Silly VIG, Why Do You Care About Oil Prices?

| About: Vanguard Dividend (VIG)

Summary

Comparing returns for VIG, SCHD, VYM, and SPY provides a fairly interesting tendency.

The domestic equity market has traded alongside oil prices throughout the first quarter.

The idea that weak oil prices will hamper oil companies does little to explanation the correlation for VIG’s portfolio which contains only 1% exposure.

When oil prices are lower it means more cash left over for consumers to spend in the other sectors.

Over the longer term cheaper oil prices should be favorable for the fundamentals of the VIG portfolio.

The Vanguard Dividend Appreciation ETF (NYSEARCA:VIG) deserves serious consideration from retirees. Unfortunately, the dividend yield has gotten fairly low, 2.21%, which makes the fund less attractive at current prices. At the latest prices, my outlook is neutral. However, I still like the fund relative to the S&P 500 (NYSEARCA:SPY) due to have allocations that I would consider more conservative.

The general theory investors should be remembering when investing in funds like VIG is that dividend yield is the dominant consideration. The dividends should be expected to rise over time and appreciation in the ETF over the very long haul (decades) should be reflective of the growth in dividends. In the short term, prices can deviate quite substantially from the path of dividends. Even though the latest sale on VIG came to an end, it is worth keeping on the radar for future opportunities.

Measuring Returns

I pulled the returns across 5 ETFs. The first was clearly VIG. The others include 3 other strong candidates for the investor's portfolio and one ETF filled with futures contracts on oil. I include that one because it is a very quick way to incorporate oil prices into the charts. The charts will start in very late December, but investors can easily eyeball the differences relative to January 8 th or 11 th.

The other ETFs are:

Vanguard High Dividend Yield ETF (NYSEARCA:VYM)

Schwab U.S. Dividend Equity ETF (NYSEARCA:SCHD)

SPDR S&P 500 Trust ETF

The United States Brent Oil ETF, LP (NYSEARCA:BNO)

Click to enlarge

Investors that looked at my portfolio will know that I hold SCHD. I see VIG, VYM, and SCHD as three of the best ETF options for domestic equity. There are a few other good ones, but these three are routinely at the top of the list.

The first thing investors may be asking is what impact dividends have on separating the total return. With the exception of BNO (which doesn't pay dividends), each went ex-dividend in mid to late March. The yields on VIG and SPY are fairly similar at around 2.1% to 2.2%. SCHD is yielding about 3% and VYM is running around 3.17%. I checked the latest dividend for each to ensure that the quarterly dividends were not out of line with normal values. Since the SCHD and VYM have a yield about 1% higher on an annual basis, their quarterly returns would be about .75% higher than demonstrated while VIG and SPY would only be .5% higher than demonstrated.

Using the chart above which starts in late December, VIG would've been the top performer with 2.62% in price return plus a .5% dividend. SCHD was a very close second with 2.31% and a .75% dividend.

The Oil Impact

Investors looking over that chart a few times may notice that there was a significant correlation over time. The lowest dips for the equity ETFs is fairly close to the timing for the lowest oil prices. When oil prices bumped up, the equity prices were bumping higher as well. The first excuse is that higher oil prices mean the oil companies will have higher earnings which will help them cover their dividends.

I believe low oil prices will hamper earnings for the sector, in some cases decimate earnings, and may lead to some significant defaults on bonds. Primarily this is a risk for junk bonds in the energy sector and for non-junk bonds that would be labeled as junk bonds if the credit rating agencies could constantly be updating their ratings.

That argument makes sense initially, except VIG doesn't have large allocations to the oil companies:

Click to enlarge

With a mere 1% allocation to the oil and gas sectors, the impact should be heavily muted. When we consider the other side of the oil prices impact, the correlation becomes even weirder.

The opposite side of the first argument (high oil prices = weak earnings) is that lower prices for oil means more money in the hands of consumers and lower expenses for companies engaged in transporting large amounts of physical goods. When lower oil prices reflect dramatically more efficient production it still means a higher standard of living in the economy. That won't be true for people that lose their jobs in the oil sector, but the job numbers have been fairly positive so there is hope that those workers won't be going into an excessively soft labor market like workers laid off after the sub-prime MBS crisis.

Consumers will still be spending money, so that should lead to significantly more income available for other consumption. While oil gets hammered, it should be positive for the majority of the economy.

Comparison

For comparison, let's take a look at the sector allocations for VYM:

Click to enlarge

Oil and Gas is just under 10% of the portfolio. For VYM the number two allocation is Exxon Mobil (NYSE:XOM). Clearly VYM has some oil exposure and it would make sense for oil prices to influence their equity prices.

SCHD also holds some material exposure to the sector:

Click to enlarge

The energy sector is a little over 10% for SCHD, so it would make sense for SCHD to also have a risk of some holdings seeing their earnings punished by weaker oil prices.

VIG is the outlier here. The allocation to oil is exceptionally low, but it doesn't seem to mute the impact of weak oil prices on the general equity market.

January 20 th

The weakest closing values for oil came on January 20 th. BNO closed at $9.15 per share. Since then shares climbed over 36% as oil prices rallied significantly. January 20 th was also the weakest closing value for shares of VIG, VYM, and SCHD.

Ironically SPY had their weakest closing value on February 11 th. Shares closed at $182.86 on the day. For comparison, SPY was at $185.65 on January 20 th. Despite climbing oil prices, SPY was down 1.5%.

How Can Investors Use This?

When oil prices are slumping and the broad equity market is selling off together, I see that as a very favorable time for VIG. Share prices can be overwhelmed by the correlation across the market even when the fundamentals for the portfolio should be stronger. I don't expect oil prices to remain this low for several years, but if oil prices remain low I would expect VIG to be in better shape than VYM or SCHD.

Remember that the market is a voting machine in the short term and a weighing machine in the long term. If the "threat" of low oil prices is sustained, VIG would be one of the ETFs that should see stronger fundamentals rather than weaker fundamentals.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SCHD over 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.

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. This article is prepared solely for publication on Seeking Alpha and any reproduction of it on other sites is unauthorized. 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.