The Case Against Using The VIG As A Dividend Growth Proxy

| About: Vanguard Dividend (VIG)

As you probably guessed from the title, I'm about to suggest that an individual collection of dividend growth stocks is likely a more relevant decision for the dividend growth investor than an ETF proxy; in this case the Vanguard Dividend Appreciation ETF (NYSEARCA:VIG). Now obviously the underlying qualifier in this case is that you have to be willing to put in the applicable homework. But given that one is so inclined, I believe that selecting individual stocks will be a more worthwhile decision over the long haul. I realize that by telling you the punch line I have essentially spoiled the article, but perhaps I can reinvigorate your interest with my even-keeled logic. In addition, I also realize that previous work has been done in this subject area; fellow Seeking Alpha contributor David Van Knapp comes to mind. I make no claims as to the comprehensive nature of this comparison.

So how did I choose the Vanguard Dividend Appreciation ETF, instead of say the iShares Dow Jones Select Dividend Index (NYSEARCA:DVY) or even the Vanguard High Dividend Yield Index ETF (NYSEARCA:VYM)? That's a good question. Well aside from the catchy ticker, in one of my recent articles someone commented on the benefits of, you guessed it, the Vanguard Dividend Appreciation ETF. I don't want to specifically run through the comment (you can check out the article if you're interested) but the basic idea was this: "professional investors do not regularly beat indices so individuals don't stand much of a chance, the VIG had a nice total return in the last couple of years, the top holdings look very much like a dividend growth portfolio and ETFs have relatively low fees". Now the reason that I didn't want to quote the comment explicitly is because I believe that the points that were indicated work not just for the VIG, but also stand as a valid argument for almost any dividend ETF.

So let's go about deflating what appears to be a perfectly reasonable argument for the dividend ETF, in our case the VIG. First and foremost, I would like to indicate that any mention of total return misses the concept of dividend growth investing quite completely. Dividend growth investors are concerned with a constant stream of rising income over time; not just rising, but increasing by a rate that far outpaces inflation. By the way, it should also be noted that this doesn't preclude an investor from capital appreciation. Rather, if dividends continue to increase for decades, then earnings too will be increasing and as we don't see say 15% yields on Coca-Cola it just so happens that capital appreciation will come anyway; whether you pay attention to it or not. It follows that comparing one's own returns to the total returns of a specified index would also be irrational for the dividend growth investor. So there we go, two out of four perfectly reasonable points passed by. Let's move on to some more concerns that the VIG happens to have relative to an individual stock dividend growth strategy.


Here's a list of the VIG's top 10 holdings, which represents almost 40% of the ETF and their respective current yields:

Current Yield
Wal-Mart (NYSE:WMT) 2.10%
Coca-Cola (NYSE:KO) 2.75%
IBM (NYSE:IBM) 1.77%
Chevron (NYSE:CVX) 3.24%
PepsiCo (NYSE:PEP) 3.12%
Procter & Gamble (NYSE:PG) 3.20%
Exxon Mobil (NYSE:XOM) 2.52%
United Technologies (NYSE:UTX) 2.77%
McDonald's (NYSE:MCD) 3.52%
3M (NYSE:MMM) 2.69%
Average Yield 2.77%

Looks reasonable right? In fact, it looks like a list of companies that I myself would have no qualms whatsoever about suggesting for further research. The problem comes in with the current yield. The SEC quoted yield (which can be found on the Vanguard website linked above) for the VIG is 2.23%. Using the last dividend payout of $0.323 and a current share price of just under $59, this seems reasonable. Of course the problem is that equal weighting in the ETF's top holdings results in a current yield of 2.77%. That is, it's not particularly difficult to find a higher current yield using many of the same holdings.


Originally I was going to include a chart for the distributions as well; but, I didn't trust the commonly quoted 2009 payout number. So why don't you just go to the Vanguard website to confirm it, you might ask? Well sports fans, that's precisely what I did; however, Vanguard only lists the last six quarters of payouts. If you ask me, that's a little ridiculous for an ETF based solely on dividend appreciation. But we do have some useful information. From what I can tell, the VIG paid out $0.873 in dividends in 2007 and has paid out $0.272, $0.317 and $0.323 thus far in 2012. If we use the same $0.323 quarterly mark for the last payout (reasonable, although possibly understated) this leads to a total dividend payout of $1.235 for 2012. In turn this leads to a 7.2% average compound annual growth rate over the last half decade. It seems impressive, but the counter argument is twofold. First, these quarterly payouts are somewhat volatile: for example, the last payout in 2011 was $0.332 against the first payout of 2012 in $0.272. I'd personally rather see my income stay the same or increase every quarter, rather than jump around. Second, while the 7.2% dividend growth rate is adequate, it's not overly remarkable. Over the last 5 years McDonald's has increased its dividend by 20% a year, Wal-Mart by 16%, IBM by 21%, PepsiCo and United Technologies by about 12% and even Coca-Cola and Chevron by around 9% a year. So in reality, the VIG is underwhelming even in comparison to many of its own top holdings.

