Are you looking for a lifetime of dependable income from investments you'll never need to manage ... or even check on? The premise seems impossible at first. Things just aren't that easy, after all.
Except, it is possible if you make a point of keeping things simple. An exchange-traded fund (ETF) is perfectly suited for the task. Not only does the average ETF hold more individual stocks than the average investor can feasibly manage on his or her own, but many exchange-traded funds' holdings are also automatically rebalanced for you, which takes your fear, greed, and lack of time out of the equation.
Here are three solid dividend-paying index funds that you could buy and hold for decades -- perhaps even forever -- and collect growing amounts of income the entire time. One of these choices, however, is arguably the best of the best.
Image source: Getty Images.
Good: Big starting yield, but slower payment growth
Any investor who has ever used a screening tool to find promising dividend stocks or ETFs has likely set a minimum yield as one of their starting criteria. And most of us have looked at the highest-yielding choices out there -- even if just to satisfy our curiosity. Unsurprisingly, given that falling stock prices result in higher yields, in many cases, companies with ultra-high yields come with baggage that makes them less than desirable as investments.
Among them, it can be to find these diamonds in the rough.
It is possible to filter out the market's best prospects from a vast universe of tickers, however, if you've got enough time and access to the right screening tools.
Enter the Schwab U.S. Dividend Equity ETF (SCHD 0.16%), which currently sports an impressive trailing dividend yield of 4%.
Based on the Dow Jones U.S. Dividend 100 index, Schwab's U.S. Dividend Equity ETF only holds stakes in companies with track records of no less than 10 consecutive years of annual payout hikes. It doesn't stop there, though. Analysts at S&P Dow Jones then rank all of these eligible companies on fundamental factors like free cash flow, return on equity, and their dividend's five-year growth rate. Only the top 100 of these tickers make the cut. Positions are based on the companies' float-adjusted market caps. Coca-Cola and Verizon are the ETF's top two holdings right now, followed by tobacco giant Altria.
Data by YCharts.
The fund is a decent premise and pick for income-minded investors, particularly if you want your investment to start producing above-average dividend income right out of the gate. Its chief downsides are its modest dividend growth rate and its modest capital gains. As it turns out, many of the companies with better free cash flows and return on equity are in slower-growth industries like oil and natural gas, or consumer staples.
Better: Faster dividend growth from a weaker starting yield
If you're OK with accepting a weaker starting yield in exchange for more net gains and capital appreciation than the Schwab U.S. Dividend Equity fund is apt to offer, the Vanguard Dividend Appreciation ETF (VIG 0.51%) is worth a look.
Built to track the performance of the S&P U.S. Dividend Growers index, Vanguard's Dividend Appreciation ETF also limits its holdings to companies that have raised their payouts for at least the past 10 straight years. That's pretty much where the similarities between the two funds end, though. See, this index only aims to hold the 100 highest-yielding U.S. listed stocks that meet that dividend-growth criteria, with one significant twist. That is, it specifically excludes the highest-yielding 25% of otherwise-qualifying stocks from being eligible for inclusion.
That might seem a bit counterintuitive -- even counterproductive -- at first. After all, the whole point of the ETF is to maximize dividend income.
Data by YCharts.
There's a good reason for this restriction, however. As it turns out, many of the market's highest-yielding names are only sporting high yields because their share prices have declined. Moreover, the underlying business conditions that can lead the market to punish a stock can mean that its dividend is at risk of being cut. Culling the top 25% may or may not be the exact right cutoff point -- but it's a reasonable ballpark estimate when it's not entirely clear where and when a higher yield is a warning.
The end result is the one you'd expect: a rather low dividend yield. Vanguard Dividend Appreciation ETF's trailing yield currently stands at a paltry 1.8%.
Just keep in mind that this fund's quarterly dividend payout has more than doubled over the course of the past 10 years, easily outpacing inflation during that stretch. The ETF's price has nearly doubled during this time as well. Owners who reinvested their dividends in more shares of the fund have experienced a near-tripling of their initial investments over the past decade.
Bottom line? If you won't actually need to draw much (or any) of your dividend income right away, there's a case to be made for owning the Vanguard fund over the Schwab U.S. Dividend Equity ETF and letting it grow into a bigger and more fruitful dividend investment for the time when you will need its passive income.
Best: Better balanced with bigger net gains
But isn't there a happy medium somewhere between these two extremes? There is. And ironically, it doesn't require any real compromise. The ProShares S&P 500 Dividend Aristocrats ETF (NOBL 0.65%) offers the best of both worlds, so to speak.
Yes, it's such a frequently recommended pick that it has almost become a cliché. Yet clichés often become clichés for good reason -- that is, their underlying premise is rooted in truth. In this instance, the truth is that this ETF's holdings are not only the stock market's most resilient dividend payers, but the market's most-proven dividend growers ... which is why these stocks are also often among the market's biggest and best gainers.
Data by YCharts.
Just as the name suggests, the ProShares S&P 500 Dividend Aristocrats ETF is meant to mirror the S&P 500 Dividend Aristocrats® Index. (The term Dividend Aristocrats® is a registered trademark of Standard & Poor's Financial Services LLC.) These are simply stocks that have raised their dividend payments annually for a minimum of 25 consecutive years, although many of them have done so for far longer. For instance, American States Water has now upped its payouts for 70 straight years, while Procter & Gamble has done so for 68. Coca-Cola's streak now stands at 63 uninterrupted years.
The upside speaks for itself -- investors holding this fund will never really have to worry (much) about their dividend income not regularly growing over time and offsetting the impact of inflation.
The thing is, these reliable income-generating stocks also produce plenty of capital growth. Number-crunching done by mutual fund company Hartford indicates that since 1973, the stocks of companies that reliably grow their annual dividend payouts performed measurably better than those that don't. Their overall net gains were about twice the average, in fact, when factoring in dividend reinvestment. Hartford's analysts concluded that companies that "consistently grow their dividends have historically exhibited strong fundamentals, solid business plans, and a deep commitment to their shareholders."
If this is the sort of simple forever income investment you're looking for, you could plug into the ProShares S&P 500 Dividend Aristocrats ETF today while its trailing dividend yield stands at a respectable and sustainable 2.5%. That's based on dividend payments, by the way, that have more than doubled over the course of the past 10 years.
