2 Vanguard Dividend ETFs Under the Microscope
We take a holdings-level look at these gold-rated funds.
A version of this article previously appeared in the July 2021 issue of Morningstar ETFInvestor. Click here to download a complimentary copy.
We previously classified dividend strategies along the growth-income spectrum in our white paper, “Dividend Funds Under the Microscope.”  Our classifications rest on the premise that dividend-income funds gravitate toward stocks with higher current yields, while dividend-growth funds forgo some amount of current dividend yield in order to favor stocks poised to grow their dividends. Here, I’ll examine this trade-off in more detail, with a case study that puts a pair of Morningstar Medalist dividend exchange-traded funds under the microscope.
I’ve chosen Vanguard Dividend Appreciation ETF (VIG) to represent the dividend-growth group and Vanguard High Dividend Yield ETF (VYM) for the dividend-income group. Both carry Morningstar Analyst Ratings of Gold. VIG singles out stocks with a long history of growing their annual dividends, while VYM tracks the highest-ranking half of the U.S. equity market by forward dividend yield.
To compare the funds’ approach to stock selection, I’ve parsed patterns in their holdings’ dividends. The survival rate--featured in Exhibit 2--is the ratio of the number of holdings that continued to grow their dividends for the period in question divided by the total number of portfolio holdings at the onset of the period. I broke these figures down further to separate statistics for the funds’ shared holdings and unique holdings to further highlight the differences in their approaches. As both funds’ underlying indexes reconstitute in March, I used end-March portfolio data in 2018 and 2016 for the trailing three-year and five-year periods, respectively. I calculated stocks’ dividend growth rates by comparing their 2020 annual dividends against their annual dividends in 2017 and 2015, respectively.
The survival rate of stocks in VIG’s March 2016 and March 2018 portfolios was upward of 90%. This was significantly higher than its yield-oriented cousin, VYM, which saw nearly half of its March 2016 portfolio drop out by the end of 2020. Not only have the stocks in VIG’s portfolio had more staying power, they’ve also been more likely to grow their dividends. As shown in Exhibit 1, nearly 91% of the stocks in VIG’s March 2018 portfolio had increased their dividends through 2020. These stocks represented 93% of its assets. Just two thirds of the stocks in VYM’s portfolio grew their dividends over that same span. These stocks represented 84% of the value of its portfolio, which is an artifact of weighting stocks by market cap. These differences are even more stark when comparing the funds’ March 2016 portfolios.
The same patterns repeat when sorting the funds’ holdings on the basis of which were shared and which were unique across the two portfolios. This data is featured in Exhibit 2. Roughly 61% of VYM’s unique holdings maintained their dividend growth over the three-year period, and just over half kept their dividends growing for the five-year period. Meanwhile, the three- and five-year survival rates for VIG’s unique holdings remained largely unchanged at 90% and 89%, respectively.
Survival rates are highest among the fund’s shared holdings. Among the 56 stocks that featured in both funds’ March 2018 portfolios, just four either decreased or suspended their dividends as of the end of 2020. This translated to a 93% survival rate among these shared holdings. For the funds’ March 2016 portfolios, this number dropped to 89%, with eight out of the funds’ 73 shared holdings seeing their dividend growth falter.
The strict inclusion criteria that VIG employs have clearly paid off in the form of a steady stream of dividends. Its 10-year dividend growth requirement and additional quality screen have yielded a portfolio of stocks that are much more likely to maintain and grow their dividends. As it screens stocks exclusively on the basis of their 12-month forward dividend yields, VYM’s constituents’ dividends have not been nearly as durable. While the holdings it had in common with VIG improved its overall survival rate, they seem to be the outliers in its portfolio. Looking at these portfolios’ vitals can give us a better understanding as to why.
Exhibit 3 features data that measures the two funds’ fundamentals on the basis of quality (Morningstar Economic Moat Rating, profitability, financial health, leverage) and valuation (valuation ratios, dividend yield). These figures represent data for equal-weighted portfolios of the funds’ March 2016 and March 2018 holdings.
The two funds’ shared holdings seem to offer a “best-of-both-worlds” balance between dividend growth and current dividend income. A greater portion of them enjoy either a narrow or wide moat than either VIG’s or VYM’s unique holdings. Nonetheless, VIG’s unique holdings do not lag far behind, while VYM has very few unique holdings with wide moats. The pattern is the same for their profitability metrics. Companies that make it into VIG’s lineup tend to be established businesses with stable cash flows.
Stable stocks tend to be more expensive. VYM’s unique holdings have much lower valuations than both of the comparison portfolios. Within VIG’s portfolio, the holdings it shares with VYM tend to be more profitable, but they are also more leveraged.
In terms of yield, VYM’s unique holdings predictably rank higher than VIG’s unique positions. And, as expected, VYM lags both when it comes to the aggregated dividend growth of its holdings. This is partly attributable to the high percentage of its holdings that either decreased or suspended their dividends. While VYM’s index removes stocks that suspend their dividend, those that reduce their payouts but still pass its yield criteria can linger in the portfolio.
Companies with the capacity to grow their dividends over an extended period of time are often mature, profitable businesses. Not only do these companies’ dividends tend to be more durable, but they generally weather downturns better than less-established franchises. This is evident in VIG’s and VYM’s drawdowns since their common inception in 2006, which are plotted in Exhibit 4. VIG’s emphasis on dividend growth has resulted in lower volatility and materially smaller drawdowns relative to VYM. From peak to trough, it outperformed VYM by 8.87 and 4.74 percentage points during the 2008 global financial crisis and the 2020 coronavirus-driven sell-off, respectively.
While VYM’s vitals don’t look great in our hypothetical equal-weighted portfolio, it’s important to point out that the fund hasn’t actually allocated a large portion of its assets to stocks that failed to grow their dividends. VYM weights stocks by market cap. So while many of the stocks it has owned over the years have cut or suspended their dividends, most of them had negligible weights in the portfolio. As a result of weighting stocks based on market cap, VYM strikes a better balance between dividend growth and current dividend yield than many of its yield-focused peers.
Many yield-focused funds weight stocks on other measures, like dividend yield. While this further boosts current yield, it also increases risk. One example is Vectren, one of VIG and VYM’s shared holdings that decreased and eventually suspended its dividend. The stock accounted for 1.3% of Silver-rated SPDR S&P Dividend ETF (SDY)’s portfolio in March 2018. SDY weights stocks by their yield. In contrast, its weight in VIG’s portfolio was 0.12% and its weight in VYM’s portfolio was 0.05%. Both funds weight stocks by market cap.
While this case study gives us a better understanding of the trade-offs involved for investors considering growth- and yield-oriented dividend funds, it is just one case among many. As always, deeper diligence is required. Our example illustrates many of the key considerations investors should take into account when analyzing these funds.
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Lan Anh Tran does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.