Are you on the hunt for an all-weather income investment you can just "set and forget"? That's fine if you are. In fact, it's good -- less is often more when it comes to investing. That is to say, attempting an active investing strategy often leads to weaker net returns than you would have gotten through a more passive approach.
As such, if you're after passive income, buying specific interest-bearing bonds or individual dividend stocks may not be the best fit for you. Plenty of investors would be better served to put their money into one of several fantastic dividend-oriented exchange-traded funds (ETFs).
And one in particular stands out among all your options.
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The best of the best
Most retail investors have likely already heard of some -- if not all -- of the market's most popular dividend ETFs, like the Schwab U.S. Dividend Equity ETF (SCHD 0.11%) or the ProShares S&P 500 Dividend Aristocrats® ETF (NOBL 0.46%). (The term Dividend Aristocrats® is a registered trademark of Standard & Poor's Financial Services LLC.) Schwab's fund tracks the performance of the Dow Jones U.S. Dividend 100 index, while ProShares' ETF is, of course, based on the S&P 500 Dividend Aristocrats® index. Either one would be a solid addition to almost anyone's portfolio.
However, none of these alternatives is arguably quite as compelling as the Vanguard Dividend Appreciation ETF (VIG 0.17%).
Data by YCharts.
Vanguard's fund is largely designed to produce reliable increases in its quarterly dividend payments. It's based on the S&P U.S. Dividend Growers index, and to be considered for inclusion in that index, a company must have increased its per-share dividend for a minimum of 10 consecutive years. That weeds out a lot of potential components that income-seeking investors wouldn't actually want to own.
There's something else about the rules for inclusion in the S&P U.S. Dividend Growers Index, however, that counterintuitively makes a world of difference to anyone interested in income investing.
Comparing and contrasting
If you've already done some homework on the market's top dividend exchange-traded funds, then you may already know they're about as similar as they are different. For instance, they all predominantly hold blue chip stocks, and their dividend yields are all in the same ballpark. The Schwab U.S. Dividend Equity ETF boasts the highest with a yield of just under 4%, the Vanguard Dividend Appreciation ETF's trailing yield is 1.7%, and the ProShares S&P 500 Dividend Aristocrats ETF's yield is nearly 2.5%.
But given the similarities of these funds, if your chief goal is income, why not just opt for the highest-yielding one? Because the Schwab U.S. Dividend Equity ETF is not actually the best long-term buy-and-hold option for most investors, including for investors who may be specifically looking for income.
As the old adage goes, the devil is in the details. The key here isn't just what's in the S&P U.S. Dividend Growers Index. It's also what's not in it.
As for what's in it, the index isn't limited to large-cap companies. It can hold mid-cap and even small-cap dividend payers as well, provided they qualify with at least 10 straight years of payout hikes. This opens the door to a lot of great stocks that many investors may have never even heard of. As for what's not in it, the index excludes the highest-yielding 25% of the stocks that would otherwise be eligible to be part of it.
On its face, that may feel like an odd choice. You expect that investors looking to maximize their dividend income would prefer to have exposure to some of the market's highest-yielding tickers. This rule assures they won't.
This restrictive standard is still a pretty savvy one, though.
The highest dividend yields are often red flags
High dividend yields are often the result of a falling stock price. Sometimes, this poor performance is just bad luck. More often than not, though, it reflects real business-level challenges.
Take Kraft Heinz and Western Union as examples. Both at one point could have qualified to be included in the S&P U.S. Dividend Growers index. After each ticker started to perform poorly, their yields grew to unusually high levels. However, their dividends then hit a wall. Western Union hasn't raised its dividend since 2021, but its yield actually began to reach frothy levels the year before. Kraft Heinz hasn't raised its dividend since cutting it in 2019, but its stock peaked a couple of years before that, then began a steep decline that would push its yield to multiyear highs.
Data by YCharts.
In other words, big yields are often red flags. Standard & Poor's is simply aiming to sidestep the problems such companies bring with them by limiting this index's holdings to stocks that can more reliably be counted on to keep raising their dividends.
That's important, but not just because you want a "forever" holding that's capable of growing its payouts in perpetuity. This stricter standard also means this index and its corresponding ETF hold stocks that should ultimately be able to deliver reliable capital gains as well. Even long-term income investors want some share price growth too.
Mutual fund company Hartford has done some extensive research on this idea, and it found that since 1973, the market's best overall-performing stocks have been those that regularly raised their dividend payments. Indeed, when factoring in reinvested dividends, these stocks more than doubled the average annual gain of stocks that didn't pay any dividends at all. In this vein, despite its lower yield, over the past 10 years, VIG's total net return was better than SCHD's and NOBL's. How? Hartford's analysts conclude that "corporations that consistently grow their dividends have historically exhibited strong fundamentals, solid business plans, and a deep commitment to their shareholders."
Data by YCharts.
Also credit the fact that the Vanguard Dividend Appreciation ETF holds a bunch of great small- and mid-cap stocks while the other two dividend funds don't. As a class, mid-cap stocks in particular tend to outperform their large-cap counterparts.
The next time you're ready to reconfigure your holdings...
But what if you already have one of the other two ETFs in your portfolio? That's OK. You're hardly doomed, and there's certainly no immediate need to swap that fund -- or any other income-producing ETF you might already be holding -- for the Vanguard Dividend Appreciation ETF. That's particularly true if such a trade would result in an unwanted tax consequence.
However, if you want reliable dividend income growth from an investment that also produces healthy capital growth, the Vanguard fund is arguably your best bet. At the very least, it deserves a spot at the top of long-term income investors' watch lists, given how easy to own and productive it would be on a "forever" basis.
Or this might help: There's nothing wrong with owning a piece of all three funds and enjoying the best of each one's unique attributes. There's less portfolio overlap between these three ETFs than you might think.
