I have been a Vanguard investor since 1988 and still have large holdings of Vanguard funds. So when the current drought in fixed income options drove me to reexamine dividend investing as an income alternative, I naturally looked to Vanguard’s own funds and ETF offerings to see if they would provide a simpler way to buy high-quality dividend stocks that would save me from having to pick individual securities.

Vanguard offers two dividend-focused ETFs, the Vanguard Dividend Appreciation ETF (NYSEARCA:VIG) and the Vanguard High Dividend Yield ETF (NYSEARCA:VYM). Stocks paying higher dividends can be risky, as I learned in my earlier investing days, so I’m not tempted by its description. Along with many other investors, I have come to think it is the safest and most productive to invest in companies that have a long history of paying average market-rate dividends that have raised those dividends year after year.

That makes VIG sound like it should be the Vanguard ETF to choose. It’s run by the company that pioneered index funds. Its expense ratio is very low, and it’s a very large, active ETF, so it’s easy to trade its shares and it’s not going to shut down anytime soon. Doesn’t that sound like a good dividend stock pick for those who don’t have the time, ability, or interest in researching individual dividend growth stocks. What’s not to like in an ETF that follows an index purporting to be one of the companies with a history of dividend growth?

It turns out a lot.

VIG’s Anemic Dividend

VIG pays a dividend quarterly. A low dividend. Seeking Alpha reports that its trailing 12-month dividend yield is a measly 1.84%. Vanguard’s information page for VIG states that its SEC yield, based on its holdings in the previous month is lower, a mere 1.68%.

This yield is considerably lower than Schwab’s U.S. Dividend Equity ETF (NYSEARCA:SCHD) which I analyzed a few weeks ago here. SCHD’s trailing 12-month yield is 3.11%. It’s also lower than ProShares S&P 500 Dividend Aristocrats ETF (BATS:NOBL), with its trailing 12-month yield of 2.24% and a very similar mission – investing in companies that have a track record of raising their dividends for many years.

Why is VIG’s dividend so low? Are the stocks in the other ETFs riskier? I doubt it. The Dividend Aristocrats are about as staid as you can get. So there must be another explanation. To find it, we need to look more closely at how VIG works.

What Index Does VIG Follow?

Passive ETFs and mutual funds by definition invest in a list of funds defined by some predefined criteria that is called an index. In the good old days, when there were far fewer index products, the indexes that passive ETFs and funds followed usually referred to one of a number of long-standing, very well-known indexes, like the S&P 500, or the Russell 1000, indexes which had been around for decades, in some cases before there were any index funds, and which represent broad swathes of the market or carefully defined various sectors.

But with the surge in popularity of index investing that has occurred over the last 15 years, a thousand new “indexes” have sprung up, allowing for thousands of new ETFs. Some of these indexes may contain as few as 25 stocks, and have very complicated criteria, which makes the line between actively chosen funds and a true index fund hard to make out. This makes it essential that before you buy into any ETF, you look very carefully at the actual index that the ETF follows and learn how it is defined.

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In the case of VIG, the index it follows, as is stated on Vanguard’s VIG summary information page, is the “NASDAQ US Dividend Achievers Select Index (formerly known as the Dividend Achievers Select Index).” Vanguard’s only description of this index states that it “provides a convenient way to track the performance of stocks of companies with a record of growing their dividends year over year.”

Well, that sounds like dividend growth investing, doesn’t it? And it’s very cheap compared to having an advisor manage your funds. Its expense ratio, which tells you how much of the money you invest in the ETF goes to Vanguard every year, is only .06%. That means that for every $10,000 you invest in VIG, you pay only $6 a year for Vanguard to do all the buying, selling, and rebalancing involved in maintaining your dividend growth portfolio. Sounds like a deal, doesn’t it? A heckuva lot of investors seem to think so. By the end of August 2020, VIG and its associated mutual fund share class (MUTF:VDADX) held 57.6 billion dollars’ worth of stock.

A Closer Look at the Index

But what exactly does “Provides a convenient way to track the performance of stocks of companies with a record of growing their dividends year over year” mean? Vanguard is often very vague about what exactly its funds invest in, though, to its credit, it does provide an up-to-date list of the stocks it holds.

Fortunately, in this case, NASDAQ provides a lot more information about the NASDAQ US Dividend Achievers Select Index that it follows on its site. You can find this information here.

The index overview page tells you that the index began on March 29, 2006. Not so coincidentally, this is when Vanguard opened its Vanguard Dividend Appreciation Index Fund Investors Shares (MUTF:VDAIX). Three weeks later on 4/21/2006, it created the VIG ETF as a share class of this fund. The NASDAQ overview also tells you that VIG is the only product that follows this particular index whose “sponsor” is the Vanguard Group.

