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Suppose you have a friend who has just inherited some money or has rolled over an IRA or 401k into a Vanguard brokerage account and wants to invest this nest egg using a dividend growth strategy.

At the moment of truth, however, he or she gets cold feet about buying individual stocks. Despite the many useful articles found on Seeking Alpha, your friend is worried about individual companies going bankrupt, inadequate portfolio diversification, and failure to earn enough interest to make retirement possible. It all seems too overwhelming.

So your friend asks you for advice. Here are some ideas that might help you arrive at an answer.

To pursue a dividend growth strategy in this context means looking for ETFs that,

  1. have a decent yield,
  2. pay dividends that increase every year or at least most years, and
  3. increase those dividends at a substantial compound annual growth rate.

Because an ETF represents a basket of stocks, questions that immediately arise with individual stocks, such as P/E, dividend payout ratio, and competitive position within their industry, become less important. If the index an ETF tracks or the investment strategy a manager follows is sufficiently diversified, then looking at the whole rather than the parts makes sense, since the individual components may balance off each other’s weaknesses, reducing overall volatility. Having owned mutual funds before, your friend is comfortable with this idea.

As a starting point, you begin by looking at all Vanguard stock and sector-specific ETFs that have a SEC yield greater than Vanguard’s S&P 500 fund (my definition of a “decent” yield). There are eleven of them, all with an SEC yield of about 2.2% or higher. But two of them don’t yet have a five-year track record, so you eliminate them, leaving only nine ETFs.

The table below shows five-year data (from Morningstar) for the remaining nine ETFs, sorted first by the number of yearly dividend increases and then by the compound annual growth rate of the dividends from 2007 to 2011.

Symb

Name

2007

Div

2008

Div

2009

Div

2010

Div

2011

Div

12-mo.

Yield

Nbr

Incr

2007-11 CAGR

VPU

Utilities

2.187

2.363

2.470

2.540

2.659

3.46%

4

5.01%

VDC

ConStple

1.159

1.173

1.738

1.906

1.894

2.33%

3

13.06%

VIG

DivAppr

0.873

1.026

0.979

1.048

1.172

2.14%

3

7.64%

VOX

Telecom

1.998

1.373

1.511

1.905

2.009

3.23%

3

0.14%

VOE

Mid Valu

1.090

0.905

0.864

1.013

1.137

2.20%

2

1.06%

VYM

Hi Div

1.357

1.443

1.168

1.091

1.327

2.94%

2

-0.56%

VBR

Sm Value

1.567

1.313

1.084

1.299

1.380

2.20%

2

-3.13%

VTV

Value

1.820

1.743

1.357

1.257

1.403

2.67%

1

-6.30%

VFH

Finance

1.490

1.331

0.499

0.434

0.558

2.02%

1

-21.77%

At first glance, you see that only one - VPU - has paid higher dividends each succeeding year between 2007 to 2011. Another three - VDC, VIG and VOX) - have had three increases during that period. The rest just don’t qualify for a dividend growth strategy.

In addition, only five ETFs have paid out dividends that have shown a positive compound annual growth rate between 2007 and 2011. One of these five VOE has already been eliminated due to an insufficient number of annual increases, so you are left with just four ETFs to choose from: VPU, VDC, VIG, and VOX. Only one - VIG - is not a sector-specific fund.

Which of these four is the best? The table below projects the future dividends for each ETF for the next five years and calculates the future yield on cost (assuming a lump-sum purchase on 1/13/2012) and the total dividend return on an initial $10,000 investment, assuming no reinvestment.

2007

-2011

Est Div

Est Div

Est Div

Est Div

Est Div

Est

5-YR

Est

5-YR

Symbol

Name

CAGR

2012

2013

2014

2015

2016

YOC

DivRetr

VPU

Utilities

5.01%

2.792

2.932

3.079

3.233

3.395

4.56%

$2,071

VDC

ConStple

13.06%

2.141

2.421

2.737

3.095

3.499

4.34%

$1,724

VOX

Telecom

0.14%

2.012

2.015

2.017

2.020

2.023

3.24%

$1,614

VIG

DivAppr

7.64%

1.262

1.358

1.462

1.573

1.694

3.07%

$1,332

Analysts differ on how to assess the attractiveness of dividend growth investments. One approach is to look at future yield on cost, which calculates the dividend yield on the original lump-sum investment at some point down the road. In this case, we look out five years and estimate the future dividend and divide it by the original price we paid five years earlier. This approach is suitable if we want to live off the income stream sometime in the future and want to know what that yield will be.

Another approach is to look at the total dividend return over the next five years, assuming no reinvestment. In this case, we want to maximize the total dividends received within that time frame.

Regardless of approach, the results depend on the two factors of current yield and compound annual growth rate. Ideally we want to start with a high yield and see the dividends grow at a high rate, but that’s not always possible.

Of the four ETFs, VPU starts out with the highest initial yield (3.46%) and a dividend that has grown at a 5.01% compound annual growth rate, enough to keep up with inflation (for the time being). Five years from now the yield on cost should rise to 4.56% and the initial $10,000 investment should have earned $2071 in dividends, assuming no reinvestment.

By contrast, VDC starts with a lower yield (2.33%), but its dividend has grown at a much faster rate (13.06%), so that in five years its yield on cost should almost catch up with VPU’s (4.34%). But since it started at a lower initial yield, VDC may pay out only 83% as much in total dividends as VPU: $1724 vs. $2071.

Like VPU, VOX starts at a higher interest rate (3.23%), but since it has the lowest compound annual growth rate of the four (0.14%), its yield should be about the same in five years (3.24%) and its total dividend return only 78% of VPU’s: $1614 vs. $2071.

Finally, VIG, Vanguard’s Dividend Appreciation ETF, starts out at the lowest initial yield (2.14%) and has a growth rate between VPU’s and VDC’s (7.64%). As a result, its potential five-year yield on cost is 3.07% but its total dividend return is only 64% of VPU’s ($1332). On the other hand, since it is the only diversified stock ETF of the four, it is potentially less susceptible to shocks which may affect the future dividends of sector-specific funds.

So what do you tell your friend? Here’s what I suggest:

“Assuming that you want to invest in Vanguard ETFs rather than in individual stocks, your best bet is VPU, the Utilities ETF, since it will likely have the highest yield on cost and largest dividend return on a $10,000 investment over the next five years. Five years from now you can reassess your decision and readjust your portfolio based on what the investment landscape looks like then. If you’re worried about lack of diversification, you might consider putting half of your money in VDC, the Consumer Staples ETF, so that all your eggs won’t be in one basket. Nevertheless, two baskets do not constitute a diversified portfolio. If you want real diversification, you should choose VIG, the Dividend Growth ETF, as long as you understand that you may earn less than 2/3 of the total dividend return you might get from VPU, because the ETF has such a low initial yield and only a moderate dividend growth rate. It’s your choice. Good luck!”

Disclosure: I am long VPU.

Source: Tracking The Best Vanguard ETF For Dividend Growth Investors