Why Did VIG Thoroughly Beat The Market In Early 2016?

| About: Vanguard Dividend (VIG)

Summary

VIG is heavy on the consumer defensive/consumer staples sector.

They went very light on financial services.

The big weight on consumer staples substantially outperformed and avoiding financials turned out to be another excellent move.

The index VIG follows has some proprietary eligibility rules that result in a few great dividend champions being excluded.

The Vanguard Dividend Appreciation ETF (NYSEARCA:VIG) thoroughly beat the S&P 500 so far this year and over the last year is up by a few percentage points because of their strong start to 2016. One logical argument is that investors simply want companies that pay strong dividends, but we can go deeper by examining the sector exposure. This is where VIG was able to dramatically beat out the broader indexes.

Unintentional Index Concentration

The composition of VIG is based on the underlying index. That index is maintained by NASDAQ and their methodology is open to the public. You simply need to look up the NASDAQ US Dividend Achiever's Select Index Methodology. The index is built using companies with at least 10 years of increasing their annual regular dividend payments. By using those qualifications, the index should be biased towards more defensive allocations.

It is worth noting that the index also states that "additional proprietary eligibility are applied." I'll go deeper into that later in the article.

Sector Allocations

Morningstar provides a fairly great tool for looking at the sector exposure of an ETF or mutual fund:

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I've added a red arrow to indicate the Financial Services sector which has a fairly light weight with only 5.52% of the allocation. The green arrow indicates the consumer defensive sector which has a 25.43% allocation. This is substantially different from the allocations for the S&P 500 as represented by the SPDR S&P 500 Trust ETF (NYSEARCA:SPY).

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The addition of about 15% to consumer defensive and the subtraction of about 9% from financial services are driving the difference in returns.

The difference is demonstrated in the following chart:

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Up through January the two funds were sticking fairly close together, but when the economic stress started hitting the economy and investors started selling off, they were selling off some sectors dramatically more than others.

I used the tools from Fidelity to grab the following charts that demonstrate the difference in the sector returns relative to the S&P 500:

Consumer Staples was fairly even up until about the start of 2016 when it substantially outperformed most of the domestic market. This was a huge advantage for VIG since they were going 25% into this sector rather than 10%.

On the other hand, the financial sector has been smashed even harder than most of the market and was severely down:

Again we see a case where the industry was holding quite even with the rest of the S&P 500 up until the start of the year. Since the end of December the financial sector underperformed by a significant margin.

Defensive Allocations

The way the VIG index is structured creates a fund with more defensive allocations. The criteria for raising dividends over the last 10 years are eliminating funds that were unable to continue raising dividends during the last recession. It would be a mistake to believe that the potential recession coming up bears any substantial resemblance to the last one. The causes are entirely different and we don't even know if the recession will come to pass.

However, the companies selected by this index may be more resistant to selling pressures simply because investors would feel more comfortable holding companies that were successful in the last scenario. I wouldn't want to hold shares in a company based on the idea that other investors would refuse to sell it on the basis of stronger price performance almost a decade ago. However, I do overweight my own portfolio towards consumer staples with allocations to Altria Group (NYSE:MO) and Phillip Morris (NYSE:PM).

Ironic Exclusions

Remember how the index established that there were also some "proprietary" eligibility criteria? I went scanning through the list of the 178 holdings in VIG looking for MO. Like the rest of the consumer staples sector, MO has been fairly stable despite the wide spread selling. Ironically, MO is not included in the fund. Given the 46 years of dividend increases and heavy overweight position on consumer staples, I thought MO would make the cut.

I also found it interesting that Yum! Brands, Inc. (NYSE:YUM) made the cut but McDonald's (NYSE:MCD) did not. It is worth noting that Wal-Mart Stores (NYSE:WMT) and Target (NYSE:TGT) are both in the fund. Remember that WMT and TGT are both raising wages for hour employees by a material amount and it should be pressing on their margins. They may also be suffering some from the foreign exchange impact of a strong dollar weakening the value of their international profits. However if the dollar stabilizes these are retailers strong enough to work with suppliers in China and capture some of the benefits from their suppliers having lower costs of production.

The other very interesting exclusion from the list is Exxon Mobil (NYSE:XOM). VIG only has about 1.1% of the portfolio in the energy sector so it shouldn't' be a surprise, but XOM is one of the first companies I would want to add to this portfolio. With oil prices falling rapidly the sector has been hit fairly hard, but XOM is one of the most stable companies in the sector.

Will VIG Continue to Outperform?

Based on the heavy weights to consumer staples and the low weightings to financials and oil, I'd see a recession as an easy opportunity for VIG to outperform. If the market moves back towards record highs, expect VIG to gain less due to the less aggressive positions.

Conclusion

The defensive allocations are precisely the reason for so many investors to appreciate VIG. It shouldn't rally as hard if the market recovers, but the downside protection from a much heavier weight to the defensive sectors is worth the smaller upside. I've demonstrated the desire for more defensive equity positions in my holdings through allocations to big tobacco.

Disclosure: I am/we are long MO, PM.

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.

Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.