As an income investor, my primary objective is reliable income throughout retirement years without having to concern myself with what the stock market is doing along the way. Instead, I'll focus on picking dividend paying stocks whose dividend is secure, the dividend history is favorable and the company has a favorable moat going forward. I suspect there are many coming into retirement…or already there...who have the same investment objective. But as much as I enjoy such income stock selection, others may not. In fact, I'd guess many such retirees would rather not go through the labor-intensive job of income stock selection. For these households, what are the alternatives? Well, there are insurance products with "minimumwhatever guarantees", but their inherent inflexibility, 'gotchas' and very high costs usually make these non-starters for most. There are the 3 classes of mutual funds that can be used. Open end managed mutual funds requires turning over the income keys to a fund manager, but dividends (actually, distributions, but I'll refer to them in this article as dividends) will vary with market fluctuations and management style, which is not secure enough for most retiree households. Closed End Funds can certainly be excellent income instruments…but these things are complicated, with several moving parts that the income investor needs to breakdown into their component parts to be able to predict dividend sustainability and avoid unpleasant and unexpected dividend cuts and household income disruption. This leaves Exchange Traded Funds or ETFs that are designed for high income. This article will focus on the long term reliability of ETF dividend income. (note: I could also include with dividend ETFs, income producing index mutual funds. However, ETFs will usually have inclusion criteria that allow more focused dividend holdings than an index fund, and I want to keep this article focused on dividend ETFs)
I'll be considering the following subset of dividend ETFs:
- Have been in existence since January 1, 2007. This will provide exposure to the 2008/2009 recession to test the effect such an economic event has on the various ETF dividends.
- Must have an average daily trading volume of at least 750,000 shares today
- Must have had at least a 2% current yield on January 3, 2007
- Passively managed
To find these, I used the ETF Database Launch Center. Here I manually screened through each of the hundreds of Dividend ETFs launched prior to 2007, searching for those specializing in sustainable high income, which hopefully I found the majority, although I may have missed a few. But I think this group of 14 Dividend ETFs should be fully representative of the income classes most income investors use. The ETFs I've included are PGF, VNQ, IYR, LQD, XLU, DVY, VPU, VYM, XLE, RWX, SDY, VIG, XLF and SPY.
Next, I downloaded all past distributions, which are almost entirely dividends (interest for the bond ETF). Capital gains distributions are rare for ETFs, but they do on occasion occur. My primary source of historic dividends is YahooFinance but I used other sources such as NASDAQ or Morningstar dividend history if I have a problem with the Yahoo downloaded dividend history.
Once all of the raw dividend data is downloaded and assembled in Excel, I determined total dividends assuming an initial $100,000 investment in each ETF at opening prices on January 3, 2007. I then set up the Excel SS to calculate the annual dividend growth/(decline) rates and from this annualized dividend growth since 1/3/2007 through 1Q2016 (9.25 years).
It is clear that high dividend yields will typically provide larger dividend payouts over time. However, high initial yield may be subject to derailment along the way if certain market conditions occur that chops the dividend of all stocks within an ETF.
This shows the ETFs response to the sharp economic decline of 2009 over 2008. Clearly, some classes of income stock had sharp dividend declines, some moderate declines and some no effect at all.
Due to the negative dividend growth during some years, the compound annual growth rate of ETF dividends cannot be a simple average, as negative years have a disproportionate effect as compared with positive growth years. For example a 10% decline in the dividend will require a subsequent 11.1% growth to return to precut level, not 10%. To take into account the negative growth requires using a geometric rate of return. If there are no negative year growth rates, then the arithmetic average will equal the geometric rate of return, but large negative growth years will have a pronounced negative effect on the dividend's Compound Annual Growth Rate (or CAGR).
Over the past 10 years the dividend ETF space…if I can call it that…has been negatively affected by 3 major evolving economic events:
Gradually declining interest rates. In January 2007, the 10 Year Treasury Note was yielding 4.76%. By January 2012 it had dropped to 1.97%. Today it is yielding 1.77%, a nearly 63% decline in 9 years. This has had a dramatic effect on the gradual decline of bond interest and on the redemption and reissue 'coupon rate' of preferred stock. It is unlikely…but possible…that this rate of interest rate decline will happen over the next 10 years
A deep economic recession due to a credit crisis. This has the greatest negative effect on the dividends of the pure financial companies as well as smaller companies sensitive to cash flow disruptions who don't have the capital reserves of larger and better financed companies or those companies who have continued demand for their services or products during economic decline.
