Exchange-traded funds (ETFs) offer many benefits for investors who want to invest in broad or narrow sectors of the investment markets without the need to make specific stock or other individual security investment choices. And you’ve probably at least once thought about getting the best of both worlds with dividend-focused ETFs: income + a basket of stocks.
However, when investing for income and yield, the ETF approach can leave quite a lot of current income and future price appreciation on the table. In the income stock investment market, a couple of strategies and tools can make picking ETF beating investments not that difficult of a task.
Benefits of Exchange Traded Funds
There are several reasons that ETFs can provide value to an investor’s financial planning.
An ETF owns securities to match a specified index. As a result the fund company does not pay an active manager and fund expenses will be low.
Index investing means that a fund will not underperform the market by more than the fund’s annual expense ratio.
The wide range of available ETFs allows you to invest by theme. For income investors, typical themes would be high-yield stocks, dividend growth stocks, REIT funds, and master limited partnership (MLP) funds.
ETFs simplify tax reporting, with a single Form 1099 from the funds you own vs. numerous 1099’s if you own individual stocks and possibly IRS Schedules K-1 if you want to invest in some limited partnerships.
Problems with ETFs for Income Investors
In the case of income stock investing the concepts behind index investing work against the investor trying to generate the highest level of a safe and growing yield from his investments. An index company uses a set of rules to select the list of constituents and the tracking ETF must own the selected stocks in the same weight as the current index composition. Indexes for market sectors are usually market-cap weighted, which means the largest companies get the most weight in the index and ETF. As a result, often the income and yield of an ETF falls short of what an investor could earn following some straight-forward stock picking rules to develop your own portfolio.
Consider the example of the Alerian MLP Index (AMZ), the most widely followed index of MLP companies. AMZ is a market cap weighted index with 50 constituents. Based on the current weightings AMZ yields 5.67% with projected 3-year distribution growth of just over 7% per year. That doesn’t sound too bad, earning 5.7% and having dividend cash flow grow by 7% every year. Yet if you were to select the 25 most attractive MLPs in the index according to yield and projected growth, an equal weighed portfolio of the 25 MLP stocks would have a current yield of 5.82% and projected annualized distribution growth of 9% per year. Factor in the half-percent or so of ETF management costs, and the hand selected MLP portfolio will show significantly better returns after a few years.
The Growing Yield Hunter’s Stock Finding Tool
The best long-term income stocks are those paying an attractive yield plus a history — and continued expectations — of regular dividend growth. A stock that pays 5% per year and increased the dividend by 6% every year is a much better investment than a stock yielding 7% that never increases the dividend. In 10 years that 6% distribution growth rate turns into an 11% yield on your original investment. And the truth is you can find stocks yielding 4% to 6% that are increasing dividends by double digit rates every year.
Here is a yield vs. estimated compound distribution growth plot of the 50 AMZ MLP stocks.
This type of chart lets you focus in on the yield you would like to receive on your investments and then look at companies with that level of yield with the highest growth potential. Or you can focus on the rapid dividend growth companies and pick out the ones near the top of the plot furthest to the right to get a higher current yield. The chart above was sourced from the MLPData.com website. I have also developed my own scatter charts for REIT stocks to dig out those companies offering the golden combination of current yield and future dividend growth. If are not interested in reviewing hundreds of companies as I have, start with a list of income stocks that interest you and make columns of their current yields and the dividend growth rate for the last couple of years. You will soon see which ones stand out from the crowd.