Is Vanguard High Dividend Yield ETF a Buy?

The data is clear: Dividend-paying stocks have historically trounced the returns of non-dividend-paying stocks, and it isn't even close. But following the trend by building your own dividend portfolio of individual stocks can be time-consuming and costly. For hands-off investors, a dividend-focused ETF may be a better solution.

Insert the Vanguard High Dividend Yield ETF (VYM 0.07%). This exchange-traded fund tracks more than 400 of the highest-yielding stocks on the market, showering its investors with nearly 60% more in dividends than they would earn by investing in S&P 500 index funds. But before you sink your entire retirement fund into this low-cost fund, here are some things you should know about how the ETF works, what it invests in, and how to decide if it's right for you.

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How Vanguard High Dividend Yield ETF works

When analyzing any index ETF, you have to dig into the guts of how it works. ETFs are designed to track an index, so whether an ETF is "good" or "bad" is a function of the underlying index it tracks. Vanguard High Dividend Yield ETF tracks the FTSE High Dividend Yield Index, which takes a simple, but effective approach to investing in dividend stocks.

The mechanics of the index are easy to understand. The index starts with a list of all U.S. stocks that pay a dividend, ranking them by their yield. The index throws out real estate investment trusts (REITs), which would otherwise dominate the fund and make it just another REIT ETF. Once REITs have been removed, stocks are added to the index one by one until it includes stocks that make up half the total market value of all dividend-paying stocks excluding REITs.

In one final twist, this fund weights stocks by market cap, so that it invests more in the largest companies and proportionately less in the smallest companies. The net result is a high-yielding ETF largely made up of the very largest U.S. stocks.

Data source: Morningstar.

Compared to, say, Vanguard Total Stock Market ETF, which simply holds basically every stock on U.S. stock exchanges, the High Dividend Yield ETF holds more megacap and large-cap stocks, and fewer small- and micro-cap stocks in its portfolio. That's primarily due to the fact that larger, established businesses are much more likely to pay a dividend than small and midsize companies.

The types of businesses Vanguard High Dividend Yield ETF invests in

Some sectors tend to pay higher yields than others. Utilities, for example, have always been some of the market's highest-yielding stocks. In contrast, technology companies tend to be some of the lowest-yielding stocks on the market, because they invest their profits for growth and trade at higher valuations.

Compare the Vanguard High Dividend Yield ETF to the S&P 500 and you'll see that it has some meaningful differences in portfolio construction. The high-yield ETF invests comparatively less in technology companies and invests far more in consumer defensive ones (consumer staples stocks). To some conservative investors, the sector differences may be a feature. To investors who want more exposure to faster-growing technology companies, it's a bug.

Data source: Morningstar. Chart by author.

A bias toward slower-growing consumer staples stocks and against technology stocks is something you'll find in almost every dividend ETF. The reality is that some stock market sectors are a high-yield desert, while others are rich with high-yielding stocks. But it's important to point out that Vanguard High Dividend Yield's performance against the S&P 500 will largely come down to the relative performance of technology and consumer staples stocks over any given period of time.

Is Vanguard High Dividend Yield ETF a buy?

For investors who want a higher-yielding large-cap ETF, this ETF is easily one of the best.

Let's start first with a big advantage: It's cheap. The fund carries an expense ratio of just 0.08% of assets, which puts it among the lowest-cost choices in dividend funds. Expenses eat directly into the yields paid by mutual funds and ETFs, so a low expense ratio is crucial. It doesn't make sense to buy a high-yielding fund that has a fee so high that it yields only as much as any other index fund.

Second, the fund offers a high, but realistic, dividend yield. Vanguard High Dividend Yield ETF has an SEC yield of about 3.2%, which is 1.2 percentage points higher than you'd earn holding a similarly low-cost S&P 500 fund. It's enough to make a difference in the income you earn from your portfolio, but it's not so high that it's a giant red flag, either.

Because the fund sorts stocks by yields, but weights them by market cap, it doesn't invest heavily in beaten-down companies that offer a high dividend yield because the dividend is expected to be cut in the future. That's one of the problems with other dividend funds that put too much emphasis on yield and not enough emphasis on the sustainability of a company's dividend -- the highest-yielding stocks may pay 15% yields, but only because the market expects them to soon have a date in bankruptcy court.

In short, this fund is cheap, diversified, and offers an impressive yield that easily tops your average large-cap stock ETF. If you want a fund that gives you exposure to high-yielding large-cap stocks, Vanguard High Dividend Yield is an ETF to buy and hold for the long haul, no doubt about it.