Better Buy: Vanguard High Dividend Yield ETF vs. SPDR S&P Dividend ETF

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Exchange-traded funds (ETFs) are a wonderful investment option for many investors -- but only if you truly understand what you're buying. And if you're looking for an ETF that pays a high dividend yield, you can't simply pick one with the word "dividend" in its name. Vanguard High Dividend Yield ETF (NYSEMKT: VYM) and SPDR S&P Dividend ETF (NYSEMKT: SDY), for instance, have far different methods and goals, though they may sound similar.

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Here's what you need to know before making a choice between Vanguard High Dividend Yield ETF and SPDR S&P Dividend ETF.

Only high yields need apply

Vanguard High Dividend Yield ETF is designed to track the performance of the FTSE High Dividend Yield Index. It is passively managed, aiming to mirror the index perfectly. The only caveat here is that the index excludes real estate investment trusts, so it doesn't actually track the entire spectrum of dividend-paying companies. According to Vanguard's website, the ETF "provides a convenient way to track the performance of stocks that are forecasted to have above-average dividend yields."

If you're looking for a way to invest in a portfolio of high-yield stocks, this would seem like an ideal option. The yield is around 2.8%, which is notably higher than what an S&P 500 index fund would provide (around 1.8%).

That sounds great on the surface, but there are some unanswered questions. For example, is yield the only criterion for inclusion in the index the ETF tracks? How are the weightings of the index components determined? These are important questions that seem to go unanswered on Vanguard's website and in the fund's prospectus and annual report.

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Vanguard High Dividend Yield ETF is built off of an FTSE index -- but it's not clear which one. The ETF's holdings appear to be a subset of the FTSE All-World Dividend Index, which is in turn a subset of the FTSE All-World Index. I couldn't find a specific index to research, but at the end of the day, it appears the index on which Vanguard High Dividend Yield ETF is built ranks U.S. stocks by forward yield, selecting the top 50% of the group for the index, which is then weighted by market cap. It gets rebalanced twice a year.

There's a simple logic to the approach of using dividend yield in this way. In effect, it will lead you to invest in great companies that have historically paid generous dividends, as well as out-of-favor companies that have high yields because their stock prices are depressed.

Market cap weighting is also an easy-to-grasp approach, though it means that the largest companies will have a disproportionate impact on performance. For example, the top 10 holdings make up 30% of an index with 400 securities in it. The largest holding, Microsoft Corporation, represents a whopping 6% of assets and is trading near all-time highs. That's far less diversification than you might be expecting from a portfolio that large.

Holding

Weight

Microsoft Corp.

6.3%

Johnson & Johnson

3.7%

JPMorgan Chase & Co.

3.7%

ExxonMobil Corp.

3.5%

Wells Fargo & Co.

2.5%

Procter & Gamble Co.

2.3%

Chevron Corp.

2.2%

AT&T Inc.

2.2%

Pfizer Inc.

2.1%

Intel Corp.

2.1%

I'm not bashing Vanguard High Dividend Yield ETF, but without more information about the construction of the index, you don't know what you're buying here.

That said, the fund's performance has been solid, providing investors with an annualized total return of roughly 8.2% over the past decade through the end of November. That's about the same as the S&P 500, but you got a larger income stream along the way. It also had a slightly lower beta and standard deviation, which means investors got market-like returns and a higher yield with a smidge less volatility. The cost of owning the fund is a very low 0.09% expense ratio.

Getting a little selective

SPDR S&P Dividend ETF takes a very different approach, tracking the S&P High Yield Dividend Aristocrats Index. The plain-English basics of the index are readily available on the ETF's website. Essentially, the index measures the performance of the highest-yielding S&P Composite 1500 Index constituents that have increased their dividends every year for at least 20 consecutive years. In effect, the ETF is using dividend increases as a screen to limit the index to the cream of the crop of dividend payers. REITs are not excluded.

Here are SPDR S&P Dividend ETF's 10 largest holdings:

Holding

Weight

Tanger Factory Outlet Centers Inc.

2.32 %

AT&T Inc.

2.23 %

National Retail Properties Inc.

1.96 %

Realty Income Corporation

1.86 %

Target Corporation

1.74 %

International Business Machines Corporation

1.65 %

People's United Financial Inc.

1.58 %

Chevron Corporation

1.52 %

ExxonMobil Corporation

1.51 %

Kimberly Clark Corporation

1.44 %

Stocks within the index are weighted by yield, meaning that the highest-yielding stocks get larger positions than lower-yielding stocks. In effect, this gives more weight to companies that tend to pay a large dividend and to stocks that are out of favor, making it similar to what you get from the broader high-yield focus of Vanguard High Dividend Yield ETF. The S&P High Yield Dividend Aristocrats Index is rebalanced each quarter, and constituents may be added or removed twice a year.

Looking at the portfolio itself, there are roughly 100 stocks in the index, with the top 10 holdings accounting for a little under 20% of the index. No single security makes up more than 2.3% of the index, whereas the top five positions in Vanguard's offering are all larger than that. Just for reference, the top holding in SPDR S&P 500 ETF as of November was Tanger Factory Outlet Centers Inc., a real estate investment trust that is currently yielding more than it has since the Great Recession.

The cost of owning SPDR S&P Dividend ETF, however, is relatively high: Its expense ratio is 0.35%. That said, it has done a little better for investors performance-wise. Over the trailing 10 years through November, the fund's annualized return is 9.7%. The ETF's standard deviation was slightly higher than the index's over that span, but its beta was lower than that of Vanguard High Dividend Yield ETF.

On the whole, I would characterize SPDR S&P Dividend ETF as performing better with a comparable level of volatility. The extra cost appears to have been worthwhile: On average, it outperformed Vanguard's dividend ETF by about 1.5 percentage points annually over the past 10 years through November. Its yield is also higher at 3.2%.

Know what you own

I don't like the idea of simply buying the highest-yielding stocks off a list -- which is basically what Vanguard High Dividend Yield ETF does, as far as I can tell. There are benefits to this approach, but I'd rather focus on owning great companies, which is effectively the goal of SPDR S&P Dividend ETF, with its focus on Dividend Aristocrats. Couple that with its better returns over time, and I'd say SPDR S&P Dividend ETF wins this contest in more ways than one.

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Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool’s board of directors. LinkedIn is owned by Microsoft. Reuben Gregg Brewer owns shares of ExxonMobil, IBM, and Tanger Factory Outlet Centers. The Motley Fool owns shares of and recommends Johnson & Johnson. The Motley Fool recommends Intel and Tanger Factory Outlet Centers. The Motley Fool has a disclosure policy.