ETF Investing

This value fund targets high-yield stocks and emphasizes large, stable firms.
By Daniel Sotiroff | 13/02/18

Dividend yields have declined over the past several decades, causing some investors to pursue high-yielding stocks to shore up their income. Fund providers have responded to this desire with rules-based strategies specifically focused on yield.

About the Author
Daniel Sotiroff 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 2017, Sotiroff was as a design engineer at Caterpillar, where he worked on front-end loaders for heavy construction and mining applications. Sotiroff holds a bachelor’s degree in mechanical engineering and a master’s degree in applied mechanics, both from Northern Illinois University.

But it's important to remember that high-yielding stocks can be riskier than the overall market. Therefore, the risk-management aspect of these funds becomes an important part of their investment merit, as are low fees and diversification. Don't ignore these considerations in the quest for yield.

 Vanguard International High Dividend Yield ETF (VYMI) is a reasonable value strategy that effectively diversifies stock-specific risk. It screens for high-yield stocks and weights holdings by market capitalization, which tilts the portfolio toward large, stable firms while also promoting low turnover. But its track record is short, which limits its Morningstar Analyst Rating to Bronze.

The selection universe starts with large- and mid-cap stocks that are part of the FTSE All-World ex-U.S. Index. The exchange-traded fund's index ranks large- and mid-cap stocks by their expected dividend yield over the next 12 months and selects those that represent the higher-yielding half by market value. Stocks that make the cut are weighted by market cap, which emphasizes companies that are large, stable and less likely to be in financial distress. This increases the likelihood of holding stocks that can maintain or grow their dividend payments in the future.

This focus on dividend yield gives the portfolio a value orientation relative to the FTSE All-World ex-U.S. Index, but it can also increase risk. Stocks with high yields may be paying out a high percentage of their earnings as dividends, which reduces the fraction that can be reinvested to grow their businesses. Alternatively, high yields can stem from stocks with poor prospects and depressed prices. But this fund's broad diversification can help mitigate these stock-specific risks. Additionally, the emphasis on large mature firms reduces the fund's allocation to those likely to be in severe distress.

The fund's country allocations look different from its parent benchmark. It substantially underweights stocks from Japan, while overweighting those from Australia and Switzerland. These latter two countries have heavy allocations to stocks with high dividend yields from the financial-services and healthcare sectors, respectively.

Historic performance is difficult to evaluate because the fund's track record is limited. Since its inception in February 2016, VYMI's absolute and risk-adjusted returns have landed in the top quartile of its category.

Vanguard charges a management-expense ratio of 0.32%, which is one of the lowest fees among international equity ETFs, both in the United States and Canada.

Fundamental view

Strategies that emphasize stocks with high dividend yields can be attractive for the income that they provide, and regular dividend payments can help investors stay invested through market downturns. But high dividend yields can come from two different types of stocks: those that trade at low prices relative to dividends paid (low valuations), and those that are highly profitable and return cash to shareholders. The former may be riskier and suffer from deteriorating fundamentals, while the latter are more stable and likely to continue paying dividends.

One way of distinguishing between stable or risky dividend payers is to screen for quality or profitability. This fund doesn't directly perform this type of screening, but it does weight its holdings by market cap. This approach emphasizes large, stable firms and can indirectly tilt the portfolio toward companies that are highly profitable and more likely to continue their dividend payments. This fund's average market cap is among the largest compared to similar funds sole in Canada and the United States, and volatility has been in the lower third of this category since the fund was launched.

International stocks currently have higher dividend yields than their North-American counterparts. However, their dividend payments tend to be more volatile because many of these foreign companies link their dividend payments to earnings. This risk can be mitigated by diversifying across multiple stocks and industries. Some strategies that emphasize dividends may focus on a narrow selection of companies, limiting diversification and increasing risk. This portfolio is well diversified across 830 stocks, and its top 10 holdings only account for 16% of its assets. But there are no caps on sectors or countries, which can cause the portfolio to make large bets on a given sector or country. This approach was intentionally employed to preserve the emphasis on stocks with high dividend yields. Currently this fund has 35% of its assets in stocks from the financial-services sector, which can be a source of sector-specific risk.

This fund also holds stocks from emerging-markets countries, which can be more volatile than their developed-markets counterparts. However, developed-markets stocks account for the bulk of the portfolio. Furthermore, many high-yielding stocks are domiciled in mature markets such as the United Kingdom, Switzerland and Australia. Japan's recent economic stimulus efforts have caused the prices of Japanese stocks to appreciate by a substantial amount, which has driven down dividend yields. Consequently, stocks from Japan have a smaller position in this fund relative to the category norm.

This fund has exposure to multiple currencies from both developed and emerging markets and does not take action to hedge this currency risk. Fluctuations between the U.S. dollar and these currencies can be an additional source of volatility. Over long time periods, these fluctuations should wash out. For Canadian investors, fluctuations between the U.S. and Canadian dollars add another layer of currency risk.

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