This ‘homemade’ strategy is for income-seeking investors who want simplicity MarketWatch Premium

By Philip van Doorn

More than ever, investors are interested in dividend stocks, as very low interest rates make bonds unattractive.

But if you are looking for income, a diversified long-term “homemade” approach to total returns may serve you better.

Mike Loewengart, managing director of investment strategy at E-Trade Capital Management, said a total return strategy for income-oriented investors “has been tough to argue with, considering the run that equities have had,” in an interview March 25.

Total return strategy

An investor looking for income might be satisfied with a bond that has a 5% yield. Good luck finding one, though.

An income-seeker might also try to build a portfolio of stocks with attractive dividend yields, or buy shares of mutual funds or exchange traded funds (ETFs) that hold higher-yielding stocks.

But the total return approach might work out much better in the long run.

If we use the S&P 500 Index /zigman2/quotes/210599714/realtime SPX -1.64% as an example, the total returns (including dividends) have been very high in recent years. Here are average returns for various periods through March 24 for the SPDR S&P 500 ETF Trust /zigman2/quotes/209901640/composite SPY -1.65% , which tracks the benchmark index with a very low annual expense ratio of 0.09%:

The S&P 500’s dividend yield is about 1.60%. So if your money is invested in SPY or another low-cost index fund that tracks the S&P 500, you don’t need much in the way of gains to support an annual withdrawal of 5%.

Obviously, the stock market doesn’t go up every year. The point is that the average returns have been enough to support a 5% annual withdrawal.

What about high valuations?

You might be concerned that stock valuations are too high today to begin a homemade income strategy, as described above. The SPDR S&P 500 ETF Trust’s forward price-to-earnings ratio was 21.7 as of the close March 24, rising from 14.4 a year earlier when the S&P 500 was just above its pandemic bottom. But two years ago the index traded at a forward P/E valuation of only 16.2.

Still, the forward P/E for SPY has declined from 23.4 on Sept. 2, even though SPY has risen 10% since then. Economic growth leads to higher earnings, which means analysts can be expected to increase their earnings estimates as the economy reopens. And higher estimates generally support higher stock prices. They at least bring the forward P/E down.

Loewengart cautioned that higher valuations likely mean lower returns for the next several years than that fat 16% average for the past five years. But he said that if you are a long-term investor looking out to at least five years, “you can be confident you will end up with a positive return.”

He also said that waiting on the sidelines for better entry points tends not to work out well: “We all saw what happened with the pandemic. If you waited it out, you missed out on returns.”

Vary the approach to cut risk and raise income

Here’s a list of 10 high-yielding, actively traded U.S. ETFs . They come in many varieties and levels of risk. One of them is the SPDR Portfolio S&P 500 High Dividend ETF /zigman2/quotes/204586803/composite SPYD -1.74% .

This ETF holds the 80 stocks among the S&P 500 that have the highest dividend yields. It is rebalanced every month and has a dividend yield of about 5%. SPYD is a good example of a way to diversify beyond the “homemade” total return income strategy based on SPY, described above. It may seem strange to say a subset of the S&P 500 can lead to greater diversification, but this is because the 80 stocks in SPYD are equally weighted.

The S&P 500 is weighted by market capitalization, which means the top five companies in the index (Apple Inc. /zigman2/quotes/202934861/composite AAPL -0.89% , Microsoft Corp. /zigman2/quotes/207732364/composite MSFT -0.39% , Amazon.com Inc. /zigman2/quotes/210331248/composite AMZN -4.41% , Facebook Inc. and Alphabet Inc.) make up 21% of SPY. None of them are held by SPYD.

Loewengart called SPYD “a viable approach for someone who really wants to emphasize dividends right now.” He went on to point out more of its divergence from the full S&P 500, because its emphasis on dividends will skew the portfolio toward financial companies, real-estate investment trusts, energy and utilities.

Advantages for the dividend group include lower price volatility, as well as tax simplicity because you don’t have to take capital gains by selling shares as you would with the “homemade” strategy. Most of the 5% being paid out will be considered “qualified dividends” by the Internal Revenue Service and subject to lower federal tax rates than ordinary income.

While he prefers the “homemade” total return strategy, Loewengart emphasized the importance of having diverse sources of income.

“There are good reasons to hold a straight high-yield dividend fund. If you want low beta and simplicity, it is a fine approach. But then you are moving away from the posture of the broad market,” he said.

Two more income approaches: