Why Vanguard High Dividend Yield ETF Shareholders Have Something to Worry About

By Dan Caplinger Markets Fool.com

Income investors love high dividend yields, and Vanguard High Dividend Yield ETF (NYSEMKT: VYM) delivers hundreds of high-yielding dividend stocks to investors looking for instant diversification at a low cost. Yet even though the exchange-traded fund has done a good job of tracking its target index and producing solid returns, there are still risks involved with dividend investing. In particular, the popularity of dividend investing has driven many investors toward the stock market who might otherwise feel more comfortable in more conservative investments like bonds and other fixed-income securities. With interest rates now poised to move higher, dividend stocks might start seeing selling pressure from investors seeking safer plays.

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The argument over dividend stocks

Vanguard High Dividend Yield has more than 400 stocks in its portfolio, and its largest holdings are among the most popular blue-chip companies in the world. With eight members of the Dow Jones Industrials (DJINDICES: ^DJI) among its top 10 positions, there's little chance the ETF will face a catastrophic meltdown.

Image source: Vanguard Group.

Yet some market commentators have noted the immense popularity of dividend stocks in recent years and pointed to rising valuations as a danger sign. Vanguard reports that the average price-to-earnings ratio for the Vanguard High Dividend Yield portfolio is currently above 21, and its stocks trade at nearly three times their book value. At the same time, though, Vanguard says the earnings growth rate for the fund is 2.1%, pointing to lackluster growth prospects for its constituents overall.

In particular, stocks in defensive industries have seen their relative valuations soar beyond where they often trade. The popularity of consumer staples stocks and utility stocks has been heightened by the rise of minimum volatility funds, which seek out stocks that tend to react less to market movements in either direction.

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The fear among some investors is that with defensive stocks having seen their share prices rise so high, they're less likely to perform favorably whenever the next bear market comes. What goes up must come down, according to that logic, and given how unusual it is for defensive investments to outperform cyclical companies in a bull market, it's entirely possible that this time will be different on the downside as well.

What could cause the exodus

Of course, market pundits have been predicting major bear markets for years, and the bull market has obstinately resisted anything more than minor corrections. Even small pullbacks have been few and far between, and so counting on a downturn is a tough stance for investors to take.

For dividend stocks in particular, though, one catalyst that could turn the tide is the Federal Reserve. Having just made an interest rate hike at its March meeting to go with its previous boost in December, the Fed appears to be looking at removing the extremely accommodative monetary policy it has had in place ever since the financial crisis. That's already having an impact on interest rates across the bond market. It will take a while for those rates to rise to the level at which they'll look attractive to investors, and there's no guarantee the economy will prove strong enough to allow the Fed to raise rates as high as it might prefer. Yet if investors who moved into dividend stocks to get income suddenly see that they can get equal or better yields from the bond market, many of them will likely jump at the chance to escape stock market volatility -- and that could easily end up causing exactly the phenomenon they're trying to avoid.

Know why you're investing

For now, the thing Vanguard High Dividend Yield ETF investors need to ask themselves is why they own shares of the fund. If you're in the camp of seeking income alternatives in an environment in which the bond market simply wasn't up to the task, then you need to have a plan in mind for how you'll react to rising rates as they come in the future.

However, for those who see Vanguard High Dividend Yield as a way to participate in the long-term growth of the stock market, short-term worries like this shouldn't be a major concern. Over time, the ups and downs of dividend stocks have generally worked out in investors' favor, and even somewhat high valuations won't change the validity of that long-term mindset.

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Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.