Dividend Growth ‘Plus’ | Seeking Alpha

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Suppose that you are like me. You find that you now lack those constantly nagging incentives to do the extraordinarily, replaced by a monotonous desire to merely avoid the potentially catastrophic. You only want to earn average investment returns, the prescription for which boils down to doing just four things and nothing besides: (1) diversify, (2) passively own shares for the long-term, (3) rely on the power of compounding by reinvesting your dividends, and (4) pay zero fees (or as close to zero as possible).

A low-cost, low-turnover passive index fund should satisfy all four of those criteria. The only fly in the ointment is that if you plan to periodically sell shares to fund your lifestyle, then at some point you may be forced to sell stock during a bear market (and selling stocks during a panic could certainly lead to a “potentially catastrophic” outcome). You want to avoid that risk. A potential solution is that if you can just live off stable, secure dividend income that keeps pace with inflation, bear markets become irrelevant since you won’t have to sell anything. If that solution sounds reasonable then is an S&P 500 index fund the right answer for you?

It depends. The S&P 500 tends to pay a rising stream of dividend income over time, but those dividends can and do fluctuate. As my recent previous article notes, at least two dividend growth index funds, the Vanguard Dividend Appreciation ETF (VIG) and the Schwab US Dividend Equity ETF (SCHD), have delivered diversification, exceptionally low expense ratios and dividend growth that since inception exceeds that of the broader market. The problem is that since inception, the overall performance for VIG and SCHD slightly trails the broader market – even after you consider the impact of reinvesting dividends.

So much for your aspirations for average returns.

The question I’d like to explore is “why did these DGI funds underperform the market?”

Why did VIG and SCHD lag the broader market?

To find the answer, start by taking a look at the top ten holdings for each of VIG, SCHD and the SPDR S&P 500 Trust (SPY) according to Marketwatch.com.

SPY holdings

Top Ten Holdings for (SPY) (Marketwatch.com)

VIG holdings

(VIG) Top Ten Holdings (Marketwatch.com)

SCHD holdings

(SCHD) Top Ten Holdings (Marketwatch.com)

You’ll quickly notice that six of the top holdings for SPY pay no dividends (those holdings are Alphabet (GOOG), (GOOGL), Meta (FB), Tesla (TSLA), Amazon (AMZN) and Berkshire Hathaway (BRK.B)). Maybe that’s the key to VIG’s and SCHD’s lagging performance?

To find out, I used Portfoliovisualizer.com to trace the performance for SCHD since inception but I added 1% allocations to each of today’s top four non-dividend-paying S&P 500 stocks that were public companies on November 2011 (which is the date SCHD started trading). Specifically, I allocated 96% to SCHD and just 1% apiece to GOOG, GOOGL, AMZN and BRK.B and ran an analysis of the returns.

The annual performance of this “SCHD Plus” portfolio is 15.39% which slightly exceeds the 15.29% performance for SPY over the same time period.

SCHD plus

“SCHD Plus” Portfolio (portfoliovisualizer.com)

I then ran the same experiment with VIG and found that the average long-term performance since the fund’s inception in 2006 comes in at 11.56% per year, nicely outperforming the 10.49% annual returns for SPY over the same time period.

VIG plus

“VIG Plus” Portfolio (portfoliovisualizer.com)

Obviously, the power of retrospect renders it mere child’s play to design any portfolio that outperforms the stock market – but we’re asking a different question. We are asking “why did SCHD and VIG underperform the S&P 500?”

At a granular level the answer is “because those funds did not own GOOG, GOOGL, BRK.B and AMZN.” That information conveys two possible lessons.

Lesson learned

Lesson one is that the index providers for VIG and SCHD failed to do the impossible, which is to predict which of the non-dividend paying stocks in the S&P 500 would soar higher in value. If that’s the correct conclusion to reach, then there is absolutely nothing actionable to take from this experiment.

Lesson two is that SCHD’s and VIG’s failure to deliver at least average returns was due to a strategic failure of underinclusiveness. You could say that the failure is “strategic” because the reason why SCHD and VIG did not (and do not) own any of Alphabet, Berkshire or Amazon is due to just one factor: none of those companies paid (or pays) a dividend. If the problem is a strategic one, then there is an actionable lesson: modify the DGI strategy to include some exposure to non-dividend paying growth stocks.

The next question would be “how?”

To get out of the business of trying to predict individual stock performance and address some of the problems of survivorship bias, I ran the same analysis as before except this time, I assumed that 95% of the portfolio is allocated to SCHD and 5% allocated to the growth-oriented and dividend-light Invesco QQQ Trust (QQQ). The result is that even with a very, VERY slight allocation to a dividend-light growth stock index, this “SCHD plus” strategy delivered long-term annual performance of 15.18%, which only slightly trails the 15.29% annual long-term performance for SPY. But consistent with the goal of “average returns, above average dividend growth,” the “SCHD plus” strategy delivered stunning and superior dividend growth of 14% per year versus 8% per year for SPY.

SCHD QQQ portfolio

SCHD Plus QQQ (Portfoliovisualizer.com)

income growth

SCHD Plus Income Growth (portfoliovisualizer.com)

The results were even tighter when I ran the same analysis with a portfolio allocated 95% to VIG and 5% to QQQ. The “VIG Plus” strategy delivered long-term annual performance of 10.47% per year compared to 10.49% for SPY over the same time period, but dividend growth of 9% per year compared to dividend growth of 7% per year for SPY.

VIG plus performance

Vig Plus QQQ portfolio (portfoliovisualizer.com)

vig plus income

Vig Plus QQQ income growth (Portfoliovisualizer.com)

Obviously none of these past results promises similar or even comparable future results, but history shows that hedging a pure DGI strategy with even scant exposure to a non-dividend-based growth strategy can deliver the best of both worlds: superior income growth without sacrificing average market returns. Investors can draw their own conclusions about whether those historical results are likely to persist (and I invite you to chime in on that question in the comments section).

Disclosing my personal bias

In my case, I have chosen to create my own “DGI” plus” strategy by owning mostly individual dividend growth stocks PLUS a few shares of non-dividend paying stocks that no pure DGI portfolio would include. To be sure, there is a vast universe of non-dividend paying candidates that I could have chosen, but ultimately I went with three of the top six holdings for the S&P 500 that pay no dividends currently. Why did I pick those? Among other reasons because the closer my portfolio gets to the S&P 500, the likelier it becomes that my returns will mirror those of the S&P 500. Specifically, I’ve allocated 3.2% of my portfolio to non-dividend paying GOOG, FB and AMZN to create my own “DGI Plus” portfolio, the holdings and allocations of which follow:

my portfolio

Author’s Personal Portfolio (author’s spreadsheet)

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