Retirement Strategy: Can A Portfolio Of ETFs Outperform A Portfolio Of Individual Stocks?

Includes: DLN, SCHD, SDY, VIG, VYM
by: Regarded Solutions


ETFs have become popular with passive investors hoping for a more secure retirement.

ETFs can offer income, but is it enough?

A portfolio of ETFs for retirement might be the best way to invest. Really? Let's see how it stacks up against dividend paying blue chip stocks.

In my previous article on retirement investing, I was asked to build a portfolio of ETFs to see how it would perform versus a portfolio of blue chip dividend paying stocks. More than one investor made this type of request:

bk14857Comments (13)

Alan ...... Those of us still working and contributing to company 401k plans that now have access to PCRA's (my in particular is with Charles Schwab). We can't invest in individual stocks but have the whole ETF universe available. My wife and I would like your thoughts on building a core dividend growth ETF portfolio with this type of account in mind. You might want to start one and call it "401K ETF DGP (dividend growth portfolio)" for those of us working stiffs that have access to personal choice retirement accounts through our employer. Thanks BK

To be perfectly clear about this, I am not a big fan of mutual funds or ETFs. I believe everyone knows where I stand on investing for retirement: A portfolio of mega cap, blue chip, dividend winning stocks will earn more, grow faster, and be completely flexible for investors to manage. My new portfolio ("BTDP") has a solid core of stocks to which we will compare, over an extended period of time, to a portfolio consisting only of ETFs. Let's call it "ETFOP" (ETF Only Portfolio).

The BTDP consists of the following stocks: AT&T (NYSE:T), Exxon Mobil (NYSE:XOM), Johnson & Johnson (NYSE:JNJ), Coca-Cola (NYSE:KO), Procter & Gamble (NYSE:PG), General Electric (NYSE:GE), McDonald's (NYSE:MCD), Chevron (NYSE:CVX), Apple (NASDAQ:AAPL) General Motors (NYSE:GM), and Ford (NYSE:F).

I believe it would be a mistake for anyone who writes about investing and offers opinions to ignore the fact that there are probably more passive investors than investors who would prefer to manage their finances as an entrepreneur of sorts.

If you fall into the category of a passive investor who does not have the desire or discipline to manage a portfolio of stocks, ETFs do offer a wide variety of investments for just about any type of investor. While I am NOT so sure that a portfolio of just ETFs could outperform a portfolio with similar core holdings, we can certainly try to find out.

There are benefits to ETFs as well as risks, of course, and I suppose I should begin this journey with a brief overview of each.

What Are The Positives And Negatives With ETFs

The Positives:

  • "Instant" diversification: There are ETFs for just about every market sector and goal. A dividend seeking investor who only wants US stocks can find one with a huge assortment of stocks included within the ETF.
  • Sound allocation: The best ETFs will have a rather small allocation in each security it holds to mitigate some of the risks of any one individual holding. Appropriate allocation is a key towards risk reduction (not risk elimination).
  • Inexpensive fees: Comparable mutual funds (which I dislike more than ETFs by the way) will more than likely have a basic fee of at least .50% greater than any ETF. Not only that, but if a mutual fund is not a "no-load" type, an investor can pay a hefty fee either when buying the fund or selling it, and sometimes in both directions. The usual ETF carries a typical management fee of .05-.75%, most will not be above .50%.
  • An ETF will trade like a stock: Buying a "share" of an ETF is like buying a share of stock. It can be bought and sold and traded daily if that is the investor's desire. It can be bought long, sold short, with either cash or margin. There are even call and put options for just about every ETF for those with the knowledge to use them.
  • Set it and "forget it": Perhaps this is the most desirable feature to an ETF. A passive investor can select what type of ETFs they want, and just let them do their "thing". An investor is relying on the specific ETF to address his or her needs and goals without having to manage a portfolio of stocks.

The Negatives:

  • You do not actually own shares of any company: This is a big one for many investors. Even though an ETF has a position in a slew of stocks from different companies, the ETF owns the shares. The buyer of an ETF owns shares of the ETF, not the underlying stocks. That means no voting rights in any company, and the inability to move in and out of a position "at will" (you would need to sell the ETF itself, and lose exposure to ALL of the underlying stocks).
  • Lack of flexibility: An investor will not have the flexibility of selling shares of a company within an ETF to buy another company within the ETF. If one company goes "bad" it will be up to the ETF management to take action while you can only sit and watch. You will lose control, and many investors who desire a more secure retirement want that control to steer their own ships.
  • There are fees paid to trade ETFs: In a mutual fund, specifically a no load fund, there are no commissions to buy or sell the fund. With ETFs there are not only the commissions but also those small management fees that bite into your total return and should obviously be accounted for.
  • Even the ETF is "passively managed": The investor who owns ETFs might be passive to a point but they do have the ability to manage the holding of the ETF and trade them as they see fit. Even more passive than the investor is the managers of the actual ETFs. Most do not do anything except perhaps set price targets to buy and sell any single holding. More than likely, an investor will not even know who the manager is, and would not be able to receive personal service.
  • The price of an ETF has nothing to do with any one specific stock: This might be a bit confusing to beginners but if you buy shares of an ETF and watch the stock market, General Electric might go up $3.00 in one day, but your ETF which owns GE, might actually go down! While there are some correlations to an overall sector, there are no correlations to a specific stock, even though the ETF trades "like" a stock.