Turnover: 14.4%

Yes, I do realize that this is an ETF that is meant to track a specified index and thus turnover results. But again, a dividend growth strategy is a long-term strategy whereby some portfolios might have exactly 0% turnover for years. With a 14% turnover, you're likely selling many more positions than the average dividend growth investor would be comfortable with. For that matter, the number requires that you are buying and selling something in a year's time frame; which I would incidentally classify as trading rather than investing.

Holdings = 133 positions

I want to be perfectly clear: I'm a big fan of the VIG's top holdings; especially with regard to a dividend growth strategy. For that matter, I'm a big fan of many of the other holdings within this ETF like Colgate-Palmolive (NYSE:CL), Target (NYSE:TGT), Walgreen (WAG) and Emerson Electric (NYSE:EMR). But there are three fundamental problems with buying an ETF. And it should be noted that this is a common problem with all ETFs and pooled funds: when you buy into a collective investment you are buying all of the holdings at the current prices.

Problem #1: Perhaps you think that Colgate-Palmolive, Wal-Mart and IBM are three of the best companies around. But that doesn't mean that you would buy these ownership stakes at any price. In fact, rational investment sense precludes you from such an endeavor. Yet when you buy an ETF you are purchasing all of the holdings at the current price. That is, there's no way to differentiate the idea that you think say Colgate-Palmolive is a great company but currently at a price that you would not reasonably pay.

Problem #2: Perhaps you have a moral opposition to say alcohol and cigarettes. If you buy an ETF like the VIG, this now requires that you are a part owner of Brown-Forman (NYSE:BF.B) or in different circumstances Altria (NYSE:MO). Again, there is no way to differentiate your moral opposition; you are purchasing everything. For that matter, it doesn't even have to be a moral opposition, perhaps you just don't think some of the companies in the ETF are of the highest quality.

Problem #3: I consider myself to be reasonably versed with tickers, but a sampling of companies that I had to look up within the VIG included: Mine Safety Appliances (NYSE:MSA), Tennant Co (NYSE:TNC), Badger Meter (NYSE:BMI), FactSet Research Systems (NYSE:FDS), AptarGroup (NYSE:ATR) and Jack Henry & Associates (NASDAQ:JKHY). That is, you might be buying partial ownership stakes of companies that you have never even heard of. Now consider this within a regular business decision. Would you just throw your money to someone that says "I'm in a lot of businesses" and you respond "good enough for me"; of course not. Think about buying into a local pizzeria. You would scrutinize over the financials, the location, demand, product, reputation, potential partnerships, suppliers, margins, current employees, sentiment and even the décor. Yet most people don't have the same mindset when buying stocks. They're identical!


Ask me how much I will pay in fees to hold my Coca-Cola partnership for 2012. The answer is $0. It is true that within pooled investments, ETFs are likely to be the lowest in the fee game; but it's all relative right? Even though the fees are comparatively low, that doesn't necessarily mean that it's a good investment. Incidentally, I have also done previous work that suggests fees might not be as big of an issue as one might initially imagine. To me the real disadvantages with the ETF still remain within the concept of buying all the holdings at the current price.

Now if you came to me and said "You can own the VIG or say Amazon (NASDAQ:AMZN) at 100 times earnings" I would chose the VIG every time. Even though I acknowledge that it is possible that AMZN might return more value in the future. But luckily those aren't my only two options for investing; we literally have thousands upon thousands of possibilities. Considering this scenario, based on the comparisons made above, I would much rather craft an individual collection of dividend growth stocks than rely on an impersonal ETF. Sure doing a bit of extra work isn't necessarily for everyone, but I would contend that a little homework never hurt anyone.

Disclosure: I am long MCD, PEP, IBM, PG, TGT, WAG, KO. 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.