The Fed Just Gave A Boost To VYM

| About: Vanguard High (VYM)

Summary

The Fed's continued reluctance to raise rates will continue to benefit dividend paying funds.

When rates do rise, investors will be less likely to rotate out of solid funds like VYM.

Lower fees and lower risk also make the fund attractive.

The purpose of this article is to discuss the attractiveness of the Vanguard High Dividend Yield ETF (NYSEARCA:VYM) as an investment option. To do so, I will look at recent fund performance, its current holdings and allocation, and trends in the market to conclude if VYM will be a profitable investment as we move deeper into 2016.

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 $69.35/share and, based on its last four dividend payouts, is yielding 3.13% on an annual basis. Year to date, the fund is up almost 4%, excluding its first quarter dividend payout, which bests the Dow Jones Index return of slightly over 2%. I expect this outperformance to continue, and will explain the reasons why below.

First, and most importantly, interest rates are staying near historic lows for longer than anticipated, as the Fed has not made another increase since December. This pace (or lack thereof) of increases has been a surprise to most market participants, and indexes have moved higher as a result. For instance, back in January before the jobs report, 45% of traders had anticipated a March rate increase. After the positive January report, that number rose to over 50%. Fast forward to April and there has still not been another rate hike, and there is reason to believe the dovish Fed will continue to remain dovish. During last Tuesday's meeting, Yellen stated the central bank will move "cautiously" with regards to further hikes. This casts into doubt that a second rate hike will be on the horizon soon. Assuming the Fed does not abruptly change course, this caution bodes extremely well for dividend-paying funds. Yields on government bonds and savings accounts will remain low, and investors will continue the hunt for yield that has persisted since the recession. This has continuously benefited funds such as VYM, and will continue to do so in the short term.

Second, aside from sporting a current yield over 3%, VYM is made up of strong US companies which will benefit from a growing and improving US economy. Here is a breakdown of the VYM's current holdings as of 02/29/2016.

1 Microsoft Corp. (NASDAQ:MSFT)
2 Exxon Mobil Corp. (NYSE:XOM)
3 Johnson & Johnson (NYSE:JNJ)
4 General Electric Co. (NYSE:GE)
5 Wells Fargo & Co. (NYSE:WFC)
6 AT&T Inc. (NYSE:T)
7 Procter & Gamble Co. (NYSE:PG)
8 JPMorgan Chase & Co. (NYSE:JPM)
9 Verizon Communications Inc. (NYSE:VZ)
10 Pfizer Inc. (NYSE:PFE)
Click to enlarge

As you can see, the fund holds some of the best and most profitable companies in the world. My premise is that, when the Fed does decide to raise rates, it will be because the US economy has gotten consistently stronger. While raising rates might be a negative for dividend funds, the companies that make up the funds should be performing better than ever under a stronger US economy. Therefore, I expect the earnings and dividend payouts of these firms to rise, providing an overall net gain for the fund.

A third reason I like the fund has to do more with its individual characteristics more than macroeconomic issues. For one, the fund has an expense ratio of .09% which, according to the Vanguard website, is "92% lower than the average expense ratio of funds with similar holdings." Secondly, the fund is properly diversified, with no sector composing more than 16% of the portfolio. The four biggest sectors in the fund are Consumer Goods, Financials, Technology, and Industrials, respectively, so there is quite a bit of diversity in the fund's holdings. Essentially, investors are getting the benefits of a traditional mutual fund without the high cost, which has been an increasingly important trend for retail investors over the past few decades.

Of course, investing in VYM is not without risk. The chief risk being that the Fed could decide to raise rates sooner, or more quickly than anticipated. While I mentioned earlier that I expect rates to rise as the economy strengthens, lessening the impact to VYM, this is not a guarantee. Poorly timed rate hikes could stifle growth or spook investors, and the flight out of dividend funds could be swift. While I would expect such a scenario to reverse and normalize, it is a potential headwind. For instance, Atlanta Fed President Dennis Lockhart and St. Louis Fed Chief James Bullard provided generally upbeat appraisals of the economy and said policymakers could lift rates as early as an April 26-27 meeting. While they are in the minority opinion, attitudes could change, and if the Fed does turn more hawkish quicker than expected, VYM will not be immune from the fallout.

Bottom line

VYM has been a boon for investors since the recession, as investors have piled into dividend paying companies in search of yield during years of unprecedented low rates. Aside from providing a reliable yield above 3%, the fund has seen impressive stock price appreciation. While some investors have been rotating out of dividend paying funds over the last year, I feel VYM has plenty of positive upsides. The rotation out of these funds has been due to the anticipation of Fed rate hikes throughout 2016, and we have yet to see those materialize. Given the dovish statement last week from the Fed, it looks like low rates will continue to linger, and funds like VYM will be primary beneficiaries of that policy. Given its low fees, reliable yield, and upside potential, investors should take a serious look at VYM.

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.