2 Dividend ETFs for an IRA

Editor's note: Since this video was recorded, the U.S. tax filing and IRA contribution deadlines have been extended to May 17, 2021.

Susan Dziubinski:

Hi, I'm Susan Dziubinski with Morningstar. Investors have until April 15 to make a contribution to an IRA if they want it to count toward 2020. Joining me today to discuss some ETF ideas for an IRA is Ben Johnson. Ben is Morningstar's global director of ETF research.

Hi, Ben. Thanks for being here today.

Ben Johnson:

Thanks for having me, Susan.

Dziubinski:

We talk a lot about how wonderful ETFs are for taxable accounts because they tend to be in general pretty tax-efficient. So, why are we talking about them as ideas for an IRA?

Johnson:

You're absolutely right, Susan. The average investor, if they have a taxable account, should absolutely consider ETFs as the natural home for taxable money given that ETFs relative to most other fund formats and open-ended mutual funds in particular tend to be much more tax-efficient. They distribute few, if any, regular capital gains distributions. But that said, any dividends, any coupon payments that accrue to that fund are going to be paid out to fund investors in the form of regular income. So, when thinking about ETFs that might have a home in a tax-deferred wrapper like an IRA, I think it makes sense to look at those strategies, those underlying asset classes that might pay out large amounts of income on a regular basis.

Dziubinski:

Your first idea is Vanguard International High Dividend Yield Index VYMI, which is of course a dividend stock product. Talk a little bit about why you like it.

Johnson:

This particular fund is actually the international cousin of a fund that we've liked quite a lot for quite a long time in the Vanguard High Dividend Yield ETF, the ticker for that one is VYM. VYMI goes overseas in search of dividend income and what it does is it looks at the entire equity opportunity set outside the U.S. It takes the highest-yielding half of those stocks, and it folds them into its portfolio, weighting them by their market capitalization. Now, unlike other strategies that tend to have a yield orientation, which can introduce risk when you go hunting for yield, this one reduces those risks by weighting by market cap. So, its largest holdings tend to be the largest, most established firms that more likely than not are simply just out of favor at the moment, which might explain their higher yields. They might be more mature firms that tend to pay greater dividends because the reinvestment opportunities are fewer and further between. So, we like the elegance of this approach. It's very simple. It throws off a nice yield, and it's performed remarkably well relative to both its peers in the foreign large-value Morningstar Category as well as the category index.

When you look at it today, it's throwing off a yield of around 3%. So, again, looking for opportunities to shield those yields from the taxman makes sense when you're thinking about parking ETFs in an IRA. The other thing to take into account, too, is that because it invests in foreign stocks, there's a certain percentage of those dividends that are paid out that don't count as qualified dividend income for U.S. investors. So, if you look back to the 2020 calendar year for this fund, just three quarters of the dividends that its underlying holdings paid out counted as QDI for U.S. investors. So, that's an additional bit of yield that you'll be able to keep for yourself if you consider shielding that within the context of a tax-deferred wrapper like an IRA.

Dziubinski:

And your second choice today stays a little closer to home but is also a dividend stock strategy--Schwab US Dividend Equity ETF SCHD. Again, what's to like there?

Johnson:

SCHD has a lot to like, much like VYMI. The difference in this particular fund strategy is that it focuses in on stocks that have grown their dividends over a long period of time, 10 years in this instance, and it looks at that universe of stocks and then seeks out the highest-yielding portion of that universe. So, it's a balance between dividend growth and current income and current yields, a balance between effectively quality and value. And the outcome for investors has just been very favorable, both because the strategy is sensible, it's sound, you invest in a diversified portfolio of companies, it's grown its dividend over time, and it sports a very low fee, which gives it a durable edge versus a lot of its peers in its category. This is another fund that's throwing off a 3%-plus dividend yield at the moment, so another one that investors might want to consider putting in an IRA.

Dziubinski:

Ben, thank you so much for your time today and for a couple of great dividend stock ideas for an IRA. We appreciate it.

Johnson:

Thanks for having me, Susan.

Dziubinski:

I'm Susan Dziubinski with Morningstar. Thank you for tuning in.

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