That basically sums up the most important points, and you as an investor need to decide what is important to you and what is not. ETFs are for lots of folks, but not for everyone!

OK, So What Would A Portfolio Of ETFs Look Like?

In an effort to put together our very first ETF-only portfolio, I have researched the ones that appear to me to be the "best of breed." If I was going to have a portfolio of ETFs for a more secure financial future, I would select the following dividend paying ETFs as my "core holdings":

Vanguard High Dividend Yield Index Fund (NYSEARCA:VYM), SPDR S&P Dividend ETF (NYSEARCA:SDY), WisdomTree LargeCap Dividend Fund (NYSEARCA:DLN), Vanguard Dividend Appreciation ETF (NYSEARCA:VIG), and Schwab U.S. Dividend Equity ETF (NYSEARCA:SCHD).

These have been selected for their dividend yield, diversification into stocks that are very similar to my new BTDP, and also have reasonable allocations within each ETF. Here is a snapshot of each ETF's top 10 holdings:

VYM Top 10 Holdings DLN Top 10 Holdings SCHD Top 10 Holdings
XOM 5.64% XOM 3.41% XOM 4.51%
MSFT 3.98% AAPL 3.35% MSFT 4.50%
GE 3.59% MSFT 3.14% JNJ 4.37%
JNJ 3.48% T 2.83% KO 4.20%
WFC 3.36% JNJ 2.38% CVX 4.17%
CVX 3.04% CVX 2.33% PG 4.13%
JPM 2.95% GE 2.29% INTC 3.56%
PG 2.92% PFE 2.13% PEP 3.56%
PFE 2.76% WFC 2.09% WMT 3.50%
T 2.48% PG 2.00% HD 3.35%
SDY Top 10 Holdings VIG Top 10 Holdings 10 TOP POSITIONS
HCP 2.92% ABT 3.94% 1 XOM 17%
T 2.52% PEP 3.93% 2 CVX 13%
NNN 2.45% PG 3.84% 3 MSFT 12%
ED 2.33% WMT 3.78% 4 JNJ 11%
PBCT 1.88% KO 3.60% 5 PG 11%
MCD 1.68% UTX 3.59% 6 T 8%
FRT 1.66% XOM 3.56% 7 KO 8%
KMB 1.65% CVX 3.41% 8 PEP 7%
SYY 1.61% MCD 3.33% 9 WMT 7%
LEG 1.59% MMM 3.07% 10 GE 6%

The column on the bottom far right is the top 10 holdings for the portfolio in total. It comes pretty close to the BTDP, and as you can see, it consists of mega cap blue chip dividend paying stocks. The only difference is that each holding is within the selected ETFs and cannot be changed unless the ETF changes them.

Since I started the "Buy The Dip Portfolio" with about $112k, I started the ETFOP with about $110k to keep them as close as possible to compare fairly easily as time goes by. I have an equal number of shares in each ETF just as I do in the BTDP, and here is what our new "ETF Only Portfolio" looks like:

Symbol Shares Yield Dividend Yrly Income Share Price Tot. Cost Tot.Value
VYM 350 2.80% $1.75 613 $62.44 21854 21854
SDY 350 3.92% $2.87 1004 $73.18 25613 25613
DLN 350 2.23% $1.49 522 $66.71 23349 23349
VIG 350 1.84% $1.39 486 $75.44 26399 26399
SCHD 350 2.47% $0.90 315 $36.61 12764 12764
x Totals 2.66% x 2940 x 109979 109979

My ultimate goal for both portfolios is to increase our income on a regular or annual basis, to create a cash flow that will enable investors who seek a more secure financial future, to have the money required to achieve that goal.

While capital appreciation is not a primary focus, it will be used as a comparative measurement to see how each portfolio does compared to each other. I know this is far from a scientific exercise, but it could very well shed some light on how each type of portfolio actually performs.

I will update this portfolio roughly once per month, and for the sake of comparison, I will make no changes to these ETFs aside from adding the dividends to the total portfolio value column as a separate line item. I will do the same with the stock portfolio, and NOT trade any of the stocks that are within any of these ETFs aside from a quarterly rebalancing.

The ETFOP is now "set" and it will do its "thing", and our stock portfolio is ready to meet the challenge. At the end of 2014, we will see who comes out ahead, and perhaps keep the portfolios intact for all of 2015 to have a longer time horizon. It won't be perfect, but it should be an interesting journey.

My bottom line is that I hope EACH performs successfully. Let the games begin!

Disclaimer: The opinions of the author are not recommendations to either buy or sell any security. Please remember to do your own research prior to making any investment decisions.

Disclosure: I am long AAPL, CVX, F, GE, GM, JNJ, KO, MCD, T, XOM. 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.