A Better Approach to High-Yielding Foreign Stocks

Dividend yields have declined over the past several decades, causing some investors to pursue high-yielding stocks to shore up their income. Fund providers have responded to this desire with rules-based strategies specifically focused on yield.

But it's important to remember that high-yielding stocks can be riskier than the overall market. Therefore, the risk-management aspect of these funds becomes an important part of their investment merit, as are low fees and diversification. Don't ignore these considerations in the quest for yield.

The selection universe starts with large- and mid-cap stocks that are part of the FTSE All-World ex US Index. The exchange-traded fund's index ranks large- and mid-cap stocks by their expected dividend yield over the next 12 months and selects those that represent the higher-yielding half by market value. Stocks that make the cut are weighted by market cap, which emphasizes companies that are large, stable, and less likely to be in financial distress. This increases the likelihood of holding stocks that can maintain or grow their dividend payments in the future.

This focus on dividend yield gives the portfolio a value orientation relative to the FTSE All-World ex US Index, but it can also increase risk. Stocks with high yields may be paying out a high percentage of their earnings as dividends, which reduces the fraction that can be reinvested to grow their businesses. Alternatively, high yields can stem from stocks with poor prospects and depressed prices. But this fund's broad diversification can help mitigate these stock-specific risks as it is one of the best diversified in the foreign large-value Morningstar Category. Additionally, the emphasis on large mature firms reduces the fund's allocation to those likely to be in severe distress.

The fund's country allocations look different from its parent benchmark. It substantially underweights stocks from Japan, while overweighting those from Australia and Switzerland. These latter two countries have heavy allocations to stocks with high dividend yields from the financial-services and healthcare sectors, respectively.

Historic performance is difficult to evaluate because the fund's track record is limited. Since its inception in February 2016, VYMI's absolute and risk-adjusted returns have landed in the top fourth of its category.

Fundamental View Strategies that emphasize stocks with high dividend yields can be attractive for the income that they provide, and regular dividend payments can help investors stay invested through market downturns. But high dividend yields can come from two different types of stocks: those that trade at low prices relative to dividends paid (low valuations), and those that are highly profitable and return cash to shareholders. The former may be riskier and suffer from deteriorating fundamentals, while the latter are more stable and likely to continue paying dividends.

One way of distinguishing between stable or risky dividend payers is to screen for quality or profitability. This fund doesn't directly perform this type of screening, but it does weight its holdings by market cap. This approach emphasizes large, stable firms and can indirectly tilt the portfolio toward companies that are highly profitable and more likely to continue their dividend payments. This fund's average market cap is among the largest in the foreign large-value category, and volatility has been in the lower third of this category since the fund was launched.

Foreign stocks currently have higher dividend yields than their U.S. counterparts. However, their dividend payments tend to be more volatile because many of these foreign companies link their dividend payments to earnings. This risk can be mitigated by diversifying across multiple stocks and industries. Some strategies that emphasize dividends may focus on a narrow selection of companies, limiting diversification and increasing risk. This portfolio is well diversified across 830 stocks, and its top 10 holdings only account for 16% of its assets. But there are no caps on sectors or countries, which can cause the portfolio to make large bets on a given sector or country. This approach was intentionally employed to preserve the emphasis on stocks with high dividend yields. Currently this fund has 35% of its assets in stocks from the financial-services sector, which can be a source of sector-specific risk.

This fund also holds stocks from emerging-markets countries, which can be more volatile than their developed-markets counterparts. However, developed-markets stocks account for the bulk of the portfolio. Furthermore, many high-yielding stocks are domiciled in mature markets such as the United Kingdom, Switzerland, and Australia. Japan's recent economic stimulus efforts have caused the prices of Japanese stocks to appreciate by a substantial amount, which has driven down dividend yields. Consequently, stocks from Japan have a smaller position in this fund relative to the category norm.

This fund has exposure to multiple currencies from both developed and emerging markets. Fluctuations between the U.S. dollar and these currencies can be an additional source of volatility. Like many of its peers, this fund does not take action to hedge this currency risk. Over long time periods, these fluctuations should wash out.

Portfolio Construction This fund focuses on dividend-paying stocks in a manner that effectively diversifies company-specific risk, while also promoting low turnover. It earns a Positive Process Pillar rating.

The selection universe starts with stocks from the FTSE All-World ex US Index, which includes stocks from developed and emerging markets. REITs and stocks that are not expected to pay a regular dividend over the next 12 months are then eliminated. The remaining stocks are ranked by their expected dividend yield over the next 12 months. Stocks are added to the index starting with the highest-yielding, and continuing until the index captures 50% of the dividend-paying universe's market cap. Stocks that make the cut are then weighted by their float-adjusted market cap. The index is reconstituted annually in March, and buffer rules are used to help mitigate turnover. To stay in the index, stocks must remain in the highest-yielding 55% of the selection universe by market cap. Additionally, new stocks are added once they break into the highest-yielding 45%. Management uses full-replication to fulfill its index-tracking objective.

Fees Vanguard charges an expense ratio of 0.32%, which is one of the lowest fees in the foreign large-value category. This should give it a durable advantage, supporting a Positive Price Pillar rating. Vanguard also offers this fund in a mutual fund format, and charges 0.42% and 0.32% for Investor and Admiral shares, respectively. Investor shares have a $3,000 investment minimum, while Admiral shares require $10,000. Additionally, the market-cap-weighted approach helps promote low turnover, which further reduces transaction costs and the overall cost of ownership.

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