Actually, not one ETF, but two! Or more! How can there be a need for a new ETF? Aren’t there enough already? Earlier this year, Motley Fool argued there are too many ETFs (1,929 at that time, probably over 2,000 by now) and they are covering pretty much every thinkable (and unthinkable) benchmark. Soon we might have more ETFs than publicly traded equities in the U.S., how crazy is that??? Why would I propose a new ETF that doesn’t already exist?
Here’s some background. I’m an index investor at heart and I like tax optimization. For so many years now, I’ve held equity index ETFs and Mutual Funds in both taxable accounts and tax-deferred accounts (both retirement and deferred compensation at work). It’s so painful to see the dividend payments in the taxable accounts getting taxed every year. Sure, it’s only about 1.9% dividend yield in the S&P500 right now but for us, that’s taxed at 15% federal, 10+% state (California!) and 3.8% Obamacare tax, for a total of almost 30% marginal tax! Isn’t there a better way? Sure! Simply put the taxable equity allocation into stocks that pay zero (or close to zero) dividends and keep the high-dividend stocks in the tax-deferred account where they can compound in peace and be taxed only once upon withdrawal rather than every year along the way! So, the two ETFs that I wish existed would exactly replicate the S&P500 if held in equal shares. But individually they’d have non-index weights and one would hold the equities with the lowest dividend yield and the other with the high-yield equities!
Notice that most folks already do this tax optimization across asset classes: Hold the tax-inefficient asset classes (bonds, REITs, etc.) in tax-deferred accounts and equities in taxable accounts. So, why not do this within the equity asset class as well for additional tax efficiency? How much extra after-tax return would we get out of this? Let’s look at the numbers…
How much variation in dividend yield is there?
A lot! I pulled some data from the web for all the stocks in the S&P500. Fidelity has a neat “Stock Screener” tool where you can pull all sorts of stock metrics, including dividend yield. Here are some fun facts (all figures as of 5/25/2018):
- There are actually 505 stocks in the S&P500. This includes two version of Google!
- The total market cap is almost $25 trillion (almost 1.5x annual GDP in the U.S.!) and the total dividend payments amount to about $470b a year, or about a 1.9% yield.
- 88 companies, equal to 19% of the index market cap, pay no dividends at all! The largest five are Amazon, Facebook, Google, Berkshire Hathaway and Netflix, responsible for more than 10% of the index capitalization!
- The highest dividend yield (by far) is almost 12%: Century Link (CTL). There’s a significant share of companies (20+% of market cap) that pay 3% or more dividend yield!
So, imagine I hold 50% of the overall equity portfolio in taxable accounts and another 50% in tax-deferred accounts. How low could I push the dividend yield if I were to hold the taxable account only in the lowest-yielding equities? The answer is 0.76%. That’s the average (market-cap weighted) dividend yield in the lower 50% of the spectrum. The remainder of the S&P500 equities, to be held in a tax-deferred account, yield a bit over 3%! The average of the two is, of course, just exactly 1.9% as in the S&P500. If the split between taxable and tax-deferred is 40/60 we can push the dividend yield in the lower portion all the way down to 0.45%.
If we assume a marginal tax on dividends of 29%, we’d save (1.90%-0.76%)x0.29=0.33% in taxes every year. 0.42% for the 40/60 split. Not a bad boost in the after-tax returns for essentially doing nothing. No market timing, no stock selection, simply a smarter way of allocating between taxable and tax-deferred accounts!
Alternative ways of dividend-hacking
Until iShares, State Street, Vanguard, Schwab, Fidelity, etc. set up ETFs to replicate this, there are (at least) three alternative routes to do this dividend hack:
- DIY! Simply buy the appropriate equities in your taxable and tax-deferred accounts. Well, it’s not that simple. If one has to spend $5 per equity trade that would negate all the tax efficiency gains. But there is a way now: FinTech to the rescue! M1 Financial is a cool new brokerage that allows you to purchase shares, even fractional shares (!), commission-free. (Note: this is an affiliate link and if you click it and open an account with at least $1,000 initial investment I’d get a referral bonus! But rest assured that I actually really like this company and I’m working on a more detailed review, coming later this year!) I’d probably not go full-hog and buy all 500 stocks in the S&P. Probably set up two “pies” in M1 Finance with 50 stocks each, one with the high dividends and one with zero/low dividends. That would get you close enough to the index already.
