A Small Twist in Index Inclusion: The Impact on Dividend ETFs

Investing can often feel like navigating a labyrinth, especially when it comes to generating passive income. If you’re on the hunt for an all-weather income investment that you can simply "set and forget," you’re not alone. Many investors are drawn to the allure of passive income, believing that a less active approach can yield better returns. However, the choice of investment vehicle can make a significant difference, particularly when it comes to dividend-oriented exchange-traded funds (ETFs).

The Allure of Passive Income

For those seeking passive income, traditional methods like interest-bearing bonds or individual dividend stocks may not always be the best fit. Instead, a diversified approach through dividend-focused ETFs can provide a more stable and reliable income stream. Among the myriad options available, one ETF stands out: the Vanguard Dividend Appreciation ETF (VIG).

The Vanguard Dividend Appreciation ETF: A Closer Look

Vanguard’s fund is designed to produce consistent increases in quarterly dividend payments. It tracks the S&P U.S. Dividend Growers Index, which has a stringent requirement for inclusion: companies must have increased their per-share dividends for at least 10 consecutive years. This criterion effectively filters out many potential components that income-seeking investors might not want to own.

The Power of Exclusion

What makes the S&P U.S. Dividend Growers Index particularly compelling is not just what it includes, but also what it excludes. The index does not limit itself to large-cap companies; it can also hold mid-cap and small-cap dividend payers, provided they meet the 10-year dividend increase requirement. This opens the door to a range of stocks that many investors may not have considered.

However, the index also excludes the highest-yielding 25% of stocks that would otherwise qualify. At first glance, this may seem counterintuitive for investors looking to maximize dividend income. After all, why not include the highest-yielding stocks? The answer lies in the understanding that high yields often come with significant risks.

The Red Flags of High Dividend Yields

High dividend yields can frequently signal underlying issues within a company. For instance, companies like Kraft Heinz and Western Union once had strong dividend histories but faced declining stock prices that inflated their yields. As their performance faltered, their dividends stagnated or were cut altogether. This pattern illustrates that high yields can often be red flags, indicating potential instability.

By excluding these high-yield stocks, the S&P U.S. Dividend Growers Index aims to sidestep the pitfalls associated with unreliable dividend payers. This approach not only helps in identifying stocks that are more likely to sustain and grow their dividends but also positions investors for potential capital gains.

The Historical Performance of Dividend Growers

Research from Hartford Mutual Funds has shown that stocks that consistently raise their dividends tend to outperform those that do not. Since 1973, these dividend growers have more than doubled the average annual gains of non-dividend-paying stocks. Over the past decade, VIG has demonstrated superior total net returns compared to other popular dividend ETFs like the Schwab U.S. Dividend Equity ETF (SCHD) and the ProShares S&P 500 Dividend Aristocrats ETF (NOBL).

This performance can be attributed to the strong fundamentals and solid business plans of companies that prioritize dividend growth. Moreover, VIG’s inclusion of mid-cap stocks, which tend to outperform large-cap stocks, adds another layer of potential for capital appreciation.

Making the Right Choice for Your Portfolio

If you already hold one of the other dividend ETFs, there’s no immediate need to swap it for VIG. Such a move could trigger unwanted tax consequences. However, if your goal is to achieve reliable dividend income growth alongside capital appreciation, VIG deserves a top spot on your watch list.

Consider diversifying your holdings by owning a piece of all three ETFs. Each fund has unique attributes that can complement your investment strategy, and the overlap between them may be less than you think.

Conclusion

In the world of investing, small twists in index inclusion can lead to significant differences in outcomes. The Vanguard Dividend Appreciation ETF exemplifies how a thoughtful approach to stock selection can yield reliable income and growth. For long-term investors seeking a "forever" holding, VIG stands out as a compelling option, making it a worthy consideration for anyone looking to enhance their portfolio with a focus on dividend growth.