Using the latest factor research to identify the drivers of Vanguard Dividend Appreciation's outperformance.
A version of this article was published in the October 2013 issue of Morningstar ETFInvestor. Download a complimentary copy here.
Vanguard Dividend Appreciation VIG targets U.S. firms that have raised annual dividends for at least 10 years straight. Uncharacteristically for a Vanguard index fund, VIG also uses some secret sauce to weed out firms that might cut their dividends. Investors can't complain too much, though. The result is a collection of quality firms, which tend to have high profits, ample dividends and share buybacks, low financial leverage, and steady earnings. These characteristics, when together, often signal the existence of an economic moat--a durable competitive advantage that allows a firm to reap above-average returns on capital despite determined competition.
Though Warren Buffett popularized the idea of the moat, he credits partner Charlie Munger for bringing him around to the idea that "it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
While it can't be said that everything VIG holds is wonderful, VIG's current holdings grew their dividends right through the crucible of 2008 (the ones that didn't were booted from the fund). Naturally, such firms tend to command premium valuations. A quality strategy like VIG is a bet that the market doesn't appreciate wonderful companies enough, particularly their earnings potential many years out. As Charlie Munger said, "If a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with one hell of a result." (Of course, it's not easy to identify in advance firms that can sustain such high rates of return for so long.)
A recent study by Cliff Asness, Andrea Frazzini, and Lasse Pedersen finds that quality stocks have historically produced high risk-adjusted returns in both the U.S. and abroad. They construct a quality factor, "Quality Minus Junk," or QMJ, that goes long a portfolio of high-quality stocks and shorts a portfolio of low-quality stocks. The QMJ factor is a bit complicated to explain, but it suffices to say for our purposes that it's based on a combination of four broad signals: profitability, growth, safety, and payout.
Frazzini now makes available the QMJ factor on his website. We can use this information to investigate whether VIG's strategy has any exposure to the researchers' quality factor. If VIG doesn't, then we're left in the uncomfortable position of having to explain why VIG should continue to outperform based on a return history that's risibly short for making strong statistical inferences. On the other hand, if VIG does have exposure to QMJ, then we can be more confident that VIG's past performance was not a fluke. QMJ, after all, has generated excess returns in the U.S. from 1956 to 2012, and abroad from 1986 to 2012.
I examined VIG's historical returns through the prism of the Fama-French three-factor model augmented with a momentum factor (UMD for "up minus down") and QMJ. (I wrote a quick primer on factor models.) What this means is regressing VIG's monthly returns from its 2006 inception to the end of 2012 against a set of monthly returns representing the market (MKT-RF), size (SMB), value (HML), momentum (UMD) and quality factors (QMJ).
VIG had a statistically and economically significant exposure to QMJ. In fact, VIG's QMJ exposure explains all of its market-beating returns. Multiplying QMJ's returns (5.1% annualized) with VIG's QMJ loading (0.26) indicates VIG earned 1.3% annualized excess returns from its quality exposure over the period. It seems VIG's screens have done a decent job of identifying quality stocks, at least as defined by QMJ.
Historically, QMJ has earned 4.5% annualized. Assuming this is a decent guide to the future and VIG's loading stays constant, one can reasonably expect VIG to earn 1% annualized excess returns over decade-long periods owing to its quality exposure. However, if you're a pessimist, a believer that all good things come to an end, including the seemingly "free lunch" in quality stocks, then a reasonable adjustment is to halve the expected excess return from VIG's QMJ loading to 0.5%. Note VIG's value loading is quite low, even if it is statistically significant. Traditional dividend strategies tend to have a lot of exposure to the value factor. VIG is distinct. Value strategies buy assets cheaply; quality strategies buy especially productive assets, even when they're not trading at steep discounts. Because quality tends to do better when value is struggling and vice versa, they're excellent complements. VIG, then, could work well with a value fund like Vanguard Value ETF VTV.
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