Why Vanguard High Dividend Yield Jumped 17% in 2016

Income investors like stocks that pay high dividends, and the companies that create exchange-traded funds have tapped into investors' demand for dividend stocks by creating dividend ETFs like the Vanguard High Dividend Yield ETF (VYM 0.84%). 2016 was a strong year for the ETF, as it produced a total return of 17%, outpacing gains in the Dow Jones Industrials and S&P 500 indexes. Yet even though the Vanguard ETF topped the overall market last year, what most investors want to know is whether its 2016 performance points to the likelihood of longer-term success for the fund. Let's take a closer look at the Vanguard High Dividend Yield ETF to learn more about how it works and why it did so well last year.

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Stats on Vanguard High Dividend Yield ETF

Data source: Vanguard Group.

How Vanguard High Dividend Yield invests

Most exchange-traded funds are tied to indexes, with the management team having the goal of matching the performance of the index. The Vanguard High Dividend Yield ETF tracks the FTSE High Dividend Yield Index, which includes more than 400 stocks of U.S. companies that have paid above-average dividends over the past 12 months. The index excludes real estate investment trusts, which means the ETF doesn't include REITs in its holdings.

Over time, the Vanguard ETF has done a good job of matching the performance of its index. Only about 0.10 percentage points separates the index's theoretical return from the actual performance of the Vanguard ETF. That's directly in line with the fund's current expense ratio of 0.09%, suggesting that when you look solely at the way the ETF invests, it's doing a good job of matching performance with minimal friction from transaction costs.

What helped the ETF in 2016?

The overall gain in the U.S. stock market was the clearest contributor to performance for the Vanguard ETF. But more specifically, strength in many of the fund's largest holdings played a key role in driving its performance, especially because the ETF has almost a third of its assets invested in its 10 top stocks.

Among its top 10 stocks as of Nov. 30, the most obvious standouts were in the energy sector. ExxonMobil and Chevron both did well in 2016, with Chevron in particular posting gains of more than 30%. The rise in crude oil and natural gas prices helped bolster the entire sector, and a large number of smaller stocks enjoyed even larger gains that contributed to the ETF's overall gains.

Financial stocks also played a role in the Vanguard ETF's outperformance. JPMorgan Chase was a top 10 holding, and it climbed by about a third as conditions in the banking world became more favorable. With rising interest rates and healthier levels of economic activity, JPMorgan and many of its high-yield banking peers were in a position to rebound from a long malaise.

What hurt the ETF in 2016?

Not all of the Vanguard ETF's picks did that well. General Electric was a high-profile underperformer, rising just 2% in 2016 as prospects for the industrial giant didn't keep up with the rest of the market. Procter & Gamble was another slight disappointment, with mid-single-digit percentage returns that held the ETF back.

Beyond the top 10, the ETF had some significant losing stocks. L Brands did particularly poorly, falling more than 27% in a tough retail environment. Still, most of the losses were relatively small, such as Coca-Cola's mild decline in the face of challenges to its sugary soft drink franchise.

Does Vanguard High Dividend Yield ETF belong in your portfolio?

Based on its 2016 performance, Vanguard High Dividend Yield ETF got the job done last year. It didn't dramatically outperform the broader market, but it did take advantage of the favorable conditions that helped support many dividend stocks as the bull market continued.

Looking forward, the prospects for dividend stocks remain attractive, and the Vanguard ETF will give you a healthy helping of stocks with above-average yields. Although high yields by themselves don't necessarily reflect the health of a dividend stock, Vanguard's process has done a good job of producing good long-term performance for investors.