VYM Is a Popular Dividend ETF for Passive Income. But Is It the Best?

Vanguard High Dividend Yield Index ETF (VYM -0.38%) has around $75 billion in assets. That’s a lot of money and it shows just how popular the dividend-focused exchange traded fund (ETF) is with investors. But is it the best dividend ETF you can buy? Here’s a nuanced look at the answer.

What does Vanguard High Dividend Yield Index ETF do?

Vanguard High Dividend Yield Index ETF is an exchange-traded fund, which is a pooled product. Shareholders are giving their money to someone else to manage on their behalf. So the big question that investors have to answer is: What is being done with the money? Vanguard doesn’t make answering that question easy.

The website for the ETF explains that Vanguard High Dividend Yield Index ETF “seeks to track the performance of the FTSE High Dividend Yield Index, which measures the investment return of common stocks of companies characterized by high dividend yields.” A little further down, in what looks like a footnote, it is explained that “stocks included in the High Dividend Yield Index have a history of paying above-average dividends.” To be fair, this does provide a general feel for what is happening, but to really know you need to understand how the index is actually being constructed. That information isn’t provided, nor is there a link to it. After all, what the index does the ETF does, so in some ways they are one and the same thing.

When you look for the FTSE High Dividend Yield Index’s methodology documents you find what you really need. It isn’t complex, but the nature of the approach is very important. To simplify, the index that Vanguard High Dividend Yield Index ETF is following simply identifies all of the dividend-paying companies on the U.S. exchanges and buys the half with the highest yields.

The good and the bad of Vanguard High Dividend Yield Index ETF’s approach

From a big-picture perspective, Vanguard High Dividend Yield Index ETF is definitely buying high-yield stocks. However, the list of stocks in the index and the ETF is huge at around 580. That’s even more stocks than get included in the S&P 500 index (^GSPC 0.02%). And that’s the biggest benefit here, because this ETF provides you wide diversification across dividend stocks with one simple purchase.

The list of positives kind of ends there. The dividend yield is 2.6%, which is better than the yield of the S&P 500 index, but it is nowhere near the highest yield you could get from a dividend-focused ETF. With so many stocks the ETF has no choice but to move down the yield spectrum, which limits the overall yield of the portfolio. And while the expense ratio is a very low 0.06%, there are higher-yielding dividend ETFs with similarly low costs.

The biggest problem, however, may actually be the fact that there’s no effort to discern between well-run companies and troubled companies in the selection process. The only thing this ETF is considering is yield and the only thing needed to get into the portfolio is a yield that is within the highest 50% of the universe. Buying Vanguard High Dividend Yield Index ETF will leave you owning great companies and terrible ones, which may not be what you want.

There are better alternatives

If your focus is diversification then Vanguard High Dividend Yield Index ETF is probably as close to the best dividend-focused ETF as you are likely to find. And while the yield isn’t exactly huge, it is still fairly attractive relative to the market’s yield today. It is not a bad option, but it may not be the best, either.

For example, Schwab U.S. Dividend Equity ETF (SCHD -0.44%) uses a screening approach to find 100 companies that are financially strong, growing, and high yield. It offers a roughly 3.8% yield, still notable diversification (but with a focus on good businesses), and has an expense ratio of just 0.06%. For a lot of investors that will probably sound more attractive.