ETF Specialist

A Better High-Yield Strategy

Daniel Sotiroff

Yields have declined over the past several decades, driving some investors into 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 yield-centric funds becomes an important part of their investment merit. Furthermore, investors should not lose sight of the basic principles that have led to improved long-term performance. Low fees and portfolio diversification should not be abandoned in the quest for yield.

 Vanguard International High Dividend Yield ETF (VYMI) strikes a careful balance between risk management and yield, earning a Morningstar Analyst Rating of Bronze.

The fund's selection universe includes large- and mid-cap stocks in the FTSE All-World ex-US Index. It ranks potential holdings 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 capitalization and added until their cumulative market cap equals half that of the selection universe. This emphasizes companies that are large, stable, and less likely to be in financial distress, meaning they are more likely to maintain or grow their dividend payments in the future.

The fund's focus on dividend yield gives its portfolio a value orientation relative to the FTSE All-World ex US Index and can increase its risk. Stocks with high yields may pay 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. The fund's broad diversification can offset some of these stock-specific risks as it is one of the best diversified in the foreign large-value Morningstar Category. However, it should continue to be more volatile than the FTSE All-World ex US Index.

Historical performance is difficult to evaluate because the fund's track record is short. Over its life, its total and risk-adjusted returns have landed just inside the top third of the category. Vanguard charges 0.32% annually for this fund, which should give it a sustainable advantage over its more expensive competitors.

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 are often a consequence of price declines, and high-yielding stocks tend to trade at lower valuations than the broader market. Declining stock prices are usually caused by weakening fundamentals and poor growth prospects, which makes them risky.

This fund mitigates the impact of risky stocks through broad diversification and weights 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. The 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 more than 800 stocks, and its top 10 holdings account for only 17% of its assets. But there are no caps on sectors or countries, which can cause the portfolio to make large bets. 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 compared with 22% for its starting universe. This bias is 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. But developed-markets stocks still 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 a limited live track record, but its target index dates back to January 2009. These historical index returns, combined with the fund's 0.32% annual expense ratio, beat more than 70% of the funds in the category from January 2009 through August 2018. That said, value strategies such as this one underperformed broad market indexes over this period. The market-cap-weighted MSCI ACWI ex USA Index topped this fund's benchmark by 0.37% annually over the same nine-year-plus span after accounting for fees.

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

The fund uses full replication to track the FTSE All-World ex US High Dividend Yield Index. Its selection universe includes stocks from the FTSE All-World ex US Index, covering names listed in both developed and emerging markets. REITs and stocks that are not expected to pay a regular dividend over the next 12 months are 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 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 semiannually in March and September, 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%.

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 and supports a Positive Price Pillar rating.

Vanguard also offers this strategy in a mutual fund format, charging 0.32% for the Admiral share class of  Vanguard International High Dividend Yield Index (VIHAX). The Investor share class was closed in November 2018, but the minimum investment for the Admiral shares was reduced to $3,000. Additionally, the market-cap-weighted approach helps promote low turnover, which further reduces trading costs and the overall cost of ownership.

Alternatives
 Schwab Fundamental International Large Company Index ETF (FNDF) (0.25% expense ratio) is another value-oriented portfolio that breaks the link between a stock's price and its weight. It earns an Analyst Rating of Bronze. FNDF uses fundamental metrics to weight its holdings, including leverage-adjusted sales, retained operating cash flow, and dividends plus share repurchases. Like VYMI, its portfolio is well-diversified across more than 800 stocks, and turnover has remained low relative to its category peers.

A market-cap-weighted value index fund, such as iShares MSCI EAFE Value ETF (EFV) (0.38% expense ratio), may also be a suitable alternative. This fund targets stocks representing the cheaper half of the MSCI EAFE Index, which includes large- and mid-cap stocks listed in foreign developed markets outside of North America. Although EFV doesn't explicitly target dividend payers, its expected dividend yield was 4.3% as of August 2018.

Negative-rated  SPDR S&P International Dividend ETF (DWX) (0.45% expense ratio) had a 4.4% forward-looking dividend yield as of August 2018. This was one of the highest expected yields in the foreign large-value category, but DWX has a much riskier portfolio than VYMI. It limits holdings to the 100 highest-yielding stocks from the S&P Global ex-U.S. Broad Market Index. So, it doesn't offer the same level of diversification as VYMI. Furthermore, it weights holdings by dividend yield, which further emphasizes the highest-yielding names and increases turnover relative to a cap-weighted strategy.

Daniel Sotiroff does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.