Vanguard Dividend Appreciation ETF (NYSEMKT:VIG) is offered up from a highly respected fund family, but that doesn't mean it will fit well in your portfolio. In fact, despite having the word "dividend" in the name, the yield today is actually lower than what you would get from buying an S&P 500 index ETF. So income isn't a big reason to own this exchange-traded fund at all. Here's what Vanguard Dividend Appreciation ETF actually does and why you may or may not want own it.

Some basics

The $49 billion Vanguard Dividend Appreciation ETF tracks the NASDAQ US Dividend Achievers Select Index. It has a minuscule expense ratio of 0.06%, making it a very cheap fund to own. Vanguard Dividend Appreciation ETF's portfolio contains around 180 stocks.

The letters ETF on a bed of green grass

Image source: Getty Images.

One thing that stood out as a bit odd was that the Vanguard dividend ETF's yield is just under 1.8%. That's actually a bit less than the current yield on the SPDR S&P 500 ETF, which comes in just over 1.8%.

For more details, you need to dig a little further into the actual index that Vanguard Dividend Appreciation ETF tracks. NASDAQ US Dividend Achievers Select Index is composed of U.S. stocks that have increased their dividends for 10 or more years. Real estate investment trusts and master limited partnerships are excluded from inclusion. There are some potential tax considerations behind that move, but to me, it still seems like a shame because both of these market niches tend to offer high yields. And some of the companies in these two sectors are financially strong, conservatively managed, and have incredible dividend histories, including Realty Income and Enterprise Products Partners.   

Then there's one more little wrinkle: "additional proprietary eligibility are applied." I couldn't find anything more explained about that in the methodology brochure provided by NASDAQ, and so I'm not sure how investors can know exactly what will or won't make it into the final index.

This is no small issue, being that the fund has zero exposure to the oil and gas sector even though ExxonMobil and Chevron, among many other oil and gas companies, have enviable records when it comes to rewarding investors with annual dividend increases. The fund is also notably light on telecommunications stocks, with just 0.05% of the portfolio in that sector. That said, Morningstar reports that the additional screens are based on profitability measures to help keep companies that might cut their dividends out of the index. That's interesting, but doesn't fully explain why Exxon, Chevron, AT&T, and Verizon aren't included in the index. All are generally considered large and reliable dividend payers.    

A modified market cap weighting is applied, with an upper bound of 4%, so no single stock will be too heavily weighted. The index is rebalanced in March, with stocks that fall out of the index (presumably due to a dividend cut or running afoul of the proprietary screens) getting pulled out as the year progresses. All told, Vanguard Dividend Appreciation largely lives up to what its name implies, but there are some notable exclusions that don't seem to make a whole lot of sense. And there's no way to know why, in some cases, because the word "proprietary" basically means that NASDAQ, the company that actually maintains the index this ETF tracks, doesn't provide an explanation.      

The big picture

In the end, Vanguard Dividend Appreciation ETF is really just using dividends as a selection tool. Generating a lot of immediate dividend income isn't the main goal. It is simply looking for companies that have proven they can increase their dividends. That's not a bad plan, since a company that can increase its dividend annually for a decade or more is, presumably, doing something right. But it's important to know that the nuances here give the ETF a growth bias. 

VIG Dividend Chart

VIG Dividend data by YCharts

Still, it's interesting to look at the dividend growth that you are actually getting, since "dividend appreciation" suggests investors should expect growing distributions over time. In the chart above, you can see that the ETF's dividend has, indeed, grown over time, but it bounces around a fair amount. That makes sense, since the portfolio it is a collection of stocks that pay dividends. The dividend the ETF pays is just a function of the dividends of the underlying stocks. The takeaway for investors is, Vanguard Dividend Appreciation may home in on companies with growing dividends, but that won't necessarily translate into a growing income stream in your pocket. There's a fair amount of volatility and the dividend could even decline.   

SPY Chart

SPY data by YCharts

So what are investors really getting here? In my eyes, a large-cap fund blending both growth and value stocks that uses dividend history as a primary stock screen. For example, the price to earnings ratio for Vanguard Dividend Growth ETF's portfolio averages out to be around 25 times, with the price to book value ratio coming in at 4.7 times. Both are higher than the same ratios for the S&P 500 Index, which are 24 and 3.6 times, respectively. That shows how much dividend stocks have been popular among investors lately.

That said, over the trailing one-, three-, and five-year periods the fund has basically tracked the S&P 500. It trails notably over the past decade, but again is roughly in line when you look back to the fund's inception. Standard deviation, a measure of price volatility, is a little below that of the S&P 500, but not a huge amount. So value investors and even most dividend investors should think twice before stepping in here.   

Look elsewhere for dividends

At the end of the day, Vanguard Dividend Appreciation ETF is just OK. It doesn't really stand out in any particular way, most notably when it comes to dividends. So if the inclusion of the word "dividend" is what attracted you, this may not be a great option for you. That said, if you like the idea of owning a broad index that's performed roughly similar to the S&P 500, but that only buys companies that have increased their dividends over time, then maybe this fund will work for you. But that seems like a convoluted way to get broad market exposure. You might just be better off with an S&P 500 fund in the long run.