VYM: Holding Up Better Than Its Peers

ETFS

Main Thesis

The purpose of this article is to evaluate the Vanguard High Dividend Yield ETF (VYM) as an investment option at its current market price. As we move in to the second half of what has been a volatile year, dividend payers remain a key part of my portfolio. However, the divergence in performance over the past year among stocks that pay dividends, and the funds that hold them, has been wide. Therefore, I am taking a fresh look at all the dividend funds I cover, including VYM. This fund has piqued my interest due to its recent out-performance of other high dividend ETFs. With that in mind, I see merits to holding this fund going forward, but it does face challenges as well, leading me to have a cautious stance. For example, the fund has a heavy exposure to the consumer, presenting a challenge due to the lingering lock-downs and high jobless claims. However, I do like the fund’s diverse make-up, which is a reason it has beaten alternatives. Furthermore, VYM has seen its distributions rise in 2020, which is a positive signal for the underlying holdings.

Background

First, a little about VYM. The fund 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.” It is currently trading at $81.56/share and yields 3.63% annually, based on its four most recent distributions. I covered VYM a year ago, and expressed some general optimism around the underlying holdings. In hindsight, VYM has not really met expectations, falling well short of the broader market, as shown below:

Source: Seeking Alpha

Given the volatile year we have seen so far, I wanted to take another look at this fund to see if I should change my rating. After review, while I see VYM holding its own in the second half of the year, I think the chances of meaningful upside are limited. Therefore, a “neutral” rating seems most appropriate to me going forward, and I will explain why in detail below.

A 1-Year Look Back At High Yield Dividend ETFs

To begin, I want to take a look at how VYM has compared over the past year against some alternative “high dividend” ETFs. Simply, this is a play that has not worked out well, compared to the broader market. Many, including myself, would have expected dividend payers to provide some hedge against the market volatility that we witnessed starting in late February, but that was not the case. A driving force behind this reality is that many dividend payers, whether “high” or otherwise, have been forced to cut, suspend, or eliminate their dividends as revenues and profits dried up. The end result was that dividend safety was paramount, and that is typically not a criteria for inclusion in to many high dividend ETFs. However, when we consider the performance over the past year, while some of the most popular high dividend ETFs all lagged the S&P by a wide margin, VYM managed to lead the pack.

To illustrate, consider the 1-year return of VYM against the SPDR Portfolio S&P 500 High Dividend ETF (SPYD), the iShares Core High Dividend ETF (HDV), and the Invesco S&P 500 High Dividend Low Volatility Portfolio ETF (SPHD), as well as the S&P 500 index, as shown in the graph below:

Source: CNBC

My point here is this offers some comfort to VYM investors. Yes, VYM has lagged the broader market, but those gains are largely being driven by the rising share prices of FAANG. For more conservative investors who continue to place an emphasis on value and dividends, VYM seems to be one of the better ways to play it. While I am personally favoring a dividend growth strategy, high dividend payers can also provide reliable income in a turbulent market, if you choose the right ones. VYM’s strong performance compared to the other popular funds in this space tells me this remains a preferable choice.

The Consumer Presents A Mixed Bag

I now want to shift the focus to the underlying holdings of VYM. As I noted earlier, this fund is quite diversified, but it is also heavily reliant on the American consumer. While the Financials sector remains the largest individual sector by weighting, VYM holds over 21% of its total assets in either the Consumer Goods or Consumer Services sectors, as shown in the chart below:

Source: Vanguard

It goes without saying this is a challenging area right now. On the one hand, Consumer Staples, which includes household products, food, cleaning supplies (among others), have seen a surge in demand as people stocked up on goods and sheltered in place. While positive for the sector temporarily, this was balanced out by a decline in discretionary consumer spending. Therefore, as a whole, consumer-oriented sectors offered both opportunity and weakness, which is a key reason why a fund like VYM has under-performed the S&P 500.

Looking ahead, it is hard to see a scenario where things get worse than they did back in March. However, I personally feel the market got too optimistic. I see a prolonged period before we return to “normal”, and even though things are better, it does not necessarily mean things are “good”. Unfortunately, many Americans seem to share my short-term pessimism. According to the University of Michigan consumer sentiment survey, readings on consumer’s opinions of current conditions and future expectations both fell in July. It seems, after seeing a bit of a rebound as states began to open up, many consumers are feeling less confident as Covid-19 cases and deaths continue to climb. Shown below are the two July readings, which are near multi-year lows:

Source: Bloomberg

Clearly, consumers have begun to accept the reality that we are in for a longer than expected downturn. While sentiment can, and often does, change quickly, I personally expect sentiment to remain at below average levels until a vaccine is readily available, and that could take a long time.

