A dividends rich equity, such as Annaly (NLY), affords the investor a wide range of options that you do not see discussed by writers and commentators that often.
In reading the many articles on NLY and other mREITs, and in reviewing the follow-up comments, I am struck by the great divide between those who favor capital appreciation and those who prefer high dividends! It seems that such brilliant people are "locking horns" over a moot point.
In this article, we explore one approach that allows you to "have your cake and eat it too!" As such, we will compare three portfolios: one for dividends only, another for growth only, and of course the one representing my proposed strategy. We will also consider the impact of taxation on each portfolio.
The profile or scenario assumptions are as follows:
- You are a conservative person
- You received $10,000 of after-tax windfall (call it inheritance) on 1/1/2004,
- You spent a month thinking about what to do, and on 2/2/2004 you invested the money.
- You know you will retire 10 years later on 1/31/2014, when you want that money to help you start a small project.
- Your combined state/federal tax-bracket during this period is around 30%
- You found yourself a reliable discount broker who will place orders for you at 0.1% of amount.
- You will continue to reinvest your after tax dividends in your chosen schema at the close of the dividends payout day!
- Cash left in the account will not accumulate interest
With such profile, you will find many people suggesting mREITs for you. They will invariably, since you do not need the income for the first 10 years, suggest reinvesting the dividends. They will even pull charts and tell you how your returns are amplified.
Of course, most will not tell you that
- These returns do not factor in taxation
- Nor will they include the transaction fees
- Nor will they consider the 1 month lag between NLY ex-div date and payout date and the price fluctuation in between
- You cannot buy partial shares of equities
The strategy I suggest here is to use the dividends afforded by the dividends-rich equity to buy a capital appreciation one. In this case, I will use Annaly as the dividends rich equity, while using the iShares Russell 3000 Index ETF (IWV) as the target growth equity. This will definitely cater to the conservative profile and provide decent capital preservation assurance -- assuming there is ever any.
The historic price data for NLY will come from here. That for IWV will come from same source. The dividends history will be obtained for NLY from here. Similarly that for IWV will come from the same source. Note that the source is missing some payout dates for IWV. For these, I have just added a week to the ex-div date, which seems to fit well the overall payout pattern.
To familiarize ourselves with the equities in question, examine the following combined 10-year monthly chart.
NLY on 2/2/2004 closed at $20.04, while it close at $10.77 on 1/31/2014! On the other hand, IWV closed at $64.5 on 2/2/2004 and at $107.11 on 1/31/2014. That is, over this 10-year period, NLY was halved, while IWV grew by 70%!
In the first scenario, you put all $10,000 into buying 498 shares of Annaly on 2/2/2004 in a taxable account. Every time you get the dividends, you subtract the 30% tax from that amount and buy the maximum Annaly shares you can get for the remaining cash in the account. The price you buy NLY with will be the closing price for that dividends payout date.
What you will find out is that on 1/31/2014 you will have accumulated a total of 888 NLY shares, and your portfolio's liquidation value will stand at around $9,564. That is, using a buy-hold-reinvest-dividends strategy you lost $36 over 10 years, but was able to -- more or less -- double the number of Annaly shares you started with.
Now, if this account was tax-sheltered, then actually, you will find out that you ended up with a total of 1,055 NLY shares, with a liquidation value of $11,364. That is, you made 11.36% profit over 10 years!
On the other extreme, if, instead of buying Annaly, you decided to buy the Russell 3000 ETF, then you would have bought 154 shares on 2/2/2004, and with all the dividends you made over the 10 years you could not have afforded more than eight extra shares. So, on 1/31/2014 you would have ended up with a 162 shares of IWV, with a liquidation value of $17,437. That is, you would have made 74.4% profit over the 10 years. If you opted for a tax-sheltered account, then in this case it would not have made much of a difference. Effectively your ending liquidation value would have been $17,825 for 166 shares of IWV.
Incidentally, and this does not apply for the case we are discussing, but may apply to someone who have retired on 2/2/2004 and decided to live off the income, if you were to actually keep the money in the account and not reinvest, then you would have ended up with the 498 shares on 1/31/20 and $6,247 in cash in the taxable account for a liquidation value of $11,610. In a tax-sheltered account, you would have ended up with $8,919 in cash, for a liquidation value of $14,283. I am an advocate or reinvestment, but in this case, given the sub-prime and financial crises, that strategy would not have served you well during those last 10 years!
Going back to our main discussion, the strategy that I am proposing is different than both. You see, start by buying NLY, as you would have with the first strategy. Yet, instead of using the dividends to buy more NLY, go ahead and use all available cash to buy as many IWV as you can afford!
Using this strategy, and in a taxable account, you will find out that at the end of the 10 year period, you would still have the original 498 shares of Annaly, and you will also have accumulated 90 shares of IWV, with $104 left over in the cash account. Your total portfolio liquidation value will be a respectable $15,107!
Here is the "kicker," if you were to do the same exercise in a tax-sheltered account, then on 1/31/2014 you would have ended up with:
- 498 shares on NLY
- 132 shares of IWV
- $15.94 in the cash account
Your total liquidation value of $19,518!
That is, with this proposed strategy, you would have beaten every other strategy, including a tax-sheltered pure-growth strategy.
The following spreadsheet summarizes the setup and results -- shown for the taxable scenario.
That is truly "having your cake and eating it too!"
In conclusion, there are many ways that an open-minded person can choose to get the best of both the growth and the high-dividends worlds, while growing a beautiful nest egg for retirement. I have only proposed one.