The Quality Dividend ETF

In mid-November last year, when Warren Buffett revealed that  Berkshire Hathaway (BRK.A) (BRK.B) had taken a massive 5.4% stake in  IBM (IBM),
 Vanguard Dividend Appreciation ETF (VIG) held four of its top five holdings in common with him. This was no fluke. VIG focuses on quality dividends, demanding that companies increase them for 10 consecutive years just to make the cut. It then imposes further tests for liquidity and financial strength. The exact formula is secret but seems to weed out companies with high leverage and poor cash flow. The result is quality rather than high yield, so income-hungry investors might be surprised by a dividend yield that just matches the market. Whereas many dividend-focused funds concentrate in smaller value companies, this fund shades slightly toward growth. While we like dividends (more on that later), we think the fund's emphasis on safer yields justifies its average yield. VIG is a great choice for a core allocation.

Back to dividends. There's a lot to recommend dividend investing. For one, dividends, or the promise of them, are the soundest reason to buy equities--any other rationale relies on Ponzi thinking. Dividend investors also buy the main driver of historical stock returns, income today instead of the promise of capital appreciation tomorrow. According to the excellent Credit Suisse Global Investment Returns Sourcebook 2011, from 1900 to 2010 the U.S. stock market experienced 6.17% annualized real growth. About 4.24 percentage points of the market's return came from dividends, 1.37 percentage points from real per-share dividend growth, and a paltry 0.56 percentage points from price/dividend expansion (also known as the speculative return).

Some academics, citing the Modigliani-Miller theorem, argue that it doesn't matter whether a company pays a dividend. A company that holds back earnings, they claim, clearly has good investment opportunities to further grow profits. However, a 2003 paper by Robert Arnott and Clifford Asness showed that, contrary to common wisdom, higher dividend payouts predicted increased earnings growth for the aggregate U.S. stock market. A 2006 study on 11 countries also showed the same relationship, though it was weaker. Ping Zhou and William Ruland found in a 2006 study that high dividend payouts predicted strong future earnings growth among individual firms. The broad sweep of evidence strongly supports the idea that dividends enforce discipline on managers who may otherwise binge on empire-building. Further poking holes in efficient-market thinking is the fact that dividend-paying stocks have outperformed non-paying stocks in almost every market studied, with lower volatility.

Fundamental View
As of this writing, the U.S. stock market is unattractively valued compared with its historical average. In order to combat depressed consumer demand, rich-world central banks have driven down real interest rates to punishingly low levels, inflating asset prices. At a price of around 1,400, the S&P 500 yields about 2% and historically has grown real per-share dividends by about 1%-2% annualized. Add in share buybacks, a hidden boost to yield, and U.S. stock investors can reasonably expect a long-run 3.5%-4.5% annualized real return.

However, this estimate may be too rosy. Corporate earnings as a share of GDP is at a record 10%, well above the 6% historical average. The surge was in part driven by a massive expansion in public and private debt that accelerated in the 2000s. Total U.S. debt as a percentage of GDP was 266% at the start of 2000; it peaked at 386% in late 2008 and has only fallen to 355% as of mid-2011. The economy still has a long way to go before leverage falls to sustainable levels--somewhere under 200%. The deleveraging process will weigh on earnings and GDP growth, likely for another decade or so, as has been the case in past great deleveragings.

Further out, changing demographics conspires against equity returns. The fast-graying baby boomers are set to withdraw from the productive economy, slowing growth. At the same time they'll draw upon health-care entitlements, worsening government balance sheets. On top of that, retirees will begin swapping equities for safer assets, further pressuring down equity prices. The combination may prove toxic to the stock market.

The picture isn't pretty for the stock market's long-term returns. This doesn't mean investors should dump stocks. A more suitable response is to plan for lower long-run returns, cut fees to the bone, and not be surprised by volatility.

Portfolio Construction
The fund tracks the Dividend Achievers Select Index, which is a subset of the broad Dividend Achievers Index. "Dividend Achievers" are stocks that have increased their dividends in each of the past 10 years. The index's author, Mergent, crafted this fund's benchmark specially for Vanguard, applying the firm's proprietary screens that weed out less liquid stocks and companies that may not be able to continue growing their dividends. The adjusted-market-cap weighting on this index results in the top 10 holdings comprising more than 40% of the portfolio, nearly twice as concentrated as broad-market indexes such as the S&P 500. It also places large sector bets against technology and toward service and manufacturing sectors. Unlike traditional dividend-focused ETFs, the fund is light on financial and utility industries.

Fees
This ETF levies a 0.13% expense ratio--a bargain. Although passive large-cap ETFs can be bought for a tad less, none holds a portfolio that is as much toward high-quality while maintaining diversity. Like most Vanguard funds, this ETF engages in securities lending, the practice of loaning out physical shares in exchange for a fee. Vanguard's securities-lending program is very conservative, and Vanguard returns all resulting income to shareholders minus a small slice for operating costs. Counterparty risk should be minimal.

Alternatives
The market is chock-full of good dividend ETFs, by far the most popular kind of strategy ETF. Some of the biggest such ETFs weight stocks by yield, increasing income potential but shouldering more distressed and declining companies.  IShares Dow Jones Select Dividend Index (DVY) charges a 0.40% expense ratio and attempts to screen for sustainable dividends by excluding stocks that have cut dividends in the past five years or paid out more than 60% of earnings.  SPDR S&P Dividend (SDY) is a tad cheaper at a 0.35% price point and requires its holdings have increased dividends every year for the past 25 years. DVY's portfolio yields more but is especially vulnerable to the business cycle, while SDY's is higher quality but rests on a much narrower base of 60 companies.

Investors leery of the idiosyncratic holdings of SDY and DVY but looking for decent yield should consider  Vanguard High Dividend Yield Index ETF (VYM). Its strategy is classic: Market weight the highest yielding U.S. stocks until the portfolio covers 50% of the U.S.' market capitalization. The result is a low-cost, higher-yielding fund with a more cautious tilt than the yield-weighted SDY and DVY.

WisdomTree offers a broad suite of dividend ETFs spanning various size styles and even using earnings as a weighting metric. Its biggest large-value offering,
 WisdomTree LargeCap Dividend (DLN), carries a competitive 0.28% expense ratio and weights large-cap stocks by their projected share of total dividends over the next year.

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Disclosure: Morningstar, Inc. licenses its indexes to institutions for the creation of ETFs and ETNs. Morningstar receives fees that are mainly based on fund assets under management. AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Scottrade, and Van Eck currently license Morningstar Indexes. These ETFs and ETNs are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on the Morningstar Indexes.