The 3 Best ETFs For Your Roth IRA

|
Includes: DGRO, DGRW, DHS, DLN, DVY, HDV, NOBL, SCHD, SDOG, SDY, SPHD, VIG, VYM
by: Evin Rohrbaugh
Summary

A single, low-cost dividend paying ETF is all you need for your Roth.

Most of the biggest dividend ETFs have failed ot beat the market since their inceptions, even with dividends reinvested, so why even put them in a Roth?

VYM, SCHD, and VIG are the best choices for maxing out the Roth.

The Roth IRA is the ideal account type for Americans to passively invest in the stock market for long term retirement income. For a couple who are both age 30, they can contribute a combined $11,000 per year to their Roth accounts. The yearly contribution limit does increase for inflation every few years, but to keep it at the current maximum for simplicity sake, this means if the couple both have a 35 year working career, they can contribute $385,000 in total. This is not including any capital gains or income produced from the investments. Since the Roth allows both tax free growth and dividend/interest income, this makes it the ideal place for Americans to passively invest in the stock market for long term retirement income, or better yet to let the snowball keep rolling and pass the account on to a beneficiary after death.

There is of course a trade off when it comes to investing in a registered account. It is not the fact that the taxation happens at the front end instead of the back, it is the issue of strict withdrawal rules as well as not being able to use the assets in your Roth as collateral for a loan. I’m not blindly advocating for all people to use margin loans to attempt to boost the returns on their journey towards retirement. The reasoning behind this rule is of course for people to avoid risk with money that is intended towards retirement. I’ll simply say that if investors are allowed to freely pick whichever specific securities they want within the Roth and when to buy and sell, then they should be allowed to use the market value of their accounts to loans, whether by a brokerage or a bank.

The only exception to this rule is the allowance of a $10,000 early withdrawal if and only if it goes towards the first time purchase of a home. Even then it must be paid back into the account relatively quickly or extra taxes will apply. Use the Roth IRA for what it is meant to be, a long term retirement account, but keep in mind that you won’t be able to use the account as collateral. Think through what this means with regards to how you want your financial future to be structured. The Canadian equivalent of the Roth, the TFSA, offers more financial freedom to Canadian citizens by allowing them to withdraw money from the account at any future time without penalty, in addition to being able to use the account for collateral.

There’s no need to make investing in a Roth complicated. So let’s simplify the goal. The goal is for the couple to set aside $5500 each per year to invest in the stock market for the long run. The dividends will be reinvested until the point where the couple can comfortably live off of the dividends without selling any ETF shares.

All that’s needed is a single ETF to max out the yearly limit with. With the right brokerage account, you won’t pay any fees on the trades when you buy this ETF, and if the goal is to live off the dividends, you won’t even need to worry about the fees of selling your shares.

Warren Buffett is right to give credit to Jack Bogle for saving American investors billions of dollars in needless fund fees over the decades, and the Charles Schwab Co deserves similar credit for competing with Vanguard on low fees. The current environment for investors has so many modern advantages. The ease of setting up a brokerage account and executing trades for low costs makes investing available for almost anyone, even with little capital to start with.

Why dividend ETFs?

The Roth is not meant to be a trading account, but even for the long term, buy and hold investor it wouldn’t be advantageous to put some of their best stocks picks into the Roth IRA. This sounds okay in theory, but the rules within the Roth set up a rather arbitrary set of guidelines such as only having $5,500 per year to invest, and the inability to carry forward any previous contribution room. Patience is one of the virtues that most of the famous value investors exhibit. Current examples would be Berkshire Hathaway holding tightly onto its war chest of cash currently around $115 billion, looking for the biggest potential acquisition of the company’s history. Or Fairfax Financial’s Prem Watsa, standing firm on his very contrarian long position in Blackberry.

The point here is that within the rules of the Roth, you are forced to buy $5500 in some kind of security. You could try and subvert this strategy by putting the $5500 into a money market fund, and trading that into the stocks you wanted to pick. In the end this would only add more complexities. Even to the person who is legitimately skilled in the selecting of securities, there would be no additional benefit to trading what would only be a small portion of their personal portfolio within a Roth. Strict withdrawal and contribution limits make it more conducive to passive, buy and hold investing.

There are certain securities that should definitely not be put into a Roth, such as fixed income, muni bonds, and growth stocks.

Fixed income

There is a rationale for holding debt instruments in the Roth, it being that interest income is taxed at a higher rate than qualified dividends are. Even with the capital gains being tax free as well, the capital appreciation in addition to interest won’t grow as much in the long run as stocks generally will.

