Dividend Investors: Vanguard Has A Warning For You

| About: Vanguard Dividend (VDIGX)

Summary

Dividend stocks have been hot.

It makes sense, given the low rate world.

But Vanguard is doing something you might want to worry about.

As the Federal Reserve has pushed interest rates toward historic lows, investors have reacted in a logical fashion by shifting toward investments with higher yields. That's fine, to an extent, but the trend has become something of a fad. Doubt that? Take a look at what Vanguard just did...

Interest? What Interest...
If you go to your local bank and open a new bank account you'll probably be shocked at how little interest you are being offered. Shift out to assets that are a little more risky, like U.S. government debt, and the numbers aren't much more compelling. Which is why it makes complete sense that investors have shifted out even further on the risk scale, pushing up the prices of dividend paying stocks and high yield bonds.

The desire for safe yield is probably best displayed by the disparate performance of S&P 500 ETF Trust (NYSEARCA:SPY), basically the broader market, and PowerShares S&P 500 High Dividend Low Volatility Portfolio (NYSEARCA:SPHD), essentially a subset of dividend paying stocks from within the broader market. The numbers are pretty impressive, with SPY up around 6% so far this year and SPHD up over 18%! To be fair, SPHD is more than just a collection of high dividend yields, it's built as a portfolio to help reduce volatility. But that type of outperformance says something about the market.

SPY Chart

More to the point, however, the assets under management in the fund have pretty much exploded over the past year or so. That's not hyperbole, either. The share count increased six fold between April 2015 and April 2016. Clearly, investors are chasing what they view as safe yield, and PowerShares S&P 500 High Dividend Low Volatility Portfolio pretty much sounds like the perfect fit.

Vanguard leads the way?
But how long can this go on before the valuations of dividend stocks get out of whack? I think they are already there-with many of the best dividend paying companies priced well beyond what a reasonable investor should be willing to pay. And, here's the thing, Vanguard seems to agree with me.

Why do I say that? The fund family just closed Vanguard Dividend Growth Fund (MUTF:VDIGX) to new investors. According to Vanguard CEO Bill McNabb, "Vanguard is proactively taking steps to slow strong cash flows to help ensure that the advisor's ability to produce competitive long-term results for investors is not compromised."

That's a polite way of saying that too much money coming in too quickly has made it hard to find good dividend-focused investments. Why? Most likely because dividend paying stocks are expensive. According to the fund family the assets in Vanguard Dividend Growth Fund have nearly doubled over the past three years, with some 10% (around $3 billion) of the fund's assets being added in the last six months or so.

Don't take this lightly
Vanguard has a long history of doing the right thing by its fund shareholders. It isn't perfect, of course, but overall it's among the most shareholder-friendly fund shops around. And, thus, you shouldn't ignore this move if you invest in dividend stocks. It's a big statement about the state of dividend investing.

Sure, you can still find high yield stocks. But you need to balance the yield with the risk you are taking on. If a stock is yielding vastly more than the market or its own peers, there's probably a reason. Make sure you know it and are willing to shoulder the risks.

As for more conservative dividend paying stocks, Vanguard appears to be saying they are expensive today. The companies may be strong and likely to hold up well through any tough patches that come up, but that doesn't mean the stocks will. That's particularly true now that so many investors have been bidding such companies up in a desperate search for safe yield. In this case, your risk isn't in the company but in the price you pay to buy it. Pay too much and your future return prospects will be diminished... or worse.

I like dividend paying stocks. But I think they are expensive, overall, today. And when I read about Vanguard closing Vanguard Dividend Growth Fund a shiver went down my spine. That's not to suggest that investors are about to sour on the dividend fad, I don't know when that will happen (though I believe sooner is more likely than later). But it should be eye opening to see Vanguard basically say that it's getting hard to make money in dividend growth stocks these days. Dividend focused investors need to incorporate that into their bigger picture view of the world.

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.