- Value vs. Growth ETFs. One could use the IUSV and IUSG (iShares Value and Growth ETFs) with a nice low expense ratio (only 0.05%, lower than the Vanguard Value/Growth funds!) and the two will roughly aggregate up to a broad index again (in this case the S&P900, i.e., large-cap plus mid-cap). It’s a low-hassle solution but not quite as effective. The yield in the Growth ETF is still about 1.27%, so there are obviously many growth companies that pay higher than average dividends. So, you’d get only about half the tax efficiency this way!
- QQQ vs. HDV. Another option: pick two equity ETFs that roughly resemble the characteristics of the top/bottom 50% dividend yield stocks in the S&P500. For example, the QQQ (Nasdaq 100 index fund) has a low dividend yield of only 0.83% with a large Tech overweight: 60+%, thus, even a bit higher than the Tech share in the low-dividend yield portion of the S&P. Likewise, the HDV (iShares High Dividend Yield ETF) has a 3.62% (!) dividend yield with heavy overweights to Consumer Staples and Energy, just like the high-dividend stocks. The caveat is that 0.5x QQQ plus 0.5x HDV is still not really near the S&P500 sector weights (and even less so with the individual security weights) so there will be some mistracking vis-a-vis the S&P500.
- Any other suggestions? Maybe the readers want to weigh in and suggest pairs of ETFs that would do trick! 🙂
Some caveats!
As always, there are some caveats, so just for the record:
- Most folks have already built their sizable index ETF/Mutual Fund portfolios. There is no point in selling your existing funds and realizing taxable capital gains. This dividend hack is most likely relevant for new investments only!
- For us personally, the new ETFs would come too late! 2018 will be our last year with high marginal taxes on dividends. In the future, we plan to stay within the 0% tax bracket for (qualified) dividends, stay well below the Obamacare tax cliff and reside in a zero-tax state (likely Washington State). In fact, given our new tax parameters, we might even go the exact opposite route and shift more money into high-dividend stocks/ETFs and completely forget about the low-dividend portion. That’s what retirement does to you: once the paychecks stop rolling in you get a new appreciation for dividends and income! 🙂
- There will be some turnover, namely when companies jump from the low-dividend to the high-dividend bucket or vice versa. The ETFs would then potentially realize taxable capital gains by reshuffling equities. Probably not enough to undo the tax advantage but it’s something to be aware of. It’s a reason to go the DIY route where you have control as to whether it’s worthwhile to shift stocks from one bucket into another when dividend yields change over time.
- There will be a slight style drift. If you take your VOO or IVV index ETF and reinvest the dividend payment it will be spread over the entire ETF by purchasing new shares. So, in a way, the high-yielding stocks generate dividends to be reinvested into the zero/low-dividend stocks as well. But if we keep the two components separate there will be no more “cross-subsidization,” i.e., the dividend income from the high-yield bucket will be reinvested only in the high-yield bucket. Without further adjustments, the two components may drift a little bit apart and no longer resemble the benchmark index after a few years of dividend reinvestments.
- What if someone has a 30/70 split between taxable and tax-deferred accounts? Or 80/20? There’d have to be customized pairs of ETFs to match the different investor preferences. Not sure the ETF providers like to issue too many different ETF pairs, but 25/75, 50/50 and 75/25 might cover enough ground for most investors!
- One could even improve the tax hack a little bit more: There are still a few REITs in the low-dividend portion (0.28% weight). Shift those into the tax-deferred bucket to avoid the dreaded non-qualified dividends from REITs that are taxed at the full ordinary income!