Although I don’t often cover domestic equity index funds, I’ll make an exception for the Vanguard High Dividend Yield ETF (VYM). VYM has become very popular with income hunters over the past decade due to the persistently low interest rate environment. I also prefer it over broader-based index funds such as the Fidelity 500 Index Fund (FXIAX) and the Vanguard 500 Index Fund (VFIAX) because of its value slant.
Anyway, as with any index tracker, the best place to start is with the index it is designed to track. That means first pulling up the rules for the FTSE High Dividend Yield Index. Now, the first thing this index does is exclude REITs and stocks that don’t pay any dividend at all. This creates a list of eligible stocks, of which the combined market value is then recorded. Those stocks are ranked according to forecast dividend yield, and that carries on until 50% of the market value of all eligible stocks is reached. The weighting of each constituent is based on market capitalization.
Okay, so what the heck does that all mean? Well, the practical effect is that stodgy mega-cap dividend stocks make up the lion’s share of the fund’s $40,000m in net assets. That means blocks of JPMorgan, Johnson & Johnson, Procter & Gamble, Exxon Mobil and AT&T dominate the list at time of writing. Indeed, those five names actually take up around 15% of the portfolio’s entire current value.
Stretching that over the next five stocks – Intel, Verizon, Merck, Chevron and Pfizer – brings the figure up to over 26%. Other favorites just outside the top ten include Coca-Cola, PepsiCo, Wells Fargo and McDonald’s. Heck, the correlation between being in the top thirty holdings in VYM and appearing on The Compound Investor is pretty strong.
The end result of this methodology is that you essentially end up with a value screen biased toward mega-cap stocks. Although dividend yield is a crude proxy for value, it is nonetheless a way of sorting cheap from expensive. That is one of the reasons to like the Vanguard High Dividend Yield ETF. It basically incorporates a simple valuation strategy while you claim economic ownership over a basket of stocks tilted heavily toward well known American blue chips.
Ultimately, if your net worth is tied to equity index funds then there are probably five things to think about. The first is the general health of corporate America and the stock market. Since that covers everything from the economy to interest rates, there isn’t much you can do about that in the short run. Longer-term, we’d expect this to be a net positive.
The second is the methodology behind the index being tracked (pretty important for obvious reasons). The third is the turnover rate, lower being better. Relative to peers, I think VYM scores quite well on that one. The fourth is the expense ratio of whichever fund (or funds) you own. It goes without saying but the lower, the better. We are looking at 0.06% per annum in the case of VYM, which is good.
The final point, put simply, is your own behaviour. If you’re somebody who will liquidate their funds in a downturn, well, there isn’t much anybody can do about that. That’s where I see VYM’s distribution stream coming in. If the likes of AT&T and Coca-Cola pumping dividends into your account is a source of motivation for you, then run with that. Being a high dividend yield fund means that income stream will always be above average relative to the wider market.
To provide some context to that last statement, just consider the fund’s recent historical performance. A decade ago, VYM units changed hands for something like $36.65 each. They currently trade in the mid-$90s per unit range. The fund has also pumped out somewhere in the region of $20 per unit by way of cash distributions in the intervening period, or around 55% of that starting figure. The equivalent figure for the S&P 500 is around 36%, just by way of comparison.
Notwithstanding the above, my view is that something like VYM should not materially underperform a broader index such as the S&P 500. In fact, it would not surprise me at all to see it outperform over a long enough period of time. The only real issue to think about is the expense ratio – at six basis points, there’s not much in that. At time of publication VYM trades at an earnings yield of 5.45% with a dividend yield in the 3% range. If you are somebody with a proclivity for dividend stocks, I’d say VYM represents a low-maintenance vehicle in which to compound wealth ahead of inflation assuming continual dividend reinvestment.
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