I host various seminars for retirees. At every seminar, one retiree always raises his or her hand and tells me they recently loaded up on dividend-paying mutual funds and preferred stocks. I shake my head and wish them luck.
I understand the logic but disagree. The last few years bear this out. Since 2016, the Vanguard High Dividend Yield ETF (VYM) – which owns high-dividend-paying stocks – has severely underperformed the broad market as measured by the Vanguard S&P 500 Index fund (VFIAX) (see Figure 1). Dividend investors in VYM gave up a tremendous amount in overall performance and diversification.
For this reason, I tell investors who are in retirement not to take an income-only approach. Instead, consider a core-and-satellite investment strategy like the one I outline below, or tune into our complimentary retirement planning webinar Nov. 16 & 17 to learn more (register here).
Dividend investing versus the broad market
It’s all about balance. If we go all in on dividend-paying stocks and mutual funds, our dividend income may increase, but at the expense of overall portfolio appreciation and diversification. Figure 1 bears this out. Many technology stocks are not high-dividend-paying stocks and are not in the Vanguard High Dividend Yield ETF. In other words, investors in the high-dividend fund missed the tech run. The S&P 500 index fund grew 70% more versus the high-dividend ETF over the past five years.
Dividend mutual funds lack diversification
Many dividend-focused mutual funds and ETFs own a greater proportion of bank, energy and utility companies than the index. The Vanguard High Dividend Yield ETF (VYM), as of Sept. 30, 2021, had about 1.5 times more in in financial service companies and roughly three times as much in energy and utility companies as the Vanguard S&P 500 Index (see Figure 2). The high dividend ETF also owns significantly less in tech: 9.67% versus 24.65%.
This is no surprise since banks, utility and energy stocks usually have higher dividends than tech stocks. However, since 2016 those bank and energy stocks did not perform as well as tech stocks. This year is a little different as energy stocks have soared.
The key is to be aware that owning dividend-paying mutual funds can lead to a portfolio that tilts heavily to three sectors of the economy. As a result, the performance can vary significantly from the broad benchmark and rely heavily on the health of banks, energy and utility companies. Granted, the S&P 500 Index owns a significant amount of tech right …….