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ETF Specialist

This High-Quality Dividend-Growth Fund Can Serve as a Core Portfolio Holding

It forgoes high yield to pursue stocks that can sustain the growth of their dividend payments.

Dividend-growth funds focus on companies that have the ability and willingness to increase their dividend payments. Companies that regularly boost their dividends often have sustainable competitive advantages. Such high-quality companies can make excellent core holdings. Morningstar's manager research team recently highlighted three great dividend-growth funds. For this article, I'll take a deeper dive into  Vanguard Dividend Appreciation ETF (VIG).

VIG is an excellent fund that offers a diversified portfolio of highly profitable U.S. dividend-paying stocks. Focusing on dividend growth reduces the fund's exposure to firms that have weak fundamentals and may not be able to sustain their dividend payments, which is a risk that often accompanies a narrow focus on yield. The fund's low fee contributes to its edge over the long run and supports its Morningstar Analyst Rating of Gold.

The fund tracks the Nasdaq US Dividend Achievers Select Index, which includes stocks that have increased their dividend payment for at least 10 consecutive years. This stringent hurdle restricts the fund to holding highly profitable firms with shareholder-friendly management teams that have consistently raised dividend payments. But this high bar also precludes the fund from holding companies like  Apple (AAPL) that initiated their dividend payment less than 10 years ago but are profitable with stable cash flow. The fund applies some additional proprietary screens to filter out firms that may not be able to sustain their dividend growth.

This portfolio favors profitable companies with durable competitive advantages. Because it doesn't pursue the highest-yielding names, its dividend yield lands near the Russell 1000 Index's. But it has been able to avoid some firms that have cut their dividend payments. For example, the fund dropped  ConocoPhillips (COP) from its holdings before the firm slashed its dividend in early 2016.

The fund's tilt toward more-stable stocks has helped it shine during market downturns. Its drawdown during the bear market from October 2007 through March 2009 measured 46% compared with 55% for the Russell 1000 Index. And its tilt toward profitable names is evident in its portfolio composition. As of this writing, the fund's return on invested capital measured 14.3% compared with an average measure of 9.9% for the Morningstar Category.

Despite taking less market risk than its average category peer, the fund outpaced the category average by 1.8% annually during the past decade through April 2018. This translated into one of the best risk-adjusted showings in the category.

Fundamental View
Investors may benefit from owning dividend-paying stocks because these payments can offer stable income and provide a cushion to stay invested during turbulent markets. But chasing dividend yield can be dangerous. The highest-yielding stocks could be under financial distress and at risk of cutting their dividend payment. Many of them pay out a large share of their earnings and have a narrower buffer than their lower-yielding counterparts to cushion these payments if their business deteriorates.

This fund strives to mitigate this risk two ways. First, it selects its holdings from stocks that have increased their dividend payout for 10 consecutive years. This screen is backward-looking, so it doesn't guarantee that a stock will maintain its dividend payment, but it demonstrates a commitment of returning cash to shareholders. Lengthy backward-looking hurdles, like this one, preclude companies like Apple that initiated their dividend payment less than 10 years ago but are profitable with stable cash flow.

Second, the index uses profitability screens to avoid stocks with deteriorating fundamentals. If a stock is more profitable, it should be able to maintain its dividend during a market downtown or raise its payout ratio in the future. For instance, this fund dropped ConocoPhillips from its portfolio before the stock cut its dividend payment in early 2016. Many of its dividend-oriented peers that rely only on backward-looking metrics still held that firm when it cut its dividend payment.

The fund's 10-year dividend-growth requirement is a tough hurdle to clear. If a company doesn't continue to raise its dividend, it is out for at least a decade. This can lead to large sector bets. The fund currently does not own any energy stocks and owns a much higher percentage of industrial and consumer staples stocks than the category average. The energy stake dropped as oil prices plunged and energy-related companies came under financial pressure and couldn't raise or had to cut their dividends. Top holdings currently include  Walmart (WMT),  Johnson & Johnson (JNJ), and  Microsoft (MSFT). The largest holdings dropped at its most recent reconstitution included  Archer-Daniels Midland (ADM) and  Kellogg (K).

