The composition of the S&P 500 changes over time as companies rise and fall in value. Today, technology-focused companies dominate the index. Many of these companies have low yields or don't pay dividends at all, bringing down the passive-income opportunity of investing in an S&P 500 index fund or exchange-traded fund (ETF).
The yield of the S&P 500 is around its lowest level in 25 years, with well-known index funds like the Vanguard S&P 500 ETF(NYSEMKT: VOO) and the SPDR S&P 500 ETF yielding just 1.2%. Here are three ways to generate more dividend income from stocks than passively investing in the S&P 500.
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1. Low-cost ETFs
S&P 500 index funds and ETFs provide a hands-off way to put money to work in the stock market. You never have to think about your performance relative to the S&P 500 because you are simply betting on the index -- and at very low cost. The Vanguard S&P 500 ETF has an expense ratio of just 0.03%. Even if you invest $100,000 in the ETF, you would only incur $30 in annual fees.
Vanguard offers dozens of low-cost ETFs that invest in hundreds of stocks with low fees. Some of these ETFs are tailor-made for value- and income-focused investors. The Vanguard High Dividend Yield ETF(NYSEMKT: VYM) has over 530 holdings, an expense ratio of 0.06%, a yield of 2.7%, and a price-to-earnings (P/E) ratio of 20.7 compared to the 28.2 P/E ratio of the Vanguard S&P 500 ETF.
The fund includes many stodgy, well-known, dividend-paying companies like JPMorgan Chase, ExxonMobil, Procter & Gamble, and Home Depot. These industry-leading companies may not be behind the latest innovation in artificial intelligence. Still, they have what it takes to grow earnings over time and, in turn, their payouts to investors.
The Vanguard Value ETF(NYSEMKT: VTV) has over 330 holdings, a 0.04% expense ratio, and invests in large-cap value stocks. The fund includes names like Berkshire Hathaway, which doesn't pay a dividend but is a top-tier value stock. The fund sports a 20.7 P/E ratio -- very similar to the Vanguard High Dividend Yield ETF -- but has a lower yield at 2.3%.
2. High-yield stocks
Stocks with high yields offer a way to generate significant passive income but often come with more risks.
United Parcel Service(NYSE: UPS) yields 4.9% as the company faces lower margins and slowing revenue growth. Over the last four years, UPS' dividend is up 59.8% while the stock price is down 37.2%, pushing the yield higher. However, UPS will likely make negligible dividend raises or simply maintain the payout while it focuses on turning the business around. In fact, the company is already showing signs of improvement, such as returning to revenue and profit growth.
Similarly, chemical giants Dow(NYSE: DOW) and LyondellBasell (NYSE: LYB) are in a major downturn. Higher interest rates have increased borrowing costs, creating a headwind for capital-intensive businesses. What's more, sluggish global economic growth has impacted demand for commodity chemicals, and competition is strong out of China.
Dow and LyondellBasell are treading water around multiyear lows, which has pushed Dow's yield up to 6.8% and LyondellBasell's yield to 6.9%. However, neither company has an impeccable track record of steadily increasing its payout over an extended period. If the downturn persists, the dividend expense could jeopardize the financial health of both companies, pressuring them to take on debt or cut the dividend.
3. Dividend Kings
Companies that have paid and raised dividends for at least 50 consecutive years are known as Dividend Kings. Recognizable Dividend Kings include names like Coca-Cola, PepsiCo, Procter & Gamble, Target, and Walmart. But there are plenty of other stable stalwarts you may not be familiar with, like industrial conglomerate Illinois Tool Works, utility American States Water, and more.
There are plenty of higher-yield stocks than Dividend Kings, but many of these companies are lower quality. To increase a payout year after year, no matter what the economy is doing, a company typically has to have stable and growing earnings and a strong balance sheet. Companies like Coke and Pepsi may not have the greatest growth prospects, but they have fairly recession-resistant business models, and both yield over 3%.
These companies may not keep pace with a growth-driven rally in the broader stock market, but they can come in clutch when the market is selling off.
Using dividends as a tool for financial success
Dividend stocks provide an excellent way to participate in the market and collect passive income. They can be helpful for financial planning or supplementing income in retirement. However, it's important not to get too caught up with dividends alone.
Keep in mind that a dividend is only as reliable as the company paying it, so it's best to focus first and foremost on the strength of the underlying business.
Over the last few decades, growth stocks have handily outpaced gains in dividend and value stocks -- as evidenced by the Nasdaq Composite's gains relative to the S&P 500. That's because growth-focused companies pour profits into innovative and long-term investments, whereas some companies pass along the majority of earnings to shareholders through dividends.
If you have a multidecade time horizon, it may be best to view dividends as a cherry on top rather than the main focus of your investment objectives.
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JPMorgan Chase is an advertising partner of Motley Fool Money. Daniel Foelber has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Berkshire Hathaway, Home Depot, JPMorgan Chase, Target, Vanguard Index Funds-Vanguard Value ETF, Vanguard S&P 500 ETF, Vanguard Whitehall Funds-Vanguard High Dividend Yield ETF, and Walmart. The Motley Fool recommends Illinois Tool Works and United Parcel Service. The Motley Fool has a disclosure policy.
