How To Use Income Investing For Index Funds

Possibly the most underrated tool in portfolio risk management is this: Take the dividends that you are receiving from a cash cow, high income-generating asset, and then redeploy those dividends into something that is either of a higher quality or promises more future growth.

I’ll give an example of how this might work out. Let’s say you greatly enjoy receiving present income, and always want to take actions that have a high probability of increasing your net worth. How would you resolve that conundrum?

For this example, I’ll use something like Linn Energy as an example of our income investments. For most of 2014, Linn Energy was paying out a dividend slightly higher than $0.24 each month. The company owns some very high-quality energy assets, however: (1) the company carries a very high amount of debt, and (2) energy assets are especially known for fluctuating. In other words, Linn Energy is not the kind of company you’d say, “Sure, I can own this for thirty years, and then pass it on to my kids, and grandkids.” Even if that ends up being the case, it would be disingenuous to pretend the asset is ideal for decades worth of estate planning.

Let’s say you are also aware that small-cap American index funds tend to deliver 12% annually (compared to the 10% annual figure with large-cap stocks, although the superior large businesses we discuss here tend to have long-term returns around the 12% mark as well), and you decide you want something like the Vanguard Small-Cap Index fund (which you can read about here) in your portfolio as well. Since its inception in 1960, the Vanguard fund has returned just shy of 11% annually.

How could you make this work? You could establish an initial investment in Linn Energy, and then tap into the power of automation to self-fund Vanguard Small Cap Index Fund indefinitely.

Let’s say you own 1,000 shares of Linn Energy. Each month, you would be collecting a little over $240. You could have those $240 checks automatically go into a Vanguard Small-Cap Index Fund, gradually building your position over time (note: If you were actually to do this through Vanguard itself, you’d need a $3,000 minimum investment, and from there, you must purchase increments of at least $100. Other brokerage houses and small-cap indexes have lower initial amounts, particularly Charles Schwab).

That would be an intelligent way to behave because you would be “de-risking” from Linn Energy with each monthly dividend collected, thus hedging yourself against the possibility of a sustained 2009 type of period in which commodity prices fall and credit markets freeze. You’d be investing $2,880 each year (or higher if Linn increases its payout) into the Vanguard Small-Cap Index Fund, allowing you to tap into broad small-cap diversification and the high long-term returns of 10-12% if the 20th century in the United States is a useful guide.

It’s not that hard to imagine a situation in which a $30,000 investment in Linn Energy in 2014 could turn into not only those 1,000 shares of Linn Energy in 2024, but an entire new $30,000 position that got self-created by the Vanguard Small-Cap Index investments as well. Broadly speaking, you can do a lot to maximize growth or add more stable assets if you methodically deploy the dividends generated by your high-yielders. Obviously, it doesn’t have to be Linn Energy for an index fund. You could take AT&T dividends and buy Disney. You could take Royal Dutch Shell dividends and buy an international index fund. It’s just something to think about how you can use the money generated by your cash cow holdings to put together a more stable or higher growth profile collection of assets for your family over time, all without having to sell anything or sell your time for labor.