The word ‘dividend’ is in the Vanguard Dividend Valuation ETF‘S (NYSEMKT: VIG) name. That could lead some investors to believe that dividends are an important factor for the exchange-traded fund (ETF). And it is, but not in a way that most income investors will appreciate.
Before you buy the Vanguard Dividend Appreciation ETF, you should understand how it uses dividends to build its portfolio.
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The Vanguard Dividend Appreciation ETF tracks an index. So from a total perspective, it simply owns everything in the index. So if you want to understand what you’re buying here, you need to look at the index S&P American Dividend Growers Index.
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From that index name you can get an idea of what he’s looking for: dividend growers. But even high-yield stocks can grow their dividends. For example, Altria has increased its dividend annually for over a decade and has a lofty dividend yield of 8.1%. You won’t find it among the 338 stocks included in the Vanguard Dividend Appreciation ETF. That seems like a glaring mistake. It’s not.
The S&P US Dividend Growers Index is designed to measure the performance of US companies that have maintained a policy of consistently increasing dividends annually for at least ten consecutive years. The index excludes the 25% highest yielding eligible companies from the index.
The above quote is from S&P Global’s product description of the index followed by the Vanguard Dividend Appreciation ETF. To highlight the most notable part, the highest-yielding stocks that pass the 10-year dividend increase screen are specifically left out. This partly explains why the dividend yield of the Vanguard Dividend Appreciation ETF is only 1.7%. Sure, that’s higher than the S&P500 indexes (SNPINDEX: ^GSPC) 1.2%, but if you’re looking for dividend income, this exchange-traded fund probably won’t be a good fit for you, even though it has the word “dividend” in the name.
To put it bluntly, the Vanguard Dividend Appreciation ETF uses dividends as a screening tool. This happens in two important ways.
VIG chart
First, focusing on a company’s annual streak of dividend increases is one way to find financially strong companies that are growing over time. That makes perfect sense; a struggling company is unlikely to be able to increase its dividend year in and year out. So using dividends in this way is a solid starting point. However, things can change and sometimes companies with a strong business history find themselves in tough times.
That brings up the second use of dividends, but this time it’s about dividend yield. Wall Street looks ahead and if it thinks a company is struggling, it will lower the price. That, in turn, will push yields up. In this way, returns act as a rough gauge of investor sentiment. But it also acts as a warning sign, with high interest rates often highlighting struggling companies that could ultimately cut their dividends. Altria, for example, has suffered a long-term decline in the number of cigarettes it sells. That is why the yield is so high.
So by excluding the 25% of dividend-growing stocks with the highest yields, the Vanguard Dividend Appreciation ETF attempts to weed out companies that may be yield traps. Or perhaps more accurately, the business risk of high-yield stocks may be too high to justify owning them. All in all, the methodology is simple yet elegant. However, it’s not an ETF that investors trying to live off the income their portfolios generate are likely to find particularly attractive.
Investors looking at the Vanguard Dividend Appreciation ETF should understand why it has the word “dividend” in the name. Using dividends as a screening tool is key. Trying to generate revenue really isn’t.
While there is a place for this ETF in many portfolios, think carefully before purchasing. If you are a growth-oriented investor or a growth and income investor, this may be the right choice. If you are an income-oriented investor, this is probably not a good choice for you.
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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool holds and recommends the Vanguard Dividend Appreciation ETF. The Motley Fool has a disclosure policy.
This Vanguard Dividend Appreciation ETF Is Better for Growth Than Dividends was originally published by The Motley Fool