A near collapse of oil and gas prices due to oversupply. This will cause severe cash flow disruption of most energy companies, particularly smaller companies, who are reliant on these commodity prices.
Although it is not likely that the next 10 years will look like the past 10 years, history does give a real snap-shot of how a dividend ETF will behave under such economic conditions were they to recur.
Clearly, under such a repeat of economic conditions, some ETFs will fare better than others.
There are many dividend ETFs out there to choose from today, and this group of 14 is but a small sample. But using each of these as a representative of other similar ETFs who use similar stock/bond inclusion criteria, should provide a reasonable guide to how other ETFs will behave under similar future economic conditions. The following are the recommendations I would make based on this dividend history, in the order I would recommend them.
VPU and XLU. Both of these had dividend growth in 2009, and with the exception of VPU's -1.4% decline in 2014, neither have a negative dividend growth year over the past 10 years. Between the two, I'd likely choose VPU as it has a slightly better 9.25 year dividend CAGR of 5.7% over XLU's 4.8%. Clearly, consolidated utilities provide reliable income and will work well in an income portfolio, assuming the 3.3% yield is sufficient.
XLE. If oil/gas prices stabilize this will be a very good ETF for dividend growth. At -4%, 2010 has been its only negative dividend growth year, with most years providing double-digit dividend growth. This dividend growth rate will almost certainly slow as the industry adjusts to lower oil/gas prices, but eventually it will rebound as the demand for energy is not going to abate. Because it is capitalization-weighted, it holds the largest of the US energy producers, with nearly 50% of the ETF made up of the top 5 holdings. If the household can get by on a 3.2% current yield, this will be an excellent long term income holding
PGF. This fixed income preferred stock ETF tends to reinforce the old saw that high yield/low(or no) growth trumps low yield/high growth. Despite its annual average decline of dividend growth of -3.5% over the past 9.25 years, it still provides greater income to the retired household than equity ETFs. With interest rates seeming to stabilize at their current level, preferred stock redemptions are slowing and so the rate of dividend decline will likely slow as compared with the past years. Assuming PGF dividends decline at the rate of 1% each of future years and the ETF VIG grows at its historic rate of 9.8%/year, it will take over 10 years for the annual dividend of VIG to catch up to PGF and over 17 years for the cumulative dividends of VIG to catch up to those of PGF.
It is noteworthy that during 2009, PGF had a -5% decline in dividends followed by a -12.7% decline in 2010. I'm not sure how much of this decline was due to the redemption of higher paying preferreds then replaced with lower yielding preferreds and how much due to default (suspension) of preferred stock dividends with the recession. But in comparison with the -68% income reduction of the all financials ETF XLF (discussed later), my sense is dividend defaults made up a small part of the dividend reduction. However, this is an ETF of FINANCIAL preferreds, and financials made up almost all of the dividend suspenders in 2009/2010 according to Quantumonline. If this makes you as nervous about this ETF as it does me, it may be better to consider other preferred ETFs such as PFF, PGX or PSK although all of them, except PFXF (no financials) hold a sizable portion of financial preferreds.
VNQ. What favors this is the most recent 4 quarter yield of 4.2% and favorable dividend growth following the recession of 2009/10. But the 35% dividend cut in 2009 is a reminder that equity REITs are, as a group, sensitive to economic recession. It has taken 5 years for this ETF to restore its dividend to its pre-recession level. If the income investor is concerned that such a deep recession could repeat itself, VNQ may not be a good choice.
SDY and VIG. SDY targets the highest yielding of the long term (>20 year) dividend paying stocks while VIG also targets long term (>10 year) dividend payers, but with a focus on financial strength. The difference in the 2009 dividend cut rate for SDY and VIG (-21% vs. -5%) and the resulting 9.25 year dividend CAGR (6.4% vs. 9%) . The significant disadvantage to these is their current yields of 2.5% and 2.2%, which will not be sufficient for most retired households requiring the income.
