Strike the Perfect Balance Between Yield and Risk With This ETF

Getting maximum yield while limiting credit risk is a difficult balancing act, but it can be achieved via ETFs like the Vanguard High Dividend Yield Index Fund ETF Shares (VYM).

In the current low-rate environment, dividends are an alternate route to high-yield debt with ETFs like VYM. The fund employs an indexing investment approach designed to track the performance of the FTSE High Dividend Yield Index, which consists of common stocks of companies that pay dividends that generally are higher than average.

The advisor attempts to replicate the target index by investing all, or substantially all, of their assets in the stocks that make up the index, holding each stock in approximately the same proportion as its weighting in the index.

In summary, VYM:

  • 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.
  • Provides a convenient way to track the performance of stocks that are forecasted to have above-average dividend yields.
  • Follows a passively managed, full-replication approach.

Striking a Sensible Balance

Morningstar ETF specialist Daniel Sotiroff recently covered VYM, noting its ability to offer yield and mitigate credit risk. One way the fund is able to stymie risk is through its aforementioned indexing approach.

“This well-diversified benchmark starts with all dividend-paying stocks in the FTSE All-World Index,” Sotiroff writes in Morningstar. “It focuses on those listed in the United States and excludes REITs. These companies, by law, must pay out 90% of their earnings as dividends, so they tend to have a higher yield than the U.S. market. Including them could cause the final portfolio to be overweight in this sector and compromise its diversification.”

Offering high dividends doesn’t mean that the company can sustain that level of yield over time. As such, VYM focuses on a company’s ability to provide ongoing dividend income.

“From these dividend-payers, the index strips out those not expected to pay a regular dividend over the next 12 months,” Sotiroff adds. “This is by no means a thorough way to avoid firms that may cut their dividends, but it does prevent the riskiest names from making their way into the portfolio.”

Furthermore, VYM adds diversification with a large swathe of holdings.

“It adds names to the portfolio, starting with those having the highest expected yield and continuing until it captures 50% of the dividend-payers’ total market cap,” Sotiroff notes. “This sweeps a large number of stocks into the portfolio and improves the fund’s diversification potential. Historically, it has held between 400 and 600 names, while its 10 largest holdings have represented less than one third of its assets.”

For more news, information, and strategy, visit the Fixed Income Channel.