Better Buy: Vanguard High Dividend Yield ETF vs. iShares Select Dividend ETF

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Income investors on the lookout for a dividend-focused exchange traded fund, or ETF, will find both Vanguard High Dividend Yield ETF (NYSEMKT: VYM) and iShares Select Dividend ETF (NASDAQ: DVY) appealing. Each offers around a 3% yield (compared to around 2% for an S&P 500 Index fund) and broad diversification. However, even though they both have the word "dividend" in their names, they go about selecting dividend stocks in very different ways. And those differences matter.

1. Playing the field vs. being selective

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Vanguard High Dividend Yield is the more broadly diversified of the two ETFs. It tracks the FTSE High Dividend Yield Index, which essentially takes all of the dividend-paying stocks around the world (excluding real-estate investment trusts) and lines them up from the highest forward yield to lowest. The highest-yielding companies that make up the top 50% of the market capitalization of the investable universe are selected for inclusion. Holdings are weighted by market capitalization, so the largest companies represent the largest positions in the fund. There are currently around 400 securities in Vanguard High Dividend Yield ETF. The index is updated twice a year.

iShares Select Dividend is a bit more restrictive. It tracks the Dow Jones U.S. Select Dividend Index. This index focuses on just U.S. listed securities (excluding real-estate investment trusts), contains only 100 stocks, and includes fundamental screens to weed out financially weak companies. Specifically, all stocks considered for the index must have paid dividends in each of the past five years, have increased their dividends over that five-year span (though not necessarily every year), have positive earnings over the past year, and have a dividend coverage ratio of 167% or better. The 100 highest-yielding stocks to pass those screens get added to the index and are weighted by dividend yield, meaning the highest-yielding stocks are more heavily weighted than lower-yielding stocks. The index is rebalanced annually.

Essentially, Vanguard High Dividend Yield is taking a shotgun approach to building a dividend stock portfolio, while iShares Select Dividend is trying to use a rifle to select stocks that it hopes are of higher quality. Both funds have roughly similar dividend yields of around 3% each, so it really boils down to investor preference. I tend to prefer the iShares approach, since it attempts to weed out lesser-quality companies.

2. The current snapshot

Vanguard High Dividend Yield's portfolio is, as you might expect, fairly well diversified by sector, with the heaviest weightings in financial services (around 16% of assets), healthcare (13%), and consumer defensive stocks (13%). Foreign stocks make up less than 3% of the portfolio, and it is heavily weighted toward large-cap names (around 88% of the fund), which isn't surprising based on the capitalization weighting scheme. As noted above, the fund holds just over 400 stocks, with the top 10 holdings making up nearly 27% of total assets.

iShares Select Dividend's 100 stock portfolio effectively contains only U.S. companies, but it has a lumpier sector breakdown. Utilities account for roughly 30% of the portfolio, with consumer cyclical stocks at around 15%, and energy stocks at 12%. That's a big difference that needs to be kept in mind, since the performance of utility stocks will have a disproportionate effect on the fund's performance. Consumer cyclical and energy stocks, meanwhile, can be volatile performers. iShares Select Dividend is more diversified by holding size, though, with large-cap stocks making up around 60% of the index, and small- and mid-cap stocks rounding out the portfolio. The top 10 holdings make up around 18% of total assets.

The different makeup of the two portfolios, meanwhile, is a concrete example of the screening that is included in iShares Select Dividend's methodology. Note, too, that while the fund is less diversified regarding sector, its assets are spread more equally across the portfolio. Despite owning 400-plus stocks, Vanguard High Dividend Yield's portfolio is more heavily influenced by its largest holdings. Once again, my preference leans toward iShares' screening approach despite the fact that it has more sector concentration.

3. What have you done for me lately?

Performance-wise, iShares Select Dividend has been the better long-term performer, with trailing annualized returns of 11.7% and 10.8% over the five-year and 10-year periods through July 2018. Vanguard High Dividend Yield's returns over those spans were slightly lower, at 11.4% and 10.2%, respectively. Performance-wise, iShares Select Dividend is the winner, by a nose.

What's interesting about this performance discrepancy is that iShares Select Dividend has a materially higher expense ratio. Vanguard High Dividend Yield's expenses of just 0.08% are tiny compared to iShares Select Dividend's expense ratio of 0.39%. That means iShares Select Dividend has managed to overcome a roughly 31 basis point cost headwind as it has outdistanced Vanguard High Dividend's performance. That said, if low costs are important to you, Vanguard High Dividend is the hands-down winner on fees.

If you are in the market for dividends...

At this point, it should be pretty obvious that my choice between this pair of dividend-focused ETFs is iShares Select Dividend. I don't personally invest in ETFs, preferring to cherry-pick my own portfolio. That's why iShares Select Dividend's approach to the stock selection fits better with my personality. Add in the performance beat, and it seals the deal for me.

One word of caution, though, before jumping into either of these ETFs: Investors should strongly consider the overall state of the market. Stocks are near all-time highs, and we haven't had a bear market in a very long time. If you are inclined to invest in iShares Select Dividend or Vanguard High Dividend, you might want to consider spreading your purchases out over time, effectively dollar-cost averaging into the funds over a year or longer to avoid, effectively, trying to time the market with a lump-sum investment.

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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.