.00
Dist 50.00 42.09 92.09
Dist 61.54 43.92 105.46
TOT 09 309.42
Dist 44.29 42.09 86.38
Dist 51.93 45.75 97.68
Dist 53.85 49.41 103.26
Dist 59.61 56.73 116.34
TOT 10 403.66
Dist 59.61 49.41 109.02
Dist 65.38 51.24 116.62
Dist 59.61 53.07 112.68
Dist 73.07 60.39 133.46
TOT 11 471.78
Dist 63.46 49.41 112.87
Dist 71.15 58.56 129.71
Dist 76.92 58.56 135.48
Dist 94.22 91.50 185.72
TOT 12 563.78
Dist 69.22 53.07 122.29
Dist 80.76 64.05 144.81
Dist 84.61 65.88 150.49
Dist ? ? ?
TOT 13 ?

We can again see that the yields were quite low or modest in the dividend ETFs. Many popular dividend growth companies were not paying a very high yield in 2007. And the figures above demonstrate the risk of investing with the crowd in an ETF, and what can happen during a market correction. The dividend ETF managers were hampered by redemptions along with some companies cutting or reducing their dividends. That said, you can see the dividend growth record for this dividend combo is quite impressive coming out of the recession.

The CAGR from 2007 through the recession is still a respectable 5.93%. Short term, over the last three to four years coming out of the recession, the CAGR for the two dividend ETFs is closer to 15%. From what I can deduct, that keeps up with or beats some of the SA DG authors on pure dividend growth. More articles on that to follow. Perhaps the ETFs do work in the good times, but have their 'issues' with things get hairy?

But that dividend growth was not enough to overcome the falling bond income over the last 3-4 years. Here's what happens when we combine the dividend and bond ETFs' income streams?

Start Date of January of 2007

ETF Dividends Bonds Total
Dist 84.64 240.21 324.85
Dist 92.37 252.42 344.79
Dist 107.56 255.50 363.06
Dist 137.77 242.98 380.75
TOT 07 1413.45
Dist 122.39 248.39 370.78
Dist 111.41 247.86 359.27
Dist 120.56 234.24 354.80
Dist 111.04 238.45 349.49
TOT 08 1434.36
Dist 110.87 231.86 342.73
Dist 00.00 231.34 231.34
Dist 92.09 232.75 324.84
Dist 105.46 232.28 337.74
TOT 09 1236.65
Dist 86.38 219.09 305.47
Dist 97.68 221.90 319.58
Dist 103.26 211.54 314.8
Dist 116.34 230.54 346.88
TOT 10 1286.73
Dist 109.02 215.34 324.36
Dist 116.62 214.58 331.20
Dist 112.68 200.81 313.49
Dist 133.46 222.04 355.50
TOT 11 1324.55
Dist 112.87 169.38 282.25
Dist 129.71 182.28 311.99
Dist 135.48 175.42 310.90
Dist 185.72 216.11 401.83
TOT 12 1306.97
Dist 122.29 167.87 290.16
Dist 144.81 167.93 312.74
Dist 150.49 162.01 312.50
TOT 13 ? ? ?

The portfolio had an initial yield of about 3.5%. But we can see the obvious that the falling income from the bond ETFs crippled the total income stream's growth potential. To further complicate issues, the Dividend ETFs suspended their distributions for a quarter in 2009 compounded by another week quarter.

That said, the income portfolio would have done its job quite well for many investors seeking income for spending. Let's ramp this portfolio up to an $800,000 total value and have a look at the income distributions. If an investor was looking for $24,000 in annual income from this portfolio - an initial yield of 3.0%. The quarterly drawdown would be $6000. At that level of income, we can see that a cash account could have been built up to weather the softer periods, and periods of outright declining income.

Start Date of January of 2007

$800k Cash
03/07 6,497 +$497
Dist 6,895 1392
Dist 7,261 2653
Dist 7,615 4268
Dist 7,415 5683
Dist 7,185 6868
Dist 7,096 7964
Dist 6,989 8953
Dist 6,855 9808
Dist 4,627 8435
Dist 6,497 8932
Dist 6,755 9687
Dist 6,109 9796
Dist 6,392 10188
Dist 6,296 10484
Dist 6,938 11422
Dist 6,487 11909
Dist 6,624 12533
Dist 6,270 12803
Dist 7,110 13913
Dist 5645 13558
Dist 6240 13798
Dist 6218 14016
Dist 8037 16,053
Dist 5803 15856
Dist 6255 16111
Dist 6250 16361

In a falling rate environment, a mix of dividend and traditional bond ETFs didn't deliver on income growth in a drawdown scenario. That said, the time period includes the most severe stock market correction since the great depression.

Conversely, from a standing start a dividend portfolio would likely not have delivered on the initial yield needs in 2007. An equity investor would have had to really stretch for yield. Sound familiar? They also had to navigate through the recession as well. Unfortunately, I don't think we have an individual investor handpicked stock portfolio on Seeking Alpha to examine through the recession - not in a drawdown scenario.

All told, if you look at the drawdown scenario depicted above where the investor started with an initial 3.5% yield, they would have had excess dollars in the cash account to cover them to date, and compensate for inflation. The lesson there of course is that no matter what your strategy, it's prudent to build in a buffer in case of an unforeseen event.

Also, is the VYM/VIG/AGG/LQD portfolio an ETF mix that an income investor would create from a standing still start date for an immediate drawdown scenario? Likely not, but it's an interesting starting point for further examination of income portfolios for both the accumulation and drawdown scenarios.

If one were to create an income portfolio, they might include assets that I currently use such as Dividend Growth ETFs, High Yield Bond ETFs, REITs and Utilities (more of that yield hog stuff) combined with that Dividend Growth. I'll admit to using all of the above and broad market indices.


The bond/dividend growth portfolio can do the trick of capturing some decent initial yield. But declining rates continue to hurt the income stream from bond ETFs. You can't have it all.

Stay tuned for round two of this income exploration. I've plotted the numbers for the VYM/VIG/AGG/LQD portfolio in the income accumulation phase with income reinvestment. Does that portfolio make more sense as an income accumulator? And what strategies are available with the income reinvestment in the accumulation phase?

Stick around, there's more to come.

And if someone knows of a site or spreadsheet that calculates income and income growth with reinvest via ticker symbols please send me an email ... ha.

Disclosure: I am long VYM, DIA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Dale Roberts aka cranky is a Streetwise Coach at ING Direct Mutual Funds. Streetwise Portfolios offer the lowest-fee, index-based portfolios available to Canadians. Dale’s commentary does not constitute investment advice. The opinions and information should only be factored into an investor's overall opinion forming process