Muni bonds

This does fall under fixed income of course, but I wanted to give special mention because the entire tax-free nature of municipal bond interest is essentially negated if put into a Roth. The interest is already tax free in a non-registered account, so the only thing to be gained would be no taxation on the capital gains, but again most people are not professional bond traders and shouldn’t be relying on buying low and selling high in the bond market.

Growth stocks

One of the benefits of investing in growth stocks is that there is no dividend to be taxed, only the capital gains. The longer you hold a growth stock which steadily increases in share price, the longer you delay any taxation on your gains. This is one reason why Berkshire has generated such sustained returns. Buffett saves his shareholders a considerable tax burden by never paying out a dividend.

Berkshire could easily be one of the dividend aristocrats or kings if that was the path that had been chosen. Some shareholders are even calling for dividends as a partial solution to the problem of Berkshire’s ever expanding war chest of cash. I personally doubt that Buffet will resort to dividends, but a special, one-time return of capital dividend might be possible one day if there is a continuous lack of opportunity for capital deployment. At any rate, I wouldn’t put any growth stocks, including Berkshire, into a Roth.

It has to be noted that most of the biggest dividend ETFSs have actually failed to beat the general market since their individual inceptions, even with dividends reinvested. The table below shows the compounded return of each of the ETFs I'll be analyzing, shown in comparison to the S&P 500 ETF, SPY, over the same time frame as the specific dividend ETF. Returns were calculated here.

ETF

CAGR* Since Inception

CAGR* of SPY in Same Timeframe

VIG

8.52%

8.67%

VYM

7.86%

8.39%

DVY

8.15%

9.00%

SDY

8.71%

8.86%

SCHD

14.80%

16.25%

HDV

11.19%

13.03%

DGRO

11.36%

11.70%

NOBL

12.01%

13.36%

SPHD

13.24%

14.99%

SDOG

13.92%

15.16%

DGRW

12.90%

12.94%

DLN

7.70%

9.11%

DHS

6.36%

9.11%

*Dividends reinvested

Starting from the top down measured by total assets, each dividend ETF has failed to beat or even match the general market, with the use of SPY. So you might ask, why even bother with one of these dividend-oriented funds?

The main reasons for the general market outperforming is the fact that the time frame for most of these isn’t that long, and that some of the highest weighted companies in the S&P are non-dividend paying tech companies that are driving much of the performance. Many of the biggest and best paying dividend companies are in the consumer staples sector, which has still yet to recover from the industry-wide scare of Amazon’s acquisition of Whole Foods.

The reason not to fret over this possibly alarming fact is that in the long run(I'm meaning at least a couple of decades) an above (market) average yield will lead to out-performance.

Any deviation the dividend ETFs have from the S&P 500 in market value will be more than made up for by the difference in dividends over the long run. Whether the dividends are used for reinvestment or taken as retirement income, an above average yield is more beneficial. Even with the higher yielding ETFs i’m recommending, it doesn’t quite reach the ideal state of the 4% rule strictly through the yield alone however.

The most ideal situation is to follow the 4% rule through dividend yield. Since that can’t be planned perfectly through a single ETF, we don’t know what the yield will be decades from now.

Also the timing happens to be just right for my statement to be true, because many of the funds have outperformed if a previous date had been chosen. It is simply a combination of the slump in the consumer staples sector and the fact that these types of consumer goods companies tend to have a very large weighting in most ETF holdings.

There is still a misconception about the S&P 500 index. The index is not simply a constant representation of the biggest 500 publicly traded companies in America. There are strict requirements the S&P selection committee follows, and this results in the worse companies being taken out every year while the better companies either stay or are added to the index. This is certainly not to be considered the same as stock picking, but it also obfuscates the issue of passive versus active investing. Can you really call it passive investing when the primary market index sees a consistent turnover in its portfolio and has a qualitative bent? With this in mind, simply using a more dividend oriented approach shouldn’t add any risk. It does eliminate the growth from non-dividend paying companies, such as the FANG stocks. Of course, this shouldn’t be an issue if one is pursuing a dividend fund from the start.

Below are the funds I’ve chosen for analysis. I’ve excluded international and actively managed funds, and stuck to only ETFs with mostly large-cap companies.

