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ETF Specialist

A Tale of Two Dividend Growth Funds

While these two funds pursue similar strategies, the active fund may have an edge over its index-based counterpart.

Expense ratios are one of the best predictors of relative fund performance. This lends support to low-cost index investing. But sometimes it can be beneficial to pay a little more for active management.  Vanguard Dividend Appreciation ETF (VIG) and  Vanguard Dividend Growth (VDIGX) offer an excellent case in point. Both funds target stocks with strong records of dividend growth, but where the exchange-traded fund tracks an index, Vanguard Dividend Growth applies active management to achieve the same goal. Yet despite its higher expense ratio, Vanguard Dividend Growth has outpaced its ETF counterpart by 1.3% annualized since April 2006, when Vanguard launched the ETF (and its associated mutual fund share classes).

Don Kilbride, the manager of Vanguard Dividend Growth, shops for stocks that are trading at reasonable valuations with a history of dividend growth and the capacity to sustain that growth. Vanguard Dividend Appreciation attempts to replicate this strategy with mechanical rules. It simply invests in stocks that have increased their dividends in each of the past 10 years and applies some proprietary screens to filter out stocks that may not be able to continue that growth. This fund weights its holdings by market capitalization, subject to a 4% cap.

This mechanization can improve consistency over time, largely mitigating the impact of manager changes on the fund's performance. It also reduces cost. Vanguard Dividend Appreciation charges a razor-thin 0.10% expense ratio, where Vanguard Dividend Growth charges 0.31%. That's still significantly lower than most actively managed funds in the large-blend category. For the additional 21 basis points, Vanguard Dividend Growth takes qualitative considerations into account and may react to changing fundamentals in a more flexible way than the rules-based ETF can. For example, until the third quarter of 2013, both funds invested in  PepsiCo (PEP). But Kilbride sold his position last year over concerns about the outlook for the firm's soft-drink business and its valuation, not about the firm's dividend. Pepsi continued to raise its dividend in 2014 and so remained in Vanguard Dividend Appreciation.       

Despite their focus on dividend growth, neither of these funds offers a particularly high dividend yield. The estimated dividend yield for VIG (2%) is lower than the corresponding figure for the S&P 500 (2.3%), while Vanguard Dividend Growth offers an only slightly higher yield (2.4%). This reflects the fact that these are really more quality-oriented than they are dividend income strategies. The types of companies that can raise their dividends for 10 years running tend to enjoy sustainable competitive advantages, relatively stable businesses, and strong profitability. More than 63% of VIG's assets are invested in companies with wide economic moats, Morningstar's assessment that a firm carries a durable competitive advantage. The corresponding value for the Russell 1000 Index is 41%. Vanguard Dividend Growth boasts an even more moat-heavy portfolio--69% of its assets are invested in wide-moat companies. This may explain why these funds' holdings generated higher returns on invested capital than the average company in the Russell 1000 Index over the trailing 12 months through June.   

These portfolios of quality holdings tend to exhibit less volatility and weather market downturns better than their less advantaged peers. Since May 2006, Dividend Growth and Dividend Appreciation exhibited low market betas (a measure of market sensitivity) of 0.78 and 0.82, respectively, and lower standard deviations of return than the Russell 1000 Index. They also both lost considerably less (25.6% and 26.5%, respectively) than the Russell 1000 Index (37.6%) in 2008. However, they have generally lagged during strong bull markets. That's not surprising because quality firms tend to be less sensitive to the business cycle than average and should experience smaller swings in fundamental value.

The chart below illustrates the growth of $1 invested in each of these two funds divided by the growth of $1 invested in the Russell 1000 Index. When the line is upward sloping, the corresponding fund is outperforming this index, and when it is downward sloping, the fund is lagging. While these two funds did well in 2008, they slightly trailed the market over the past five years. Historically, the protection that quality stocks offer during market downturns has more than made up for their shortfalls during better times.  


 
Although Vanguard Dividend Growth did better than the ETF over the past several years, absolute performance comparisons do not tell the whole story. A handful of lucky trades in a concentrated period could explain superior performance over a long horizon, but it may not be reasonable to expect that outperformance to continue. Therefore, it is important to evaluate the consistency of outperformance. The chart below shows the performance of Vanguard Dividend Growth relative to Vanguard Dividend Appreciation in the same manner as described for the previous chart. Though it experienced its best period of relative performance prior to March 2009, Vanguard Dividend Growth exhibited reasonably consistent outperformance. This should give investors greater confidence that this performance edge was not merely the product of luck. Superior stock selection in the health-care sector accounted for a large portion of the fund's outperformance.

Kilbride is paid to beat Vanguard Dividend Appreciation's index. Vanguard pays Wellington, the fund's subadvisor, a management fee with a performance adjustment based on the fund's three-year performance relative to the NASDAQ U.S. Dividend Achievers Select Index, VIG's benchmark. That gives Kilbride and his colleagues a nice incentive to make meaningful active bets relative to this benchmark. Only about 42% of the fund's holdings' assets are invested in stocks that are also included in Vanguard Dividend Appreciation. It also has a more concentrated portfolio of 50 holdings. This focus allows Vanguard Dividend Growth to profit from its best ideas and look different from VIG, which includes 163 holdings. Despite its narrower portfolio, Vanguard Dividend Growth has a smaller portion of its assets invested in its top 10 holdings (27%) than does VIG (37%).

There are other notable differences between these two funds' portfolios. Vanguard Dividend Growth tilts toward larger firms relative to Vanguard Dividend Appreciation, as the table below illustrates. These firms tend to be more profitable and less volatile than their smaller counterparts. The funds' sector weightings also look a bit different. For instance, relative to the ETF, Vanguard Dividend Growth overweights the more volatile consumer cyclical and financial services sectors, and underweights consumer defensive stocks. This is partially offset by its larger stake in relatively stable health-care stocks and smaller exposure to cyclical industrial stocks. The table below summarizes some of the salient characteristics of each fund's portfolio.



And the Winner?
While one fund isn't categorically better than the other, Vanguard Dividend Growth has a reasonable chance of outpacing the ETF. It has a relatively modest cost hurdle to overcome and its manager is specifically incentivized to beat the index Vanguard Dividend Appreciation tracks. It also has greater flexibility to respond to changing fundamentals and take into account qualitative information that the ETF ignores. That said, Vanguard Dividend Appreciation's consistent rules-based approach may well be difficult to beat over the long term, particularly if Kilbride or any of the key analysts at Wellington leave the firm. It largely captures the essence of Vanguard Dividend Growth's strategy. Therefore, Vanguard Dividend Appreciation is a fine choice for investors who are skeptical of Kilbride's ability to consistently identify index-beating securities (or of Vanguard's ability to retain him).    


 

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