Index funds are like ready-made portfolios that track specific financial indexes, sectors, or industries. They spread money across dozens, hundreds, or sometimes thousands of different stocks, offering diversified market exposure without the hassle of researching each stock individually.
Income investors should consider the Vanguard High Dividend Yield ETF (VYM +0.32%). The index fund can turn small contributions into significant sums that generate substantial dividend income. For instance, $500 invested monthly could grow into $915,300 over three decades, and that total could generate $27,000 in annual dividend income.
Here's what investors should know.
NYSEMKT: VYM
Key Data Points
The Vanguard High Dividend Yield ETF
The Vanguard High Dividend Yield ETF tracks 450 large U.S. companies forecast to pay above-average dividend yields. It consists entirely of value stocks, meaning its constituents tend to be mature, slow-growing companies. The ETF spreads money across 10 of the 11 market sectors, though it is most heavily weighted toward financials, consumer staples, industrials, and healthcare.
Listed below are the 10 largest holdings in the Vanguard High Dividend Yield ETF.
- Broadcom: 3.6%
- JPMorgan Chase: 3.6%
- ExxonMobil: 2.9%
- Johnson & Johnson: 2.7%
- Procter & Gamble: 2.6%
- Home Depot: 2.5%
- Merck: 2.2%
- AbbVie: 2.1%
- Chevron: 1.7%
- Walmart: 1.7%
One reason the Vanguard High Dividend Yield ETF is attractive is its ultra-low expense ratio of 0.06%, meaning the annual fee on a $10,000 portfolio would be just $6. The average expense ratio on similar funds is 0.9%, meaning the annual fee on a $10,000 portfolio would be $90.
How $500 per month could create $27,000 in annual dividend income
The Vanguard High Dividend Yield ETF returned 158% over the last decade, compounding by 9.9% annually. I will assume a slightly more conservative return of 9% per year in the future to introduce a margin of safety. At that pace, $500 invested monthly would be worth $915,300 in three decades, assuming all dividends were reinvested.
Investors can stop reinvesting dividends to earn passive income after three decades. The Vanguard High Dividend Yield ETF paid an average dividend yield of 3.02% over the last decade. At that rate, the $915,300 portfolio would generate $27,600 in annual dividend income. But the principal and the payout would continue to increase over time.
To elaborate, the Vanguard High Dividend Yield ETF would have returned 6.5% annually over the last decade had dividends not been reinvested. Assuming a more conservative annual return of 6%, the $915,300 portfolio -- now paying $27,600 in annual dividend income -- would be worth $1.2 million in another five years. That $1.2 million portfolio would pay $36,200 in annual dividend income, assuming a dividend yield of 3.02%.
How $500 per month could create $30,000 in annual dividend income
Alternatively, investors could use two index funds: one to maximize returns during the initial 30-year period, and another to maximize dividend payments thereafter. For instance, the S&P 500 (^GSPC +0.83%) returned 10.3% annually over the last three decades. At that pace, $500 invested monthly in an S&P 500 index fund would grow into $1.2 million over the next three decades.
Investors could then sell the S&P 500 index fund and reinvest the proceeds in the Vanguard High Dividend Yield ETF. Long-term capital gains tax would consume a portion of the profit, leaving investors with roughly $996,000. But that sum would still generate $30,000 in annual dividend income, assuming a dividend yield of 3.02%.
The Vanguard High Dividend Yield ETF can supplement a portfolio of individual stocks
The Vanguard High Dividend Yield ETF is a proven moneymaker that has consistently paid an above-average dividend. Those qualities make it an attractive addition to a portfolio of individual stocks. Investors know the index fund returned 9.9% annually over the last decade, and it's not unreasonable to believe that it can generate similar returns in the future. That makes the fund a sort of safety net.
Specifically, investors can spend their time and energy researching and managing a small number of individual stocks, while simultaneously making regular investments in the Vanguard High Dividend Yield ETF. If the individual stocks outperform the fund, investors will come out ahead. But if those stocks underperform, investors should still be OK because the index fund should limit downside.
