An Index Fund Strategy For Early Retirees

For early retirees investing for cash flow, the lure of the actively-managed high-yield fund can be powerful.  Unfortunately, most people underestimate the risks of investing in the high yield market, and reaching for yield ends in disaster more often than not.  By virtue of being broadly-diversified as a general rule (there are exceptions), most index funds tend to have lower yields than many income-focused actively managed funds (such as the excellent Vanguard Wellesley Income fund).

But that doesn’t mean you can’t be both an index investor and an income investor.  It just means you’ll have to slice and dice your portfolio a bit, tilting more towards higher-paying value stocks (being sure not to take on too much risk as a result).

Income Investing With Index Funds

As a general deal, value-oriented stocks (that is, stocks with a low price relative to the underlying company’s earnings and book value) tend to pay higher dividends.  Slam dunk, right?  Just buy all value stocks and call it a day!   Not so fast.  Most of these value stocks are cheap for a reason: the market doesn’t expect them to fare as well as higher-priced stocks.  Still, there is ample evidence the market has a tendency to undervalue the potential of many of these value companies.  The famous Fama/French value premium states that investors can rightly expect a premium in exchange for owning value stocks, albeit at the (assumed) cost of  taking on a bit more risk.

Two Value Index Funds With Good Yields

As usual, you don’t have to look too far past Vanguard for your index fund needs.

• Vanguard Value Index Fund (VIVAX, 2.22% yield, 0.26% ER) – The Vanguard Value Index Fund is a mainstay of slice n’ dice portfolios everywhere.  Owing to all the recent dividend cuts in the financial sector (a popular sector for value-oriented funds), VIVAX doesn’t quite have the same yield advantage over the Total Stock Market Index Fund (VTSMX) as it normally does.  Still, this fund should regain much of its old poise as the financial sector continues to improve and dividends continue to be raised.
• Vanguard Small-Cap Value Index Fund (VISVX, 2.25% yield, 0.28% ER) – Like the fund above, the Vanguard Small-Cap Value Index Fund is a classic choice for small-value tilters.  If there’s one thing that’s more powerful than the Fama/French value premium, it’s the small-cap value premium.  Since small-cap value stocks tend to be among the market’s lease favorite securities, their appreciation potential (and yields) are even larger than average.  Small-cap value stocks tend to deliver the best risk-adjusted returns of the Morningstar style box over long periods of time.  Like the Value Index above, VISVX’s yield has been hit hard by the recent financial crisis.  Look for this one to recover nicely.

Don’t Forget REITs!

Value stocks aren’t the only place to find above-average yields in the stock market.  Real Estate Investment Trusts, or REITs, offer all the advantages of investing in real estate without the hassle of managing any properties yourself.

• Vanguard REIT Index Fund (VGSIX, 4.31% yield, 0.26% ER) -  Due to special tax rules requiring REITs to pay out at least 90% of their net income to shareholders, REITs typically yield far more than most other types of stocks.  Real estate can be a great source of steady, inflation-adjusted cash flow without taking on too much risk.  I would caution against devoting more than 20% of your portfolio to this particular asset class, though.