There's a lot to like about exchange-traded funds (ETFs), and there's a lot to like about high yield stocks. However, marrying the two in the form of Vanguard High Dividend ETF (VYM 0.30%) sounds better than it actually is for dividend-focused investors. Here's why investors looking to live off dividend payments will probably want to stick to individual stocks instead.
It's all about the index
Vanguard High Dividend ETF is a passively managed exchange-traded fund. That means it blindly tracks an index, in this case the FTSE High Dividend Yield Index. Vanguard, however, doesn't make it easy to understand what's happening at the index level. Even the prospectus is shockingly shy on details.
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To be fair to Vanguard, the objective really is to "track the performance of a benchmark index that measures the investment return of common stocks of companies that are characterized by high dividend yield." And the principal investment strategy actually is "an indexing investment approach designed to track the performance of the FTSE High Dividend Yield Index, which consists of common stocks of companies that pay dividends that generally are higher than average." But this doesn't tell investors what's going on, because what's important to understand is the index methodology. For that, you have to research the FTSE High Dividend Yield Index.
Keeping the logic simple, according to information available from FTSE Russell, the index ranks stocks by forward dividend yield, excluding real estate investment trusts, and then creates a portfolio that includes the highest-yielding half of the stocks. The index is weighted by market cap and rebalanced semiannually.
Some things to consider
There are some problems here if you're a dividend investor looking to live off the income your portfolio generates.
- Vanguard High Dividend ETF's dividend yield is roughly 3%. That's notably more than you would collect from an S&P 500 Index ETF, which yields only about 1.6%. But it would still be difficult to suggest that 3% is a particularly high yield. It's pretty easy to find stocks yielding 5% or more that have incredible dividend histories and strong businesses even today. Maybe the list of such high-yield opportunities is smaller, bringing in diversification issues, but that simply leads into the second problem.
- Vanguard High Dividend ETF is rebalanced twice a year, which means any dividend stocks that have appreciated will get sold if their yield drops out of the top half of the list -- technically below 55%. Or the ETF will add to the stock as it recovers because the market cap has increased -- buying at less desirable yield levels. There's also the possibility, if the market cap drops relative to other companies in the index, that the size of a recovered high yield stock in the portfolio will be reduced just as the business has become more desirable to own. A high yield often highlights a stock that is out of favor, which can be a great time to buy a stock. But if you're looking to create a long-term income stream from such opportunistic investments, this ETF is going to buy and sell in ways that don't let you benefit from being a long-term investor.
Go it alone
Exchange-traded funds can make investing easy, but they have to make logical sense with your investment approach. When it comes to building a collection of reliable high-yield dividend payers, the best time to buy is often when the stocks are out of favor. And then you'll probably want to hold on for decades, collecting the fat yield you bought even if the stock price recovers from depressed levels. Why would you mess with your position in a great dividend company just because its yield isn't in the top half of the investable universe, its market cap has increased, or some other dividend stock you own has a larger market cap?
To cherry-pick an example, ExxonMobil's (XOM 0.13%) yield was around 10% in 2020, but it it's down to around 3.4% today. Would you want to touch that 10% yield or cling to it for decades, knowing that the company has increased its dividend annually for around 40 years?
Simply put, your key metric should be yield on purchase price, because you're buying for the income. That the company's fortunes have improved, leading to stock-price appreciation, is really just icing on the cake that proves out your original investment thesis. Most investors looking to create a stable stream of dividend payments will want to own individual stocks and not an index-linked product like Vanguard High Dividend ETF.
Not a great fit for dividend investors
Giving Vanguard High Dividend ETF its due, the turnover rate is fairly low, around 10% a year or less of late, and the dividend payment per share has gone up in each of the past four years. It also owns names you'll probably know well, including ExxonMobil and Procter & Gamble. So it's not a bad investment, per se. But it isn't opportunistically buying out-of-favor stocks with high yields like you could, as an individual investor, building an above-average income stream over time. The frequent rebalancing really turns Vanguard High Dividend ETF into a total return story, even though the name suggests it's all about the dividends.
