The Secret of Vanguard High Dividend Yield ETF's Success

By Dan Caplinger Markets Fool.com

The Vanguard High Dividend Yield ETF (NYSEMKT: VYM) has become one of the largest dividend-focused funds in the business, with more than $21 billion in assets under management. Yet although a long bull market has had an unquestionably positive impact on the Vanguard dividend ETF, the solid performance of the fund is only one factor in its success, and it's arguably not even the most important one. Rather, much of Vanguard High Dividend Yield's growth has come from investors who have been almost desperate to get the benefits of dividend stocks. That has been good to the Vanguard dividend ETF, but it does raise some dangers that could lead to a reversal at some point in the future.

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How Vanguard High Dividend Yield has grown

Vanguard High Dividend Yield has taken full advantage of positive conditions in the stock market, and its popularity has come even when the fund's total returns have been modest. In the fiscal year that ended on Oct. 31, the Vanguard dividend ETF saw its assets grow by almost 40%. Investors saw the value of their holdings in the fund climb by almost $6 billion during that 12-month period.

Yet the market wasn't responsible for most of those gains. According to the fund's annual report, dividend income accounted for roughly $600 million of the increase in the fund's assets, or about 10% of the total rise. Realized gains added another $350 million, and unrealized appreciation in the value of the dividend stock portfolio added another $533 million. All told, the rise in net assets coming from the fund's operations amounted to just about a quarter of its total increase.

Image source: Vanguard Group.

Instead, where the Vanguard dividend ETF got most of its gains was from new money coming into the fund. Vanguard's unique fund structure combined traditional mutual-fund shares and ETF shares under a single corporate umbrella, but all told, investor inflows amounted to almost $4.9 billion. After accounting for distributions of investment income, demand for fund shares remained strong.

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What risks are there for Vanguard High Dividend Yield?

What has been the secret of Vanguard High Dividend Yield's success, however, could become its eventual downfall. So far, a combination of strong stock-market performance and low interest rates has made dividend stocks the perfect confluence of growth and income investing. Those seeking current income haven't been able to get enough of it from traditional fixed-income investments, and they've turned to dividend stocks to make up the difference. Positive returns have rewarded their risk-taking, and many have taken comfort in the idea that high-dividend stocks also tend to be in defensive industries that have historically fared fairly well during market downturns.

Now, however, some of the tailwinds that have helped dividend stocks are starting to lessen. The rise in short-term interest rates from the Federal Reserve hasn't gone very far yet, but there have been some upticks in prevailing bond-market rates. If yields on bonds continue to rise, then fixed income could once again become a viable income-producing alternative to dividend stocks, and interest in the Vanguard dividend ETF could wane.

At the same time, valuations on defensively oriented dividend stocks have grown very high. That reflects the skepticism that conservative investors have about how much further the bull market can run, but it also could prove to be counterproductive, in that a market downturn could leave those highly valued dividend stocks vulnerable. In other words, having anticipated the protection that dividend stocks have provided in the past, investors might well have priced out any defensive characteristics, leaving them in a riskier position than they realize.

Vanguard High Dividend Yield will still make a good long-term play for investors seeking to combine the growth and income available from dividend stocks. However, if adverse conditions pose a threat in the future, some of the inflows the fund has seen could dry up. Shareholders in the Vanguard dividend ETF should keep an eye on the market, to see if cracks in the bull develop that could lead to a reversal of fortune for the fund.

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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.