So right away that tells you that it follows its own unique methodology which makes it different from any other dividend growth index. NASDAQ goes to some length to explain what that methodology is. You can see all the details here. The most important facts that emerge from this discussion of its methodology are these:

  • The index selects companies that have raised their dividends for 10 years.
  • It excludes limited partnerships and REITs.
  • Additional proprietary (i.e. secret) eligibility standards are applied.
  • The index is a “modified market capitalization weighted index” where the total price of the shares held is multiplied by a divisor of some sort.
  • The index is evaluated and reconstituted every March with the holding changed the third week of March. Stocks that meet the index’s criteria are added and those that don’t are removed, though, the methodology document also states that stocks failing to meet the criteria can also be deleted during the year.
  • At the time of re-balancing, the maximum weight of any Index Security in it is adjusted so that does not exceed 4% of the whole index.
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Since the list of holdings for the index still lists Disney (NYSE:DIS) stock among its top 10 holdings as of today and Vanguard lists it among VIG’s top 10 holdings as of August 31, 2020, despite it having suspended its dividend, it doesn’t look like the folks who maintain this index are quick to kick out stocks. Vanguard’s list of the stocks held in VIG also still contains other companies that have suspended their dividends, including TJ Maxx (NYSE:TJX), Ross Stores (NASDAQ:ROST), and Marriott (NASDAQ:MAR).

Given the unusual circumstances these companies have faced, this may be prudent. I don’t rate it as necessarily negative, though if these companies continue to suspend their dividends, I would hope the index would not keep them around until late next March.

Market Cap Weighting May Explain the Low Dividend

VIG holds 212 stocks, which is a lot more than the 103 held by SCHD, but only half of the 424 held by VYM. This sounds very diversified, but that diversification is illusory. Because of the way that market cap weighting is applied, more than one third of every dollar put into VIG goes into the top 10 stocks it holds. Together they comprise 35.60% of the index. Moreover, according to Vanguard’s information page, 13.18% of every dollar you put into VIG goes into only three stocks, Microsoft (NASDAQ:MSFT), Walmart (NYSE:WMT), and Procter & Gamble (NYSE:PG).

And there’s where your crummy dividends come from. As you can see from the chart below, the dividends of five of the top holdings range around 1%, not including the suspended Disney dividend, and that Disney hit is significant, as it makes up almost 3% of the fund’s holdings.

VIG Top Ten Holdings

The Rest of the Cap Weighted Story

Though those top 10 stocks dominate, looking at the full list of holdings that Vanguard provides, we can see that among the other 202 stocks VIG holds are many stocks with much more modest market caps. Though most are large-cap, there are some mid-cap and small-cap stocks. The long list includes a good selection of Dividend Aristocrats – stocks that have paid dividends for 25 years or more.

Unfortunately, because of the cap weighting system the index uses, most of these stocks each makes up a very small percentage of the ETF’s holdings, which of course means that its dividend contributes very little to the dividend you receive when you buy VIG.

For example, VIG’s holding of Clorox (NYSE:CLX), which has increased its dividend for 42 straight years, only makes up .33% of its holdings. Its 2.12% yield is twice that of Microsoft’s, but there is more than 14 times as much Microsoft stock in the ETF as there is Clorox. By the time we get to the 50th holding, by cap weight, Kroger Co (NYSE:KR), its stock only makes up .28% of the ETF. And there are still 112 more stocks to go.

Many of them the high-quality, dividend-paying stocks with long histories of increasing dividends you’d like to own. But do you want to own them in microscopic quantities? Mid-cap stock Sonoco Products (NYSE:SON) with its 31 years of dividend growth and its 3.17% yield makes up only .06% of VIG’s holdings. Its contribution to the dividend you receive is so small as to be completely meaningless.

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Cap weighting is the killer here. For every $100 you put into VIG, $4.80 goes into Microsoft, $35.60 into those top 10, $.28 into Kroger, and a whole lot less into the other half of the stocks listed. You are literally only putting 2 pennies into the last 50 or so mid-cap holdings listed. Why even bother. Together they make up about 1% to 2% of VIG’s holdings.

You Can Do Better

A focus on cap weighting undoes any benefit of diversifying your dividend stock holdings. Why buy a fund that over-weights Visa (NYSE:V) with its 40.90 P/E ratio, its relatively short 11-year history of paying a dividend, and that tiny .58% dividend yield? Do you really want to buy Microsoft for its dividend right now with its 32.48 P/E ratio, its relatively short 10 years of dividend growth history, and that 1.07% yield? There may be are many reasons to buy those companies’ stocks, but it would make a lot more sense to wait and buy them when the price is such that the dividend becomes more attractive. Even if your dividend for Microsoft grew at 10% a year, you’d still be looking at a yield under 1.25%.

If I’m investing for the dividend and the income flow it gives me right now, I’d like that dividend to be significantly higher than what I can get in a five-year CD. Right now, the best nationally offered CDs are paying at least 1.50% with some regional credit unions offering rates that are higher.

Stocks go down, unlike the principal of CDs. Stocks with P/Es over 30 are very likely to go down. I just don’t see where my risk is going to be compensated buying this ETF. At the very least, the criteria used to build an ETF should specify a floor and ceiling for the yields of the stocks it holds. I don’t want a large investment in a stock paying a .58% dividend any more than I want one in a stock paying 9% or more. I don’t want companies with astronomical P/Es. If I did, I’d just keep buying Vanguard’s Total Stock Market ETF (NYSEARCA:VTI). VTI’s trailing 12-month dividend yield is 1.62%, just 22 basis points lower than VIG, and it is far more diversified since it holds so many non-dividend-paying growth stocks.

There may have been times over the last 14 years when buying this ETF made sense. But this is not one of them. And I hope that having read this, the lesson you will take away is that no matter what an ETF says it is doing, it is always a very good idea to look at how the index it follows is constructed and what stocks you are actually buying when you buy that ETF.

Disclosure: I am/we are long PG, KR, VTI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Via SeekingAlpha.com