In a series of articles, I explored asset combinations that would deliver on income generation and portfolio price protection or what's better known as lowering volatility. Of course the income conundrum these days is that bonds, a typical source of income for retirees and those in the drawdown phase, have been delivering less and less over the years by the way of income due to falling rates and yields. That's been great for bond investors on the price side of the equation (and for those with balanced portfolios - that traditional mix of stocks and bonds). But on the yield side, investors have taken a hit.
I also put together a traditional income portfolio (The Ultimate Income Portfolio) that combines dividends from traditional dividend growth companies combined with REITs, MLPs, Preferred Shares and high yield bonds to see how that performs on the income generation front. I also wanted to see how that compares to a typical dividend growth investor who selects his own companies.
So far, as would be expected, the advantage is on the side of the income portfolio, as the three ETFs used to provide that generous income have trumped the dividend growth investor for income and income growth. The income portfolio simply purchases more initial yield as is available, and surprisingly the income has also increased at a higher rate than the dividend growth portfolio.
The ETF portfolio holds Vanguard's Dividend ETF (VYM) at 50%, Guggenheim's multi-asset class ETF (CVY) at 35% topped off with the high yield bond ETF (HYG) at 15%. All dividends are reinvested into the growing yield of VYM. That move (redirecting higher income into the growing dividends) is called the Cranky Maneuver, and it's a move I practice in our own self directed retirement accounts. The dividend growth portfolio is courtesy of David Van Knapp who provides a public portfolio.
Here's how that ETF income portfolio has delivered on the income front with an initial investment of $40,000.
Start Date of January of 2007
And for the purposes of comparison between ETFs and an investor who selects his own companies, I then used Mr. Van Knapp's start date of June of 2008 and his starting portfolio value of $46,780. Portfolio comparison followed. David operates a dividend growth public portfolio that is available here.
Here's how those portfolios stacked up with our estimates for 2013 income.
The ETF portfolio of course had the advantage of having a large initial lead on the income front. That said, even on the income growth front, the ETF portfolio was able to increase its lead from 2010 through 2012.
Another note, the lead for the ETF income portfolio would be more than stated above, as Mr. Van Knapp recently confirmed in his 2013 final report card article (comment section) that he has not been factoring his trading fees or subscription costs in his public portfolio. Fees of course are real and important. The subtraction of fees would first off lower the portfolio income by a few hundred dollars a year. And also, those dollars were not available for reinvestment, meaning that would compound the lost income and total return.
Nonetheless, let's have a look at the final numbers on income that came in for the two portfolios in the fourth quarter of 2013. As per the title of this article, VYM (the dividend growth driver of the portfolio) had a banner year. It offered a distribution of .44 in September and ended the year with a .53 distribution in December, an increase of 20%. That .53 distribution is an all-time high for VYM. It is 8% above the 2012 December payout and 40% above its December 2011 distribution. Looking at VYM's Vanguard dividend cousin, VIG also had a nice .40 distribution, its second highest payment on record.
For my calculations, I had projected a distribution of .49 for VYM. There's a nice 8% boost above that projection. With respect to the other two ETFs, CVY held steady with a .32 distribution, while the high yield bond ETF HYG offered its highest payment of 2013 with a .47 extra distribution bumped up into 2013 in addition to the .45 distribution in early December. There was a little Christmas present courtesy of the bond component. 2014 did not see a January payment for that ETF.
The DVK portfolio would have annual income in the area of $2305, not the $2585 reported for 2013. David noted he has $220 per year in subscription costs plus an estimate of $60 per year in trades as per David's response in his comment section. On total return and income generation, we would then need to lower the income by a minimum of $280 per year.
Here are the adjusted comparisons for 2013. DIFF equals the percentage differential between the ETF portfolio and David's portfolio. I only adjusted the DVK numbers for 2013 (not 2008-2012) to reflect the fees in the account.
The ETF portfolio increased its income stream by 17% in 2013. That increase is identical to David's reported numbers (not including any fees). From 2010, the ETF portfolio that uses VYM as the driver and is being fed by higher yielding ETFs has higher income growth to date. And apologies, the $2802 projection for 2013 was incorrect. The projection should have read initially well above $2900. I did input the wrong number.
What about total return?
Well there's the kicker, it's all about the total return in the accumulation phase. Income is either a way to manage risk or contribute to total return. The only thing that matters in the accumulation phase is total return, and then how much money (portfolio value) you will have to eventually purchase income and perhaps also harvest some of the assets. Most investors (myself included) will harvest income and sell some assets along the way. Hey, why give it all to the kids and the tax man? That's another article to follow - for sure.
David has done a very reasonable job with returns right in line with the broader markets. If we factor in the fees, David's total return would be under $69,000 and just below the returns of the S&P 500. But the winner in the total return race would be the ETFs that a dividend growth investor should be comparing against - the dividend and dividend growth ETFs. SDY (SDY) from the June 1 start date would have returns of 67.6%, VIG (VIG) would have returned 56%, and VYM would have returned 54%. These simple ETFs win on total return. And by surprise, it appears that the VYM/CVY/HYG income portfolio had total return figures that handily beat the market. That was not the intention at all, and it's a head scratcher. Article to follow on that total return story.
And in the accumulation phase, if one has a longer time horizon and a higher risk tolerance level they might consider skipping the dividends altogether and buying the total market that includes small cap and mid cap companies. Vanguard offers the total market in VTI (VTI); it delivered 53.5% over that time frame. Over longer periods, the small cap outperform will typically be quite considerable. And certainly all of these comparisons are short term. VIG outperforms SDY from VIG's inception date of May of 2006, still a shorter term evaluation. It's early days for comparing dividend ETFs to those who select their own companies, but we have moved through one market cycle, and the results are telling, or at least worth consideration for investors deciding what course to take.
If you are in the accumulation phase and have reasonable time frame and a moderate to higher risk tolerance level, focus on total return. Income that you don't need to spend (yet) is meaningless. Purchase the ETFs and markets and sectors that will deliver on total return. Or you can certainly select your own stocks from the ETFs and indices - ETF skimming. If you buy and hold enough of them you may get the returns that the markets are offering.
If you are in the drawdown phase, you might also purchase a modest amount of higher income investments such as the REITs, MLPs, preferred shares, utilities and higher yielding bonds. SA author Bob Johnson neatly frames this as having core (dividend growth) and satellite holdings (higher income generation).
Having very decent income to spend can help reduce the need to harvest (sell) the actual investments. That said, one might also consider moving a portion to cash to protect against and market turbulence that affects dividends and income from bonds. Investors of all stripes took a nasty hit on income and portfolio value in the last recession.
Lastly, I am not anti-stock picker. I am just not seeing any evidence that those selecting their own companies are able to beat the market or index. I mostly see underperformance of those who offer public portfolios or share their results. I do think that in the distribution phase an investor might be able to better manage their income (as stock selectors) on the core dividend growth side if they hold enough companies to reduce risk and they are patient. VIG is the ETF that held up incredibly well during the recession, but its yield leaves something to be desired. Once again, that low yield can be managed by adding in some satellite higher yield.
And remember always to evaluate your risk tolerance level. Can you handle a 20, 30, 40 or 50% market correction? Make your best estimate and add in bonds as needed.
Happy investing and be careful out there.
Additional disclosure: Dale Roberts aka cranky is a Streetwise Coach at ING Direct Mutual Funds. The Streetwise Portfolios offer index-based complete portfolios 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.