Fund

SEC Yield

ER

Total Assets

Commission-Free Trading

Inception

Benchmark

One Year Fund Flows

VIG

1.95%

0.08%

29.3 billion

Vanguard, TD Ameritrade, Firstrade

4-21-2006

NASDAQ US Dividend Achievers Select Index

774.89 million

VYM

3.17%

0.08%

21.73 billion

Vanguard, TD Ameritrade

11-10-2006

FTSE High Dividend Yield Index

1.1 billion

DVY

3.47%

0.39%

17.22 billion

Fidelity

10-31-2003

Dow Jones U.S. Select Dividend Index

-1.06 billion

SDY

2.25%

0.35%

16.05 billion

n/a

11-08-2005

S&P High Yield Dividend Aristocrats Index

-775.78 million

SCHD

3.10%

0.07%

7.9 billion

Schwab

10-19-2011

Dow Jones U.S. Dividend 100 Index

1.34 billion

HDV

3.62%

0.08%

5.87 billion

Fidelity

3-29-2011

Morningstar Dividend Yield Focus Index

-800.6 million

DGRO

2.26%

0.08%

4.04 billion

Fidelity

6-10-2014

Morningstar US Dividend Growth Index

1.72 billion

NOBL

2.20%

0.35%

3.67 billion

Schwab

10-9-2013

S&P 500 Dividend Aristocrats Index

214.94 million

SPHD

3.63%

0.30%

2.66 billion

n/a

10-18-2012

S&P Low Volatility High Dividend index

-497.66 million

DGRW

1.88%

0.38%

2.31 billion

Schwab, E*TRADE

5-17-2013

WisdomTree U.S. Dividend Growth Index

324.01 million

SDOG

3.79%

0.40%

2.27 billion

Schwab

6-29-2012

S-Network Sector Dividend Dogs Index

-133.37 million

DLN

2.51%

0.28%

2.00 billion

E*TRADE

6-16-2006

WisdomTree LargeCap Dividend Index

-130.71 million

DHS

3.3%

0.38%

959.86 million

E*TRADE

6-13-2006

WisdomTree Equity Income Index

-305.69 million

The fund flow data shows an exodus from higher fee ETFs and presumably some of that is flowing into the lower fee funds. The price war continues to go on as Vanguard recently announced commission-free trading for over 1800 ETFs. None of these are Vanguards own funds, which are already free of commission through a Vanguard brokerage account.

The Top Three

From this list there are three acceptable ETFs: VIG, VYM, and SCHD.

Below is a look at the top ten holdings of each ETF and the % of holdings:

VIG

VYM

SCHD

Microsoft 4.2%

JP Morgan Chase & Co 3.6%

PepsiCo Inc 4.91%

Walmart 3.8%

Exxon Mobil Corp 3.6%

Pfizer Inc 4.91%

Johnson & Johnson 3.8%

Johnson & Johnson 3.3%

Verizon Communications 4.77%

PepsiCo Inc 3.5%

Wells Fargo and Co 2.5%

Proctor and Gamble 4.77%

McDonalds Corp 2.8%

Chevron Corp 2.4%

Home Depot Inc 4.46%

3M Co 2.6%

AT&T Corp 2.4%

Walmart Inc 4.28%

MedTronic PLC 2.6%

Intel Corp 2.4%

Exxon Mobil Corp 4.27%

Union Pacific Corp 2.5%

Pfizer Inc 2.1%

IBM Corp 4.11%

Texas Instruments Inc 2.4%

Verizon Communications 2.1%

3M Co 4.04%

Abbott Laboratories 2.4%

Cisco Corp 2.1%

Union Pacific Corp 3.88%

I consider each ETF to be equally suitable for being the sole security in the Roth IRA. I do however favor VYM and SCHD due to the higher yield. The type of long-term investing that I’m describing doesn’t depend on the ETF perfectly tracking the market. Once the retiree is living off the dividends, the market value doesn’t really matter as much. Therefore, an ETF with an above average yield will help both the compounding process as well as enable a higher living standard in retirement.

The deciding factor between SCHD and VYM of course is whether you have a brokerage account with Vanguard or Schwab. The reason I always emphasize this is because Roth investing will necessarily be done on a regular basis as opposed to a one time, lump sum. When dollar cost averaging, paying zero commissions for each purchase will make a significant difference in the real return.

I would like to give a favorable mention to NOBL, despite it not being in my top three. The simplicity of having equal weighting to all the constituents of the dividend aristocrats index is something I appreciate. The main issue with this fund is that the expenses are still too high for tracking such a straightforward index. Hopefully their expenses will come down eventually, which would make it an even more competitive choice.

Conclusion

The best way for a working American to save and invest in stock market for the long run is through the Roth IRA account. Using just a single, dividend paying ETF simplifies things so the investor can simply dollar cost average and let compounding work its magic. Even though most of the popular dividend ETFs haven’t beaten the market since inception, the dividend bent will result in over performance in the very long run for the right funds. VYM, SCHD, and VIG are my top picks, but VYM and SCHD offer a higher yield which will be beneficial for both the compounding and income receiving phases.

Disclosure: I/we 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.