SPY. This is a Dividend ETF only because most S&P 500 stocks pay a dividend. With a dividend reduction of -20% in 2009 and a current yield of 2.1% and a 9.25 yr dividend CAGR of 5.7%, I see no advantage to this ETF over SDY or VIG.
IYR. This all-inclusive Real Estate (not just REIT) ETF underperformed VNQ by paying out 10% less in dividends over the past 9.25 years, has a lower current yield than VNQ, took a bigger hit to its dividend in 2009 than VNQ and has almost the same geometric dividend CAGR as VNQ. I see no advantage to IYR over VNQ.
LQD. Due to the steady decline of its yield due to gradually declining interest rates, LQD's current yield of 3.3% is close to the yield of 4 equity dividend ETFs but with virtually no opportunity for dividend growth. With the average 8 year duration, it will take many years for the LQD bonds to mature to be replaced by future bonds of higher yield….assuming interest rates eventually rise. The only reason to consider LQD is if one requires the income and is convinced that equities will take a nose-dive...along with their dividends...over the years ahead. Otherwise, for most income investors, there is little chance for any significant dividend growth from this 3.3% yielder.
RWX. This Asian/Australian REIT is the only equity ETF to have a long term declining dividend. Annual distributions have varied widely, but its overall 9 year dividend growth rate has been negative. I see no income value in this ETF.
XLF rounds out the bottom of my recommended list for long term reliable dividend paying ETFs. This ETF performed abysmally in 2009, losing 68% of its annual dividend in 2009 with a 9 year dividend CAGR of -7.5%, the lowest of this group. The most recent 12 month dividend is only about ½ of XLF's pre-recession annual dividend. Dividend growth has been double digit since 2012, but XLF had 3 successive dividend reduction years of 2008/09/10 that dropped its annual dividend from $2,086 in 2008 to $422 2 years later, an 82% drop, using the above investment model. As a matter of personal choice, I do not hold pure financial stocks. Other views may vary, but I view the pure financials as companies who generate dividends from squiggly lines on paper that are incomprehensible to all but those who wrote them…which are firmly backed by squiggly lines on other pieces of paper. No thank you.
From these data, there is a single important take-away:
- ETFs that focus on a particular industry or income class that tend to respond the same to a market threat, will diversify one's income portfolio for unsystematic income risk, or individual security risk. This kind of ETF will NOT diversify for a threat to that industry or income class. LQD and the REIT ETFs clearly show this.
I have not taken into account taxation, which arguably should be considered although it does add another dimension of complexity. So as a general guide, I will offer this: if the retired household has an Adjusted Gross Income of under about $98,400 for 2016, for those married filing jointly age 65 and older, the current yields on REIT and Bond ETFs should be multiplied by .85 to determine their after tax equivalent yield for comparison with those ETFs that distribute qualified dividends.
Some may be concerned why I did not include the ETF's expense ratio. Actually, I use the Income Expense Ratio (IER) which is the ETF's total expenses divided by total fund income, as shown on the ETF's annual shareholder report/Statement of Operations. The IER shows how much of the fund's income was kept by the house before distributions to shareholders. I did not do this because I'm looking at fund results which will be net of expenses. Those funds with higher expenses will likely show lower dividend performance than equivalent ETFs with much lower expenses. Thus, I felt adding in the IER would serve more as a distraction than a help.
In the above calculations, I have downloaded reams of dividend data and performed a multitude of calculations. I have gone over these numbers at least twice as a check on accuracy. However, there is just me, so it is entirely possible I have transposed a number or misplaced a number. If you find such, please point it out and I will check and adjust using the edit feature SA provides.
I have only focused on dividend ETFs with a 9.25 year dividend history and as I mentioned at the outset, there are many, many ETFs to choose from today. As I have done in the past, anyone who would like to have access to the Excel SS I built to review the method I used or to insert data to test another dividend ETF, feel free to send me a PM with your e-mail address and I will send this to you.
Disclosure: I am/we are long VIG, VNQ, XLU, SDY.
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.