There is really no "right" way to invest, since every person has their own unique needs and desires. That is just as true with dividend investing as it is with investing more broadly. That's why it is so important for investors to understand what an exchange-traded fund (ETF) is doing before buying it, because it has the word "dividend" in its name.
Comparing the Vanguard High Dividend Yield ETF (VYM 1.00%) to the Vanguard Dividend Appreciation ETF (VIG 0.92%) helps to explain why, but it will help to start with a third popular "dividend" ETF first.
Dividends can mean many things
One of the best examples of an ETF that misleadingly has the word "dividend" in its name is the WisdomTree US Quality Dividend Growth Fund (DGRW 0.83%). The fund starts out by looking only at the stocks within the WisdomTree U.S. Dividend Index. That index is, indeed, filled with dividend stocks, but the only requirement to get on the list is to pay a dividend. When it comes to the ETF, the actual selection process is based on growth and quality factors like long-term earnings growth expectations and historical rates of return on equity.
NASDAQ: DGRW
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In essence, the only role dividends play in the WisdomTree US Quality Dividend Growth Fund's process is that holdings have to pay one. Not too surprisingly, the yield on this ETF is 1.6%. Paying a dividend is simply a proxy for quality within a selection process that is really about looking for growth stocks. If you were trying to find dividend growth stocks, the WisdomTree US Quality Dividend Growth Fund probably wouldn't be what you were looking for.
The Vanguard Dividend Appreciation ETF does what it says
That brings the story to the Vanguard Dividend Appreciation ETF, which is one of the more popular dividend ETFs on offer from financial powerhouse Vanguard. It tracks the S&P U.S. Dividend Growers Index. This index consists of U.S. stocks that have increased their dividends every year for at least 10 consecutive years. That is a very clear focus on dividend growth.
NYSEMKT: VIG
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But there's another small wrinkle that investors need to understand. The index excluded the highest dividend-yielding stocks that make the list, by only selecting the lowest-yielding 75% of the possible candidates. Why do that?
First, higher yields often show up among troubled companies that are in danger of cutting their dividends. Second, there are a number of slower-growing sectors, like utilities, that tend to have above-average yields all the time. Basically, this final screen, which would be easy to miss, ensures that the Vanguard Dividend Appreciation ETF will never be a high-yield ETF. It only has a 1.8% yield, as a result.
The Vanguard High Dividend Yield ETF is all about the yield
If you are looking for stocks with big dividend yields, then the Vanguard High Dividend Yield ETF is going to be a better option. Although it excludes real estate investment trusts (REITs), a sector known for having high yields, from consideration, its fairly simple construction methodology ensures that it will own higher yielding stocks. How? Like the WisdomTree US Quality Dividend Growth Fund, it starts by only looking at dividend payers. But then it selects the 50% of the list with the highest yield for inclusion in the fund.
NYSEMKT: VYM
Key Data Points
While the process here clearly means the Vanguard High Dividend Yield ETF is meant to track a list of the highest-yielding stocks, there is one caveat. It is basically looking at almost the entire US stock market, so its portfolio ends up being very large. The ETF currently owns around 550 stocks. That increases portfolio diversification, but it means that the overall yield will probably not be as high as with more focused ETFs. The Vanguard High Dividend Yield ETF's yield is roughly 3% right now. That's not bad, but you can easily find higher-yielding ETFs.
You might see the Vanguard High Dividend Yield ETF's large portfolio and diversification as a flaw or a feature. But if you didn't know about it, you would risk buying something that didn't fit with your investment approach.
ETFs can help simplify your life, but only if you dig into the details
All the ETFs listed here are fairly popular, and they all hint at the use of dividends in some way based on their names. But as you can clearly see, just putting the words "dividend" or "yield" in an ETF's name doesn't mean it's doing what you think it is doing. If you want to buy ETFs because they can make your investing life easier, that's great, but you still need to do your homework to make sure you buy the right ETFs for you.
