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  • Home>Research & Insights>Investment Insights>This Fund Finds Yield Without Loading Up on Risky Stocks

    This Fund Finds Yield Without Loading Up on Risky Stocks

    This fund manages to target high-yielding stocks while maintaining broad diversification.

    Adam McCullough, CFA, 09/20/2017

    Vanguard High Dividend Yield ETF VYM offers an attractive dividend yield without taking excessive risk. While it doesn't screen its holdings for profitability or their dividend sustainability, the fund's broad market-cap-weighted portfolio effectively diversifies risk and promotes low turnover. Its cost advantage gives it a durable edge against its peers and supports a Morningstar Analyst Rating of Silver.

    The fund's index starts with all U.S. dividend-paying stocks (excluding REITs and smaller stocks), targets the higher-yielding half, and weights them by their market capitalization. This generates a portfolio of more than 400 stocks that leans toward mature giants such as Microsoft MSFT, Johnson & Johnson JNJ, and Exxon Mobil XOM. Most of these firms are growing more slowly than the broader market, so the fund has a value orientation. They also tend to be more profitable and exhibit lower volatility than the constituents of the Russell 1000 Value Index.

    High-yielding stocks usually pay out an above-average share of their earnings in the form of dividends, leaving a smaller buffer to preserve dividend payments should earnings fall. Indeed, this fund owned ConocoPhillips COP, which offered a 6.4% dividend yield at the end of 2015. The firm subsequently cut its quarterly dividend to $0.25 per share from $0.74 in February 2016 to conserve capital. Although the fund targets high-yielding companies, its market-cap-weighting approach helps it to effectively diversify the risk of solely focusing on yield. In fact, its portfolio represents nearly 38% of the holdings in the Russell 3000 Index. And while the fund has meaningful exposure to a few of its largest holdings, they are not among its riskiest positions.

    The fund outpaced its average large-value Morningstar Category peer by 1.5% annually from its inception in November 2006 through August 2017 and had a more-favorable risk profile to boot. This was attributable to its greater exposure to consumer defensive stocks, smaller exposure to financials stocks, and more-favorable stock exposure within several sectors. The fund's risk-adjusted returns landed in the top quintile of its category from inception through August 2017.

    Fundamental View
    In a theoretical frictionless market, dividend-payout policy shouldn't have any impact on stock returns (for further reading, see the Modigliani-Miller Theorem). A dividend payment should reduce the firm's stock price by an offsetting amount. But in practice, dividends often matter because they can impose greater discipline on managers in their capital-allocation decisions, leaving less money for low-return investments. And managers may use these payments to signal their confidence in their firms' prospects. Dividends can also help address some behavioral issues, including many investors' reluctance to realize capital gains to meet income needs, and may give them the fortitude to weather market volatility.

    Investors can benefit from owning dividend-paying stocks, but chasing yield can be dangerous. The highest-yielding stocks could be under financial distress and more likely to cut their dividends than their lower-yielding counterparts. Many of these stocks pay out a large share of their earnings as dividends, leaving a small buffer to cushion these payments if their business deteriorates. This fund mitigates some of this risk through its broad diversification. It holds more than 400 names and market-cap-weights its holdings, so the larger and more stable dividend payers make up a greater portion of its holdings. These firms should be better able to maintain their dividend payments during a market downtown than smaller, higher-yielding stocks.

    Market-cap weighting tilts the portfolio toward the largest dividend stocks, which are not necessarily the highest-yielding. But this approach limits the fund's exposure to the riskiest stocks and reflects the market's view about the relative value of its holdings. Even though it doesn't tilt toward the highest-yielding stocks, the fund's average dividend yield during the past decade through August 2017 measured 3.3%-20% higher than the category average. Market-cap weighting also helps keep turnover low. The fund does not remove stocks before they cut their dividends unless such cuts are reflected in the third-party dividend forecasts it uses to select them.

    Like most dividend-oriented strategies, this fund has a pronounced value tilt. Mature, slow-growing firms tend to trade at lower valuations and pay out a larger share of their earnings as dividends than their faster-growing counterparts, which invest aggressively to expand. Both characteristics can lead to higher dividend yields. Not surprisingly, the fund's holdings were expected to pay out a larger share (55%) of their earnings as dividends at the end of August 2017 than the Russell 1000 Value Index (46%), based on calculations from earnings and dividend forecasts presented in Morningstar Direct.

    Adam McCullough, CFA, is an analyst on Morningstar’s manager research team, covering passive strategies.