One ETF Replaces Your Dividend Growth Portfolio

| About: Vanguard Dividend (VIG)
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A few days ago, I wrote a post titled Are Dividend Growth Investors Doing It All Wrong?, which cast some questions at the methods of dividend growth investors. Let's take a quick look at some of the issues I brought up, and then delve into the meat of easily replacing a dividend growth portfolio with a single ETF.

I brought up two major points, which were:

  1. The lack of diversification in many dividend growth portfolios.
  2. The focus on the dividend, and the lack of focus on total return.

I pointed out that many dividend growth portfolios are focused too much on consumer names, something that happens because I believe dividend growth investors (like many other investors) place a premium on businesses that they personally are familiar with. Dividend growth investing largely ignores entire sectors (like technology) and anything smaller than the largest of mid cap stocks. This is a major flaw on the part of any investor, since studies have shown that small cap value stocks tend to outperform all other stocks, albeit with a little more risk thrown into the mix.

Which brings me to the second point, and that's the fascination with the dividend. I often hear that dividend growth investors don't care about the price of an underlying security, and the only thing that really matters is the rising distribution. This seems fine on the surface if an investor's goal is income, but in reality is extremely shortsighted. I came up with an alternate portfolio, one yielding approximately two times that of a typical dividend growth portfolio, and pointed out the simple math that, a higher current yield will outperform a smaller current yield with higher growth for a long time. The bottom line is total return is more important than a rising dividend stream, since investments can be sold for income if needed.

Dividend growth investors often tout the compounding they get when they reinvest dividends, seemingly forgetting that all investment returns compound when you reinvest them. Meaning, investors can create their own dividend growth vehicles by buying a stock with a, say, steady 6% yield, and simply reinvesting that dividend. Or, shifting those dividend dollars to a different investment they've identified as having a higher potential total return.

Anyway, I certainly enjoyed reading the opinions of all the dividend growth investors who weighed in on my post, and I'm always happy to generate discussion. As a thank you to all the dividend growth investors who commented, I've decided to simplify their lives by replacing their painstakingly researched dividend growth portfolios with an ETF, freeing up all sorts of time for golf, or other non-sport related hobbies.

In the comments of my post, I was introduced to a website called Sensible Stocks, ran by a dividend growth investor. Luckily for us, he created an actual portfolio back on June 1st, 2008, and tracked the results online. Through December 1st, he's up 51% on his portfolio, including reinvested dividends. This compares to a 47% return on the S&P 500, which puts his outperformance at around 1.5% annually. That's not half bad.

His holdings include the usual dividend growth suspects, including PepsiCo, (NYSE:PEP) McDonald's, (NYSE:MCD) Johnson and Johnson, (NYSE:JNJ) AT&T, (NYSE:T) and Philip Morris, (NYSE:PM) among others. There are 16 names in total. For the sake of argument, let's call it a "typical" dividend growth portfolio.

Let's compare that portfolio to Vanguard's Appreciating Dividend ETF, (NYSEARCA:VIG) which, according to Vanguard's website, "seeks to track the performance of a benchmark index that measures the investment return of common stocks of companies that have a track record of increasing dividends over time." There are 146 stocks held in the ETF. Here are the top 5, along with the percentage they make up of the fund.

  1. Proctor and Gamble (NYSE:PG) - 4.1%
  2. PepsiCo (PEP) - 4.0%
  3. Abbott Laboratories (NYSE:ABT) - 4.0%
  4. Wal-Mart (NYSE:WMT) - 4.0%
  5. Coca-Cola (NYSE:KO) - 3.7%

How has this ETF performed from our predetermined time period (from June 1, 2008 to December 1, 2013)? Excluding dividends, the fund is up 37.9%. Hey, that already outperforms our so-called "typical" dividend growth portfolio. What happens if we take all the dividends and reinvest them in new units of the ETF?

I took the time and put some numbers in a spreadsheet, and came up with the answer. The ETF is up 73.6% over the same time period, crushing both the S&P 500 and the chosen dividend growth portfolio. Based on a 2.04% yield on VIG, the ETF also has a yield on cost of 3.54%, assuming you're into that sort of thing.

Am I naive enough to think that past performance is the only factor determining future results? Of course not. There's no way to determine whether that certain blend of stocks will continue to outperform the S&P 500. I do think, however, that it has a good chance of outperforming the average dividend growth investor, and do it at only a cost of 10 basis points a year. Why wouldn't a dividend growth investor gladly pay their 10 basis points and get exposure to a fund that easily replicates their investment thesis?

Why exactly do I think that? Dividend growth investors often tout that value and dividends go hand in hand, and they're picking the best of both worlds when they invest. Sorry, but as a seasoned value investor, I see very little actual value in large cap dividend paying stocks. Dividend growth investors are happy to continue buying their favorite names at 52 week highs, often justifying it by talking about how an entry point now pushes up their average price paid to something below today's price value, a ridiculous argument if I've ever heard one. Sorry folks, that doesn't sound anything like value investing to this author.

I urge all investors to search for all kinds of stocks, not just dividend growth names. There's value in searching for forgotten small cap stocks. There's little value in analyzing Proctor and Gamble for the millionth time.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.