ETF Investing

This fund doesn't offer the highest yield, but its profitability screen reduces its risk.
By Adam McCullough | 17/10/17

Vanguard U.S. Dividend Appreciation Index ETF (VGG) offers a diversified portfolio of highly profitable U.S. dividend-paying companies. This dual focus reduces the fund's exposure to firms with weak fundamentals that may not be able to sustain their dividend payments, which is a risk that often accompanies a narrow focus on yield.

About the Author
Adam McCullough, CFA, is a manager research analyst for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc. He covers passive strategies. Before joining Morningstar in 2016, McCullough worked as a growth equity analyst for FCI Advisors and served on its manager research committee. Before that, he was the lead analyst on two macro-driven, top-down exchange-traded fund strategies and a covered-call strategy for Tower Wealth Managers. Both firms are Registered Investment Advisors in Kansas City, Missouri. McCullough began his career with Ernst & Young’s financial-services office advisory practice, focusing on risk management and derivative valuation. McCullough holds a bachelor’s degree in finance and accounting from Syracuse University. He also holds the Chartered Financial Analyst® designation.

This fund's entire portfolio consists of units of the U.S.-listed  Vanguard Dividend Appreciation ETF (VIG). The underlying fund tracks the Nasdaq US Dividend Achievers Select Index, which includes stocks that have increased their dividend for at least 10 consecutive years but excludes REITs and other companies that have low dividend-growth potential. It applies proprietary profitability screens to land on its final list of constituents. While Nasdaq does not disclose its screens, these filters seem to include profitable companies with stable earnings and exclude stocks with low dividend-growth potential. Its holdings are market-cap-weighted, but individual positions are capped at 4% of the portfolio. The index is reconstituted annually.

The fund's focus on firms that are financially healthy enough to grow their payouts favours profitable companies with durable competitive advantages. Its dividend yield lands near that of the Russell 1000 Index, but the fund's portfolio sports a higher return on equity, return on assets and return on invested capital. Those traits can come at a premium, and the fund's portfolio may trade at higher valuations than the Russell 1000 Index.

Despite taking less market risk than its average peer, the fund outpaced the median fund in the U.S. Equity category by 1.7% annually over the three-year period ended Sept. 30, 2017. This was because of its greater exposure to consumer defensive stocks, smaller exposure to financial stocks and more favourable stock exposure within several sectors. And the fund's risk-adjusted returns have earned it a 4-star Morningstar rating.

Fundamental view

In a theoretical frictionless market, dividend-payout policy shouldn't have any impact on stock returns. A dividend payment should reduce the firm's stock price by an offsetting amount. But in practice, dividends often matter because they can impose greater discipline on managers in their capital-allocation decisions, leaving less money for low-return investments. And managers may use these payments to signal their confidence in their firms' prospects. Dividends can also help address some behavioural issues, including many investors' reluctance to realize capital gains to meet income needs, and may give them the fortitude to weather market volatility.

Investors can benefit from owning dividend-paying stocks, but chasing yield can be dangerous. The highest-yielding stocks could be under financial distress and may be more likely to cut their dividends than their lower-yielding counterparts. Many of these stocks pay out a large share of their earnings as dividends, leaving a small buffer to cushion these payments if their business deteriorates. This fund strives to mitigate this risk two ways. First, it selects its holdings from stocks that have increased their dividend payout for 10 consecutive years. Second, the index uses profitability screens to avoid stocks with deteriorating fundamentals. If a stock is more profitable, it should be able to maintain its dividend during a market downtown or raise its payout ratio in the future.

Whereas most dividend-themed funds end up with a value tilt and a high-dividend yield, this fund falls in the large-blend section of the Morningstar Style Box and has a dividend yield in the same ballpark as the Russell 1000 Index. However, the fund tilts toward more-profitable stocks. For instance, a greater percentage of its assets are invested in stocks with Morningstar Moat Ratings of wide (61% as of April 2017 to the Russell 1000 Index's 47%).

The fund's 10-year dividend-growth requirement is a tough hurdle to clear. If a company doesn't continue to raise its dividend, it is out for at least a decade. Top holdings currently include  Microsoft (MSFT),  Johnson & Johnson (JNJ) and  PepsiCo (PEP). Compared with the Russell 1000 Index, the fund has much larger stakes in the industrials and consumer staples sectors and less exposure to the financials, energy and technology sectors. The energy stake dropped as oil prices plunged and energy-related companies came under financial pressure and in some cases cut their dividends, which precludes their inclusion.

The fund's stringent profitability requirements may help it to weather volatile markets. During the financial crisis from October 2007 to March 2009, the underlying U.S.-listed fund lost 7.5% less than the category average drawdown of 54%. Its subsequent recovery lagged the category average, but its cumulative return from the start of the financial crisis through April 2017 landed in the top quintile among its U.S.-listed.

Vanguard charges a 0.30% expense ratio of for this fund, as well as for the currency-hedged version (VGH). This fee is a fraction of the 1.19% median levy among actively managed F-class mutual funds. However, investors with access to a U.S.-dollar account would be better served by investing directly in the underlying fund, which charges a mere 0.08%.

Don’t miss out on communications from Morningstar Canada! Sign up for our specialised newsletters, get early notice of our events, and get access to exclusive promotional content. Manage your subscriptions here.
Video Reports
Click here to view all