A Simple 3 ETF Combo For A Complete Diversified Dividend Portfolio

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Includes: DGRO, SCHD, VYM
by: Dave Dierking, CFA
Summary

To diversify your dividend income portfolio, I suggest a three-pronged approach that focuses on dividend growth, dividend quality and high yield.

This simple 3 ETF portfolio includes one fund that focuses on each of those strategies.

Each ETF is 5-star rated by Morningstar and comes with an expense ratio of under 0.10%.

If you're an investor looking to build a dividend-producing portfolio using ETFs, you'll be happy to know that you have a lot of great options to choose from. There are dozens of 5-star Morningstar-rated dividend ETFs not just from the likes of Vanguard, Schwab (NYSE:SCHW) and BlackRock (NYSE:BLK), but also smaller ETF issuers, such as Invesco, FlexShares and WisdomTree. Better yet, the never-ending fee war in the ETF industry means you can own some of these fantastic funds for as little as 0.10% annually or less.

But constructing a well-rounded dividend ETF portfolio isn't as simple as just picking the funds with the highest ratings or historical returns. Different ETFs employ different strategies for targeting dividends, so it's important to hold a mix of these strategies in order to diversify your coverage. I suggest that investors take a three-pronged approach to create a dividend ETF portfolio. By that, I mean including funds that focus on three distinct strategies - dividend growth, dividend quality and high yield.

Dividend growth is pretty easily definable and includes targeting companies with long histories of paying and growing their dividends, such as the dividend aristocrats. Dividend quality can take on several appearances, but it generally focuses on companies whose dividends are sustainable and supported by balance sheet strength. This is generally defined by strong cash flows, high returns on equity, manageable payout ratios and profitability. Including high yielders' attempts to boost the portfolio's total income.

If you want to build a high quality, well-rounded dividend portfolio, I suggest using a simple 3 ETF combination. Not only do these ETFs hit on each of the areas I describe above, but each fund also comes with:

  • A 5-star rating from Morningstar
  • An expense ratio of less than 0.10%
  • A substantial degree of liquidity to help avoid high spreads and other unnecessary trading costs

To be fair, this ETF trio isn't perfect. It's a little light on overseas exposure and doesn't have much dedicated to smaller companies, but if you're looking for simplicity, high quality and low cost, this combo will fit great in just about any portfolio.

Dividend Growth - iShares Core Dividend Growth ETF (DGRO)

I've long considered DGRO to be one of the top dividend ETFs in the marketplace. The qualifications for making it into this portfolio are fairly straightforward. Components must pay a qualified dividend (which means REITs are out), have at least five years of uninterrupted annual dividend growth and have an earnings payout ratio of less than 75%. Companies that are in the top decile based on dividend yield are excluded right off the bat. This is done in order to remove those names that might have an artificially high yield due to poor stock price performance or could be at risk for a future dividend cut. It's essentially a means of improving the overall quality of the portfolio. The fund can invest in companies of any size, although it tends to lean heavily towards large-caps.

DGRO holds in the #1 spot in the Dividend ETFs category of the ETF Focus Power Rankings and for good reason. It ranks in the top 3% of Morningstar's Large Blend category over the past three years and has done so with about 5% less risk than the S&P 500 (SPY). DGRO also uses a dividend-dollars-weighting methodology to construct the portfolio, a strategy which gives greater weights to those companies which have the greatest payouts to shareholders. This focus on total dividend payments instead of market caps or yields could give DGRO a competitive advantage by offering more of a pure play on dividend growth.

Alternatives: The dividend growth category is most notably represented by the ProShares S&P 500 Dividend Aristocrats ETF (NOBL) and the SPDR S&P Dividend ETF (SDY). These two funds require consecutive annual dividend growth increases of at least 25 and 20 years, respectively. SDY also has a razor-thin expense ratio, a 5-star track record and, since it looks at the S&P 1500 for its components, a more all-cap composition. NOBL sticks with just the S&P 500 and its 0.35% expense ratio puts it a step behind both DGRO and SDY.

Dividend Quality - Schwab U.S. Dividend Equity ETF (SCHD)

SCHD is actually a combination of the growth, quality and yield factors all in one terrific ETF. It invests in companies with at least 10 consecutive years of dividend payments and strong fundamental measures, such as a high cash flow to total debt ratio, return on equity, dividend yield and 5-year dividend growth rate. Like DGRO, it also excludes REITs as well as things such as MLPs and preferred shares. The top 100 companies that score highest according to this combination of dividend growth, yield and fundamental strength make the final cut.

