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An Upgrade for This Excellent Vanguard Dividend Fund

Thanks to its low costs, Vanguard Dividend Appreciation Index now earns our top rating of Gold.

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The following is our latest Fund Analyst Report for Vanguard Dividend Appreciation Index (VDADX). Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.

Vanguard Dividend Appreciation Index focuses on quality franchises that have reliably increased the amount of cash they give back to shareholders over time. Its stringent selection criteria yield a portfolio that balances income, capital appreciation, and risk. Its low fee gives it a durable edge versus its large-blend Morningstar Category peers and a low hurdle to clear toward beating its category index. Under our enhanced rating methodology, which places greater emphasis on fees, both U.S. share classes of the fund earned a Morningstar Analyst Rating upgrade to Gold from Silver, while the Canadian share class is rated Silver.

The fund tracks the Nasdaq US Dividend Achievers Select Index, which selects stocks that have increased their annual regular dividends for at least 10 consecutive years. The long lookback period ensures constituents are stable firms with proven track records. This criterion is strict enough to take out even household names like Intel (INTC) and Apple (AAPL). Nasdaq applies additional proprietary screening, the specifics of which are undisclosed. While the index sponsor doesn't provide details on these measures, they seem to focus on firms with better financial health and growth prospects. This is evidenced by the fact that the index portfolio boasts higher earnings growth and profitability metrics as compared with the Nasdaq US Broad Dividend Achievers Index, its starting universe. A greater percentage of its portfolio is invested in stocks boasting a narrow or wide Morningstar Economic Moat Ratings than the Russell 1000 Index. This dials down risk and will give the fund an edge in rocky markets.

This portfolio's equity-income orientation results in sector tilts. At the end of April 2021, it was overweight in industrials and consumer staples and underweight in technology. Additionally, the index hasn't owned any energy stocks since 2017, and its eligibility criteria exclude REITs. Of all these sector biases, being light in tech has hurt the worst in recent years. The emerging dividend payers in the sector haven't yet made the cut for the fund's index, and many are years away from a decade of dividend growth.

Process | Above Average 

This fund should offer competitive returns and a superior risk profile relative to its category index over the long haul. However, its stringent selection criteria introduce concentration risk and sector bets that may not be adequately compensated, limiting its Process rating to Above Average.

The fund fully replicates the Nasdaq US Dividend Achievers Select Index, which selects stocks on the basis of persistent dividend growth. The index is derived from the Nasdaq US Broad Dividend Achievers Index, which filters the broad U.S. market for firms with at least 10 consecutive years of increasing annual regular dividends. From this starting universe, Nasdaq excludes REITs and adds a proprietary screen to exclude stocks that are likely to have trouble continuing their dividend growth. While Nasdaq doesn't disclose the specifics of this screen, it seems to emphasize more-profitable, faster-growing companies.

Selected constituents are weighted by market cap. There is a 4% cap on any individual holding's weight. Its top holdings tend to drift past this limit between the yearly reviews, though not substantially. At the end of each month, any stock that has suspended its dividend or decreased it by more than half will be removed from the index. The index has been more lenient in extreme circumstances. For example, in 2020 it allowed a grace period before removing constituents that had suspended their dividends.

The index's strict inclusion criteria yield a portfolio of top-quality stocks. The stability of its constituents' franchises has insulated the portfolio from volatility. Its risk profile stands out relative to both the category index and category peers.

The fund forgoes dividend yield in search of durable dividend growth. As of the end of April 2021, its 12-month yield was only slightly higher than the Russell 1000 Index. This might not meet the needs of all income-oriented investors but will offer a good balance between a steady dividend stream and risk.

Absent from its lineup are many household names that either don't pay dividends or have yet to meet the index's inclusion criteria. Most prominent among those left out is Apple, whose current stretch of dividend growth dates back to 2012. Besides having no exposure to energy and real estate stocks, the index is also heavily underweight in technology names, while loading up on industrials and consumer staples.

The index's discerning selection criteria yield a small lineup. The fund held 212 stocks as of March 2021. Market-cap-weighting concentrates its assets in the few largest constituents. The fund's top 10 holdings have historically accounted for around 35% of assets.

People | Above Average 

Vanguard's equity index group boasts seasoned managers and a dedicated supporting staff well equipped to provide tight index tracking, earning it an Above Average rating.

Gerard O'Reilly and Walter Nejman comanage this strategy. O'Reilly, a principal at Vanguard, has been with the firm since 1992. Nejman has been with Vanguard since 2006. They both started on the strategy in 2016 to replace longtime manager Ryan Ludt as he transitioned into a different role within the firm.

The managers are responsible for the fund's trading, providing more portfolio insights than a stand-alone trader. They are supported by a global team of dedicated personnel and sophisticated, scalable technology that optimize precision and reduce managers' workload. Vanguard frequently rotates its managers to promote breadth and depth across the team. Its independent risk-management team works closely with the managers to monitor trades and review any potential issues. Managers' compensation is tied to performance using a combination of tracking error and excess return metrics, which aligns their interests with investors'.

Parent | High 

The Vanguard Group entered a new era in early 2019 with the passing of its founder and conscience, John C. Bogle. Unlike its mid-1970s origins, when outflows were the norm and its survival was in question, Vanguard now wears the crown as the world's biggest retail asset manager. More than 90% of its USD 5.6 trillion in global assets under management, as of June 2019, are in the United States, but the firm has designs to grow its non-U.S. business, especially in the United Kingdom, Australia, Canada, Japan, China, and Mexico.

Vanguard gained its stature by following Bogle's playbook: pairing relatively predictable strategies, both passive and active, with minimal costs. That’s enriched Vanguard's investors, and those outside its flock who have benefited from industrywide fee compression. While Vanguard's passive business now faces stiff price competition from its biggest rivals, inflows into its U.S. strategies still dominate.

Not content, Vanguard aims to transform investment advice, too. In May 2015, it launched Personal Advisor Services, a burgeoning discretionary asset-management business that pairs automation and human advice; and in September 2019 it disclosed plans to launch a digital-only counterpart. Vanguard's industry leadership readily merits a High Parent rating, but the firm must stay on its guard to prioritize investor interests over merely expanding its kingdom.

Performance 

Being underweight in tech and overweight in industrials and consumer staples hurt the fund's performance over the past few years. Its strict selection criteria have also left out emerging divided growers in the consumer discretionary and healthcare sectors. From its inception in 2006 through March 2021, the U.S fund's exchange-traded fund share class has underperformed the Russell 1000 Index category benchmark by 41 basis points annualized. Although its total return might not look attractive, the strategy's risk-adjusted performance typically lands in the category's top quartile.

The fund has been less volatile than the category index, offering downside protection through most major market crises during its existence. From its inception in 2006 through March 2021, it captured 89% of the category index's upside and just 88% of its downside. During the early-2020 coronavirus-driven shock from Feb. 19 to March 23, the fund outperformed the Russell 1000 Index by 2.74 percentage points. However, it lagged the benchmark by 19.58 percentage points from late March 2020 through March 2021.

Since its inception, the fund trailed the Nasdaq US Dividend Achievers Select index by an amount approximating its annual expense ratio.

Price 

It's critical to evaluate expenses, as they come directly out of returns. The share class on this report levies a fee that ranks in its category's cheapest quintile. Based on our assessment of the fund’s People, Process, and Parent Pillars in the context of these fees, we think this share class will be able to deliver positive alpha relative to the lesser of its median category peer or the category benchmark index, explaining its Analyst Rating of Gold.

Lan Anh Tran does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.