Don't expect high yield from this fund because it is focused on dividend growth. Most dividend-themed funds end up with a value tilt because they explicitly target stocks with higher dividend yields, but this fund falls in the large-blend category and has a dividend yield in the same ballpark as the Russell 1000 Index. That's because this fund pursues stable, profitable names with a higher potential of raising their dividend payments, rather than targeting stocks with high dividend yields. As of April 2018, more than 65% of the portfolio was invested in stocks with Morningstar Economic Moat Ratings of wide compared with less than 50% for the Russell 1000 index. In addition, its portfolio scores higher than the Russell 1000 index on several profitability metrics, such as return on invested capital.

Portfolio Construction
The fund targets profitable dividend-paying U.S. stocks with a history or raising their dividend payments. This results in a well-diversified portfolio of dividend-paying stocks with durable competitive advantages and shareholder-friendly management teams that should weather market downturns better than most and reward investors over the long haul. It earns a Positive Process Pillar rating.

The fund replicates the Nasdaq US Dividend Achievers Select Index. This is a subset of the Nasdaq US Broad Dividend Achievers Index, which holds U.S. stocks that have grown their regular dividend payment for at least 10 consecutive years. From this broader list of stocks, the fund excludes REITs and limited partnerships and applies proprietary profitability screens to determine its final list of constituents. While Nasdaq does not disclose its screens, these filters seem to favor profitable companies with stable earnings. The fund weights its holdings by market capitalization, and individual positions are capped at 4% of the portfolio. The index reconstitutes annually in March, but stocks with deteriorating fundamentals may be dropped at any time.

The fund has never issued a capital gain. Low turnover contributes to its tax efficiency. Also, more than 80% of the fund's $34 billion in assets are held in its exchange-traded fund share class, which helps limit the impact of fund flows on its tax efficiency.

Vanguard charges a low 0.08% expense ratio for this fund. This fee is a fraction of the 0.89% median levy that the fund's large-blend peers charge, and it earns a Positive Price Pillar rating.

Over the trailing three years ended April 2018, this fund lagged its benchmark by 8 basis points per year, less than its average annual fee over this time frame.

Silver-rated  Schwab U.S. Dividend Equity ETF (SCHD) (0.07% fee) balances profitability with high yield to tilt toward profitable dividend payers. SCHD requires stocks to have paid (not necessarily increased) its dividend for 10 consecutive years to be eligible for inclusion. SCHD targets 100 stocks with high dividend yields, return on equity, cash flow/debt, and five-year dividend-growth rates. Its higher emphasis on yield pushes this fund into the large-value category.

 Vanguard High Dividend Yield ETF (VYM) (0.08% fee) prioritizes dividend yield over sustainability and carries a Silver rating. VYM sorts U.S. dividend-paying stocks by yield, targets those representing the higher-yielding half, and weights them by market cap. VYM does not screen its holdings based on their profitability, so it may hold stocks with deteriorating fundamentals. VYM lands in the large-value category, while VIG sits in the large-blend category.

Bronze-rated  PowerShares S&P 500 High Dividend Low Volatility ETF (SPHD) (0.30% fee) selects 50 high-yielding stocks from the S&P 500 but seeks to reduce risk by excluding the most-volatile high-yielding stocks. SPHD weights its holdings by their yield, so it may be riskier than VIG.

 WisdomTree U.S. LargeCap Dividend ETF (DLN) (0.28% fee) selects the largest 300 stocks by market cap from a proprietary index that weights its holdings by the value of dividends that each stock is expected to pay over the next year relative to the aggregate value of the portfolio. DLN's broad diversification and weighting by dividend payment reduce its risk and support its Bronze rating.



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Adam McCullough has a position in the following securities mentioned above: AAPL. Find out about Morningstar’s editorial policies.