Of course, sentiment does not always reflect what is going on in the economy. Sometimes sentiment can appear bearish or bullish, but actual spending figures tell a different story. In some ways, this is the case now, as retail spending figures surged last month. However, we have to remember that many economic figures were extremely weak during the worst of the pandemic spread. Therefore, while retail figures look strong on a month-over-month comparison, when we expand the time horizon out, we actually see current sales figures are at a historically low level. A perfect illustration of this reality is exposed when we consider the two graphs below:

Source: Charles Schwab

My takeaway here is while the consumer picture has certainly improved over the past few months, we are still a long way from pre-crisis levels. While it is possible we see continuous improvement over the coming months, consumers appear to be losing faith in the recovery, as evidenced by the recent sentiment readings. While investors can hope for the best, it is important to recognize the risks facing the market, and consumer-oriented sectors in particular. In my view, this balance provides justification for my neutral stance on VYM.

Dividend Growth Is Very Positive

My next point has a more positive slant, and concerns the fund’s dividend. As a high yield fund, investors will want to see VYM sporting an above-average yield (compared to the market), but they should also be looking for some dividend growth as well. In my opinion, this is all the more critical now, given how many high yielding stocks turned out to be not so high after all, as they slashed or eliminated their dividend payouts. This reiterated the importance of not just looking at the size of a dividend, but also its safety.

Fortunately, the story so far in 2020 is positive for VYM. While payouts could certainly change in the second half of the year, we can take comfort that the first half saw dividend growth just below 9%, on a year-over-year basis:

Jan – June 2019 Dividends Jan – June 2020 Dividends YOY Growth
$1.28/share $1.39/share 8.6%

Source: Vanguard

Simply, I view this very positively. VYM’s yield above the 3.5% range puts it above what many dividend funds are offering, and its growth this year gives me confidence in the financial position of the underlying holdings. All things considered, I view the story behind the dividend to be a reason to own VYM.

VYM Lacks Real Estate Exposure

My final point touches on the why behind the performance divergence in some of the high dividend funds I compared VYM to at the beginning of the review. While HDV is more similar to VYM, except for a notable difference in Energy exposure, SPYD and SPHD are vastly different funds compared to VYM. Despite all being “high dividend” ETFs, HDV and VYM essentially lack any Real Estate exposure, while the Real Estate sector is the top weighting in both SPYD and SPHD, as shown below, respectively:

Source: State Street; Invesco

Personally, I think this is another selling point for VYM. This is not because I don’t want Real Estate exposure, because I do. But for me personally, I like to invest in broad Real Estate ETFs which encompass each sub-sector, or select individual names I think are well positioned in the current climate. By contrast, funds like SPHD and SPYD primarily hold the tickers that have the highest yields. This often means they are buying in to the most beaten down holdings within the sector. This is not inherently “bad”, and many investors may actually prefer this strategy, as they are essentially betting on a reversion to the mean from some unloved sectors. Generally, this type of strategy can pay off, but for now, I am not so sure.

To understand why, consider some of the areas that have been hardest hit within the Real Estate sector. Retail comes to the forefront, as stores, shopping centers, and malls have had to shut their doors. This led to revenues drying up, hurting stock prices broadly. This has also accelerated bankruptcies across the retail space, pressuring large mall REITs, such as Simon Property Group (SPG), among others. That is a holding in both SPYD and SPHD, and is exactly the type of stock I would want to avoid right now. While buying in to beaten down areas is often a good long-term strategy, right now I would not advocate it. The reason is that many stocks and sub-sectors (like malls) are going through fundamental changes that will not necessarily correct any time soon. Yes, malls and shopping centers are opening back up, but consumer demand is not likely to return to pre-crisis levels for quite a long time. Social distancing measures are going to remain in place for the foreseeable future, and online spend will continue to eat away at the revenues for traditional shopping centers. In fact, just this past week, mall owner CBL & Associates (CBL) announced it was preparing to file for bankruptcy.

My point here is I do not see the trends that have pushed Retail REITs lower abating any time soon. I expect this to remain a challenging environment, at least for the remainder of 2020, so buying in to them now seems premature. For support, we can look to how mall traffic has rebounded in areas of Europe that have re-opened faster than America. A great example comes out of central Europe, which continues to see annual declines in retail traffic, despite an easing of restrictions, as shown below:

Source: Bloomberg

Ultimately, I prefer VYM’s portfolio against these alternative high dividend options. While funds like SPYD and SPHD sport a higher yield, they are holding some of the weakest areas in the economy. In normal times, a rebound in those areas could be due. For now, I prefer to bank on the companies that are not disproportionately impacted by the Covid-19 pandemic.

Bottom line

VYM is a fine option for a long-term hold, as its high dividend focus, dividend growth, and diversification offer investors a well balanced option in a crowded space. While the fund lacks Real Estate exposure, I view this positively, as I prefer sector REITs rather than dividend funds for that exposure anyway. These positives tell me there is merit to holding VYM going forward, but I must express some caution, given how strong the equity rebound has been. The result from this rebound tells me that finding more upside in the short-term will be a challenge. Therefore, I continue to like the story behind VYM, but would encourage investors to be selective with entry points at this time.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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