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Dividend stocks are often touted as a great way to build wealth. However, this is an overly simplistic, and often incorrect, viewpoint. Many dividend stocks lose money for investors over time, especially if the dividend is not reinvested.
This problem also plagues most income-oriented exchange-traded funds (ETFs). Moreover, some investors have resorted to using derivative strategies such as covered calls to boost their income from dividend stocks or income-oriented ETFs, which is usually a losing proposition due to the way this strategy works.
However, there is a simple and effective way to solve this problem for those who want to use dividend payments to supplement their retirement income. Some Vanguard ETFs that pay dividends have demonstrated the rare ability to provide both steady income and capital growth without relying on reinvesting the dividends. Furthermore, there is no need to use risky strategies such as put-underwriting to generate meaningful levels of income from an equity portfolio.
To demonstrate, let’s walk through an example comparing four Vanguard-indexed ETFs to four widely held blue chip dividend stocks.
The Vanguard dividend portfolio
For this example, I’m selecting four Vanguard ETFs that have a strong track record of both paying dividends and generating positive returns over the prior 10 years. Those ETFs are the Vanguard 500 Index Fund (NYSEMKT: VOO), Vanguard High Dividend Yield Index Fund (NYSEMKT: VYM), Vanguard International High Dividend Yield Fund (NASDAQ: VYMI), and Vanguard Dividend Appreciation Index Fund (NYSEMKT: VIG). The table below lays out the key metrics for each fund.
|
Ticker |
Index tracked |
Yield (%) |
Alpha |
Beta |
Expense ratio (%) |
|---|---|---|---|---|---|
|
VOO |
S&P 500 |
1.48 |
0 |
1 |
0.03 |
|
VYM |
FTSE High Dividend Yield Index |
3.14 |
1.36 |
0.77 |
0.06 |
|
VYMI |
FTSE All-World ex US High Dividend Yield Index |
4.45 |
6.08 |
0.94 |
0.22 |
|
VIG |
S&P U.S. Dividend Growers Index |
1.92 |
0.86 |
-0.79 |
0.06 |
*Alpha and beta refer to the performance of the ETF relative to appropriate benchmarks over the past 36 months.
These four funds would have delivered the following results for an initial capital outlay of $250,000 per fund invested 10 years ago.
|
Ticker |
Total returns sans dividends |
Total return with dividends reinvested/before taxes |
|---|---|---|
|
VOO |
$604,960 |
$696,520 |
|
VYM |
$423,440 |
$542,540 |
|
VYMI |
$314,790 |
$431,560 |
|
VIG |
$548,340 |
$638,930 |
|
Total |
$1,891,530 |
$2,309,550 |
These four funds would generate $58,816 of annual dividend income before taxes after 10 years at their current yields. The best part, though, is that you would have almost doubled your initial investment even if you did not reinvest the dividends at the beginning. These diversified funds are also inherently less risky than individual stocks.
Let’s do the same thought experiment using ExxonMobil (NYSE: XOM), Verizon Communications (NYSE: VZ), PepsiCo (NASDAQ: PEP), and Altria (NYSE: MO).
|
Ticker |
Total returns sans dividends |
Total return with dividends reinvested/before taxes |
|---|---|---|
|
XOM |
$263,900 |
$410,002 |
|
VZ |
$195,210 |
$320,940 |
|
PEP |
$515,940 |
$692,930 |
|
MO |
$281,330 |
$514,180 |
|
Total |
$1,256,380 |
$1,938,052 |
These four blue chip dividend stocks, at their current yields, would produce $106,633 of yearly dividend income before taxes in this hypothetical scenario of holding them for 10 years and reinvesting the dividends over this period. However, these four well-known dividend stocks would have markedly underperformed these four Vanguard ETFs in terms of both uninvested and reinvested dividend returns.
Key takeaway
One of the drawbacks of investing in individual stocks for future income generation is that a company may reduce or stop paying dividends. This risk is much lower for these Vanguard ETFs, but it could still occur in extreme global situations.
The main point, however, is that these Vanguard funds would have delivered positive returns over the prior 10 years, regardless of whether shareholders reinvested the dividend or not. This is not always the case for individual stocks — even blue chip companies like the ones mentioned above.
For instance, Verizon would have lost money for shareholders who didn’t reinvest the dividend over this 10-year hypothetical holding period. Moreover, academic research on the topic shows that this outcome is fairly common among dividend stocks, highlighting the advantages of buying diversified ETFs that pay regular cash distributions and that have low fees and tax liabilities.
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George Budwell has positions in Vanguard S&P 500 ETF. The Motley Fool has positions in and recommends Vanguard S&P 500 ETF, Vanguard Specialized Funds-Vanguard Dividend Appreciation ETF, and Vanguard Whitehall Funds-Vanguard High Dividend Yield ETF. The Motley Fool recommends Verizon Communications. The Motley Fool has a disclosure policy.
4 Vanguard ETFs That Can Serve As a Complete Income and Capital Appreciation Portfolio was originally published by The Motley Fool
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