Over the past three years, SCHD's performance is almost without compare. The fund has outperformed Morningstar's Large Value category by more than 4% per year and has done so with about 10% less risk. Its performance against the S&P 500 has been equally remarkable. During a period that has almost entirely favored growth stocks, SCHD and its value tilt have still managed to outperform the broader market by about 0.3% annually, again, with less risk. Dividend seekers will be pleased to know that this track record also comes with a yield that's more than 1% higher than the S&P 500 (2.9% vs. 1.7%).

Alternatives: The FlexShares Quality Dividend Index ETF (QDF) uses a proprietary model based on management efficiency, profitability, cash flows and dividend yield to produce a portfolio with an above-average sustainable yield with market comparable risk. It's also a 5-star fund, but its 0.37% expense ratio is on the higher end. The O’Shares FTSE U.S. Quality Dividend ETF (OUSA), run by Shark Tank's Kevin O'Leary, looks at profitability, operating efficiency, earnings quality, low leverage, low volatility and high dividend yield to select more than 100 large-cap and mid-cap names. It also has a strong track record, but a 0.48% expense ratio is a disadvantage.

High Yield - Vanguard High Dividend Yield ETF (VYM)

With assets of roughly $22 billion, VYM is one of the largest dividend-centric ETFs available in the marketplace. Its focus is very simple. It looks to invest in the highest yielding companies within the total U.S. stock market. Its parent index, the FTSE All-World High Dividend Yield Index, ranks companies according to their forecasted dividend yield over the next 12 months and contains the highest yielding stocks accounting for 50% of the investable market capitalization. Due to their unfavorable tax treatment, REITs are excluded.

Funds that focus purely on high yielders haven't done quite as well lately since rising interest rates have made those 3%+ yields look comparatively less attractive. Despite that, VYM has still managed to rank in the top 15% of Morningstar's Large Value category over the past 3-, 5- and 10-year holding periods. Although the fund screens companies by yield, it is market cap weighted, giving it a heavy large-cap tilt. VYM's dividend yield currently stands at 3.2%.

Alternatives: I see three main alternatives to VYM in the high yield space. The SPDR Portfolio S&P 500 High Dividend ETF (SPYD) measures the performance of the top 80 dividend-paying stocks in the S&P 500. It carries an expense ratio of 0.07% and a yield of 4.1%. The Oppenheimer S&P Ultra Dividend Revenue ETF (RDIV) selects the 60 highest yielding securities from the S&P 900 (essentially all large-caps and mid-caps) and weights the portfolio by annual revenue, instead of market cap or yield. It yields 3.6%. The ALPS Sector Dividend Dogs ETF (SDOG) selects the five highest yielding securities in each of the 10 GICS sectors from the S&P 500 and equal weights them. It currently yields 3.7%.

The 3 ETF Combination

Here's a look at the three ETFs side by side.

If you equal weight the three funds, you end up with a very respectable 2.75% yield and an expense ratio of just under 0.08%. From a standpoint of composition, VYM and DGRO look very similar as far as which sectors they're invested in, while SCHD is a little more heavy at the top. Not surprisingly, this combination is very value-oriented. A combined P/E ratio of around 15.7 comes in well below the S&P 500's ratio of 18, which could be beneficial since the valuations of a number of growth stocks and ETFs are starting to look stretched (the Vanguard Growth ETF (VUG), for example, has a P/E of more than 22). Both beta and the standard deviation of historical daily returns suggest this trio could be anywhere from 5-10% less volatile than the S&P 500.

Dividend ETFs are fairly highly correlated and these funds will be no exception, but the real advantage of using these three ETFs together is how relatively different they actually are.

Credit: ETF Research Center (etfrc.com)

VYM and DGRO look the most similar considering they have nearly identical sector weightings and number of components with their portfolios, but overall asset overlap is just under 60%. The low asset overlap between SCHD and the other two funds is at least partially attributable to the fact that SCHD has far fewer holdings, but even then there are some noticeable differences. SCHD looks most like VYM, which shouldn't be surprising since they both use dividend yield as a major factor in stock selection, but less than 2/3 of SCHD's components show up in DGRO.

Conclusion

I hear from a lot of dividend investors who generally fall into one of two camps - 1) those who focus on dividend growers and want to generate a sustainable income while giving themselves regular raises and 2) those who target high yielders and want to live off of their portfolio income but a 2% yield just won't suffice. I'm a firm believer in diversifying your income sources and using a combination of these strategies to achieve both of these objectives at the same time.

If you're using ETFs for that purpose, you'll be hard-pressed to find a trio much better than this. Granted, it's not without some minor issues. As mentioned earlier, there's no international exposure and the combo would have only about 10% of assets dedicated to mid- and small-caps. But this three 3 ETF combination still gives you the best of all worlds, and that should ultimately help you produce better risk-adjusted returns with an above average dividend yield.

Disclosure: I am/we are long DGRO, SCHD, QDF. 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.