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The Right Reason to Buy Into Vanguard's Classic Dividend Strategy

Don't buy it for its dividends or perceived safety; buy it because you think value and quality strategies work.

Samuel Lee, 06/13/2014

A version of this article was published in the November 2013 issue of Morningstar ETFInvestor. Download a complimentary copy here.

While high-yield assets are generally expensive, Vanguard High Dividend Yield Index VYM is a fine holding that avoids gorging on the most overvalued sectors: real estate and utilities, a vice of more-aggressive high-yield strategies. By design the fund excludes real estate investment trusts, and its holdings are market-weighted, keeping its utilities allocation from growing big. The fund strikes a balance among market representation, yield, and quality. Its construction is straightforward: Each year it ranks stocks by their forward dividend yield according to consensus analyst estimates and includes the highest-yielding ones in its portfolio until 50% of the eligible universe's aggregate market capitalization is reached. VYM excludes stocks forecast to not pay a dividend in the coming year.

Many investors own VYM for safety or income--both bad reasons. Peak to trough, VYM lost more than the S&P 500 during the financial crisis. Its since-inception total return is close to the S&P 500's. An investor who lived off the dividends would've been no worse off than an investor in the lower-yielding S&P 500 who "manufactured" his own dividends by selling appreciated shares.

A better reason to own VYM is because one believes it provides a unique tilt that either enhances returns or reduces risk in one's overall portfolio. In other words, you believe VYM's simple quantitative trading strategy will add value over the market.

It's a good thing, then, that VYM can credibly lay claim to such a quality. Its yield focus creates a value tilt, meaning the fund's holdings tend to be cheaper than the market by fundamental valuation ratios. Historically, cheap stocks have tended to beat expensive stocks, a pattern found in almost every equity market studied. The return generated by value stocks above growth stocks is called the value premium.

The case for VYM, then, really rests on how strongly you believe in the existence of a value premium, how you expect the value premium to behave, and how exposed VYM is to it.

The extent to which a fund is exposed to this premium is called its value loading. Stocks with high loadings tend to benefit more from the value premium. For example, if a fund's value loading is 0.5 and the value premium is 4% annualized (the historical realized premium from 1926 to 2013), the fund's excess returns attributable to its value exposure will be 2% (0.5*4%).

Samuel Lee is an ETF Analyst with Morningstar.

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