Tech stocks have significantly outperformed value stocks since the beginning of 2023. However, things can change quickly. If you are more interested in long-term wealth building than trading or growth investments, a dividend investment strategy may be right for you.
We will show you how to use ETFs to create a diversified portfolio for a dividend investment strategy in this article. Read on below...
What is a dividend investment strategy?
Profitable companies that don’t necessarily need to use their profits to reinvest into their business or finance acquisitions pay dividends to their shareholders. These dividends are earnings that are distributed typically on a quarterly or annual basis and form part of the returns an investor can expect from investing in stocks in addition to the returns in price appreciation.
When investors are focused on a divided investment strategy, they tend to pick stocks or funds that invest in companies paying high or higher-than-average dividends. These companies are typically mature blue chips with stable business models that can afford to pay out the bulk of their earnings to shareholders.
Risks associated with a dividend strategy
No investment strategy is free of risk. As is investing in ETFs or shares with high-dividend yields. Although these companies are typically less risky than high-beta sectors like tech, nevertheless risks remain, in particular:
- Lack of diversification: Concentrating too heavily on high yield stocks can leave you overexposed to certain sectors and companies.
- Interest rate sensitivity: High dividend payers are often found in rate-sensitive sectors like banking, utilities and real estate. Sharp moves in interest rates can negatively impact their stock prices.
- Vulnerability to economic downturns: Dividend cuts are more likely during recessions, especially for financially weaker high yield companies.
A prudent dividend strategy focuses on dividend growth and stability, not just current yield. High-quality companies with secure dividends should anchor the portfolio.
Understanding key factors of dividend ETFs
When evaluating dividend ETFs, it's crucial to look beyond just the dividend yield. The yield alone doesn't give you the full picture. You also need to consider the fund's composition and weighting methodology. For example, some high dividend yield ETFs may be concentrated in just a few stocks or sectors, making them riskier.
Others may include companies with unsustainably high payout ratios.
A good starting point is to compare the ETF's yield to relevant benchmarks. The S&P 500 index currently has a dividend yield of around 1.5%. Consequently, an ETF yielding 3-4% could seem attractive, but you need to ensure the holdings are diverse and the dividends are supported by healthy earnings.
It is advised to examine the fund's long-term total return versus total return for the overall market. High yields don't help much if the share price is declining.
Liquidity is another key factor. This refers to how easy it is to buy and sell shares of the ETF without impacting the price. Funds with lower average daily trading volumes tend to have wider bid-ask spreads and higher volatility. When buying and selling, you may get stuck paying more or receiving less than the stated net asset value.
As a rule of thumb, aim for ETFs with an average daily volume in excess of $10 million at least.
Check historical trends too, as some funds may have decent volume overall but very sporadic trading. You want an ETF liquid enough that you can enter and exit positions smoothly when needed.
How to build a dividend investment portfolio using ETFs
ETFs are well suited to constructing a dividend portfolio since there are numerous options of liquid, low-fee exchange-traded funds available that are pre-selecting dividend-payers based on suitable benchmark indices. To build your portfolio, follow the below steps:
1. Understand what dividend investing means
A dividend portfolio is a collection of dividend-paying stocks that aim to provide a consistent income. Dividend stocks offer relative stability and may pay increasing amounts over time, providing a steady income.
2. Know your investment objectives
Depending on the yield of your choosing ETFs, to generate for example $1,000 per year in dividend income, you would need to invest around $25,000 in dividend-paying ETFs at a yield of 4%. This range varies depending on the dividend yield of the ETFs you choose. You can discover ETFs such as VUSA and ACWI on our website.
3. Choose the right ETFs
Select the most suitable exchange-traded funds (ETFs) for your strategy, tracking a dividend index by a reputable Index provider based on your choice of geographic region and sectors. ETFs you select should score well on diversification, low fees, and high liquidity with low spreads.
4. Diversify your portfolio
Remember to diversify your holdings by adding a portion of your portfolio to bonds, commodities, gold and other assets depending on your risk appetite and investment time horizon. Choose financial stability over growth and find companies with modest payout ratios and a long history of raising their dividends.
5. Risk Management
Set limits on individual positions, increase exposure to defensive assets when markets become more volatile, and invest in both active and passive funds.
6. Reinvest the Dividends
Reinvesting your dividends can be a powerful tool for growing your investment. Some investors opt to reinvest their dividends manually, while others use a dividend reinvestment plan (DRIP), which automatically reinvests dividends back into shares of the company without fees or commissions.
7. Monitor Your Portfolio
Regularly review your portfolio to ensure it aligns with your financial goals. Be aware of any changes in the market or in the companies you've invested in that could impact your dividends.
8. Avoid chasing yield
Chasing yield can lead to poor outcomes if you don’t do your homework. It's important to understand what you're investing in and why.
So, in this article we have deciphered that investing in divided-focussed ETFs can be a good way to build long-term wealth, sustainability and within a diversified portfolio. As with any type of portfolio construction, it is important that you understand the aspect of diversification well: only investing in high-yielding stocks can lead to concentration risk although the stocks themselves are considered more conservative compared to other industries such as growth-reliant tech companies.
Hence, make sure you add dividend ETFs only to a part of your portfolio either as a part of the equity portion in a portfolio in a 60-40 portfolio or under a core-satellite approach.