The Vanguard High Dividend Yield ETF (NYSEMKT: VYM) is a great example of why investors need to examine more than just the name of an exchange-traded fund (ETF) before hitting the buy button. Dividend yield is an important part of the story here, but the real benefit of this ETF actually lies elsewhere.
Here’s what you need to know about the Vanguard High Dividend Yield ETF before you buy it for passive income.
Just going by the name might lead you to believe that this ETF is all about dividend yield. And yet the yield is fairly modest at just 2.8%. To be fair, that’s more than twice what you would collect from an S&P 500 index fund, but there are other exchange-traded funds with much higher yields that you could buy.
The truth is, the use of “dividend yield” in the name is simply signaling that yield is an integral part of the screening process. And that process is what investors need to fully understand before buying the Vanguard High Dividend Yield ETF. It’s actually pretty simple.
In reality, the ETF tracks the FTSE High Dividend Yield index. So what the index does, the ETF is basically doing, too.
First, it creates a list of all dividend-paying companies on U.S. exchanges. Then it arranges that list by yield, from highest to lowest. Step three is to select the top half of that list in terms of yield for inclusion in the index. The last step is to weight the stocks by market cap, so the largest companies have the biggest impact on the Vanguard High Dividend Yield ETF’s performance. All of that comes for a very modest expense ratio of 0.06%.
At this point, you may be wondering what the issue is since the ETF’s selection process is focused entirely on dividend yield. The key step that is easy to overlook is the first one. The Vanguard ETF’s fishing pool is gigantic, which leads to a very large portfolio. It currently owns over 550 stocks (more than the S&P 500!), which is a gigantic number and shows that the selection process may be a bit indiscriminate.
With that many stocks, the Vanguard High Dividend Yield ETF has no choice but to move lower and lower down the yield spectrum as it adds to the portfolio. Every added “lower” yielding stock reduces the overall yield that the ETF can provide to investors. So if you are specifically trying to highlight yield, this ETF probably won’t be the best fit for your portfolio.
