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Portfolio Construction during Retirement

Should one load up on dividend-paying mutual funds and preferred stocks in retirement? Dividends provides a flow income, usually every 3 – 6 months in SA. But how does it stack up in reality?

The last few years bear this out and we will use the following 2 funds as a comparison. 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 suggest that investors who are in retirement do not take an income-only approach. Instead, consider a core-and-satellite investment strategy like the one I outline below.

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 now.  That too is a concern and something investors need to be aware of.

Therefore, I advocate for a more balanced core portfolio, adding income satellites for retirees where it makes sense. Here’s how that works:

Create a good core

Instead of a focusing on income-only investments, retirees should hold the bulk of their nest egg in a core portfolio of low-cost broadly diversified index funds. Here we suggest large cap indexes, small cap indexes, international and emerging market indexes and equal-weighted indexes. Equal weighting is a simple idea: We buy the same dollar value in each stock, representing an equal part of the value of the portfolio. Equal weighting reduces the glaring overexposures to tech, banks and energy stocks noted earlier

Add  some active and passive fixed income managers, as well as active equity managers where it makes sense, like in ESG, or a specialty strategy, such as hedging or merger arbitrage.Then adjust the allocations as time goes on depending on performance and perceived opportunities. A good core should keep pace with the broad market, but with less risk than the broad market.

Create income satellites

If you have a strong core, you can round out your portfolio using satellites. A satellite is a tilt or a slight overweight in the portfolio.Whilst in retirement, use a high-dividend-paying ETF as a satellite. Individual stocks and ETFs are good for their tax efficiency.

Preferred stocks are a satellite. Preferred stock is a separate class of stock that companies issue. Preferred stock has higher yields than regular common stock,

Real estate investment trusts (REITs) are a good income satellite for retirees, too. REITs have high yields, usually 4%-5%. we recommend retirees have 2%-5% of their overall portfolio in REITs. That’s enough of a tilt to boost the income and diversification, but not enough to wreak havoc on the overall portfolio if the sector performs badly. There are several types of REITs, such as multi-family housing, warehousing and data centers, active and passive mutual funds, and ETFs.

Focus on total return, not income

Instead of focusing on income, focus on total return. In a good year for the stock market, such as 2019, 2020 and so far 2021,  take the profits or gains from the portfolio and re-invest. In a bad year, we may take less from the portfolio or use our bonds and cash, so our stocks have time to recover.

Dividend and interest income are usually not enough to cover clients’ lifestyle expenses. Taking profits is also like rebalancing. It reduces our risk. For the past five years taking profits from growth stocks has reduced exposure to IT and software companies. This approach didn’t help the portfolio grow, but it did reduce the risk of being overexposed to tech – risk of loss is something retirees usually care more about than performance.

Conclusion

Unless you have a strong conviction about financial, energy and utility companies, steer away from high-dividend-yielding funds and ETFs for the bulk of your money. Instead, try a core-and-satellite approach. A good core is well-balanced and well-diversified across industries, large and small companies, and domestic and foreign stocks. Consider adding income satellites like high-dividend stocks, preferred stocks and REITs in small amounts. Satellites can increase the portfolio income without changing the risk too much. It’s all about balance.