By Samuel Lee
In mid-November last year, when Warren Buffett revealed that
Berkshire Hathaway (BRK.A) (BRK.B) had taken a massive 5.4% stake
Vanguard Dividend Appreciation ETF (
held four of its top five holdings in common with him. This was no
fluke. VIG focuses on quality dividends, demanding that companies
increase them for 10 consecutive years just to make the cut. It
then imposes further tests for liquidity and financial strength.
The exact formula is secret but seems to weed out companies with
high leverage and poor cash flow. The result is quality rather than
high yield, so income-hungry investors might be surprised by a
dividend yield that just matches the market. Whereas many
dividend-focused funds concentrate in smaller value companies, this
fund shades slightly toward growth. While we like dividends (more
on that later), we think the fund's emphasis on safer yields
justifies its average yield. VIG is a great choice for a core
Back to dividends. There's a lot to recommend dividend
investing. For one, dividends, or the promise of them, are the
soundest reason to buy equities--any other rationale relies on
Ponzi thinking. Dividend investors also buy the main driver of
historical stock returns, income today instead of the promise of
capital appreciation tomorrow. According to the excellent Credit
Suisse Global Investment Returns Sourcebook 2011, from 1900 to 2010
the U.S. stock market experienced 6.17% annualized real growth.
About 4.24 percentage points of the market's return came from
dividends, 1.37 percentage points from real per-share dividend
growth, and a paltry 0.56 percentage points from price/dividend
expansion (also known as the speculative return).
Some academics, citing the Modigliani-Miller theorem, argue that
it doesn't matter whether a company pays a dividend. A company that
holds back earnings, they claim, clearly has good investment
opportunities to further grow profits. However, a
by Robert Arnott and Clifford Asness showed that, contrary to
common wisdom, higher dividend payouts predicted increased earnings
growth for the aggregate U.S. stock market. A
on 11 countries also showed the same relationship, though it was
weaker. Ping Zhou and William Ruland found in a
that high dividend payouts predicted strong future earnings growth
among individual firms. The broad sweep of evidence strongly
supports the idea that dividends enforce discipline on managers who
may otherwise binge on empire-building. Further poking holes in
efficient-market thinking is the fact that dividend-paying stocks
have outperformed non-paying stocks in almost every market studied,
with lower volatility.
As of this writing, the U.S. stock market is unattractively valued
compared with its historical average. In order to combat depressed
consumer demand, rich-world central banks have driven down real
interest rates to punishingly low levels, inflating asset prices.
At a price of around 1,400, the S&P 500 yields about 2% and
historically has grown real per-share dividends by about 1%-2%
annualized. Add in share buybacks, a hidden boost to yield, and
U.S. stock investors can reasonably expect a long-run 3.5%-4.5%
annualized real return.
However, this estimate may be too rosy. Corporate earnings as a
share of GDP is at a record 10%, well above the 6% historical
average. The surge was in part driven by a massive expansion in
public and private debt that accelerated in the 2000s. Total U.S.
debt as a percentage of GDP was 266% at the start of 2000; it
peaked at 386% in late 2008 and has only fallen to 355% as of
mid-2011. The economy still has a long way to go before leverage
falls to sustainable levels--somewhere under 200%. The deleveraging
process will weigh on earnings and GDP growth, likely for another
decade or so, as has been the case in past great deleveragings.
Further out, changing demographics conspires against equity
returns. The fast-graying baby boomers are set to withdraw from the
productive economy, slowing growth. At the same time they'll draw
upon health-care entitlements, worsening government balance sheets.
On top of that, retirees will begin swapping equities for safer
assets, further pressuring down equity prices. The combination may
prove toxic to the stock market.
The picture isn't pretty for the stock market's long-term
returns. This doesn't mean investors should dump stocks. A more
suitable response is to plan for lower long-run returns, cut fees
to the bone, and not be surprised by volatility.
The fund tracks the Dividend Achievers Select Index, which is a
subset of the broad Dividend Achievers Index. "Dividend Achievers"
are stocks that have increased their dividends in each of the past
10 years. The index's author, Mergent, crafted this fund's
benchmark specially for Vanguard, applying the firm's proprietary
screens that weed out less liquid stocks and companies that may not
be able to continue growing their dividends. The
adjusted-market-cap weighting on this index results in the top 10
holdings comprising more than 40% of the portfolio, nearly twice as
concentrated as broad-market indexes such as the S&P 500. It
also places large sector bets against technology and toward service
and manufacturing sectors. Unlike traditional dividend-focused
ETFs, the fund is light on financial and utility industries.
This ETF levies a 0.13% expense ratio--a bargain. Although passive
large-cap ETFs can be bought for a tad less, none holds a portfolio
that is as much toward high-quality while maintaining diversity.
Like most Vanguard funds, this ETF engages in securities lending,
the practice of loaning out physical shares in exchange for a fee.
Vanguard's securities-lending program is very conservative, and
Vanguard returns all resulting income to shareholders minus a small
slice for operating costs. Counterparty risk should be minimal.
The market is chock-full of good dividend ETFs, by far the most
popular kind of strategy ETF. Some of the biggest such ETFs weight
stocks by yield, increasing income potential but shouldering more
distressed and declining companies. IShares Dow Jones Select
Dividend Index (
) charges a 0.40% expense ratio and attempts to screen for
sustainable dividends by excluding stocks that have cut dividends
in the past five years or paid out more than 60% of earnings. SPDR
S&P Dividend (
) is a tad cheaper at a 0.35% price point and requires its holdings
have increased dividends every year for the past 25 years. DVY's
portfolio yields more but is especially vulnerable to the business
cycle, while SDY's is higher quality but rests on a much narrower
base of 60 companies.
Investors leery of the idiosyncratic holdings of SDY and DVY but
looking for decent yield should consider Vanguard High Dividend
Yield Index ETF (
). Its strategy is classic: Market weight the highest yielding U.S.
stocks until the portfolio covers 50% of the U.S.' market
capitalization. The result is a low-cost, higher-yielding fund with
a more cautious tilt than the yield-weighted SDY and DVY.
WisdomTree offers a broad suite of dividend ETFs spanning
various size styles and even using earnings as a weighting metric.
Its biggest large-value offering, WisdomTree LargeCap Dividend (
), carries a competitive 0.28% expense ratio and weights large-cap
stocks by their projected share of total dividends over the next
Morningstar licenses its indexes to certain ETF and ETN providers,
including BlackRock, Invesco, Merrill Lynch, Northern Trust, and
Scottrade for use in exchange-traded funds and notes. These ETFs
and ETNs are not sponsored, issued, or sold by Morningstar.
Morningstar does not make any representation regarding the
advisability of investing in ETFs or ETNs that are based on
Azure Is Windows 8's Secret Weapon