From a big-picture perspective, you have two choices when it comes to investing: You can invest broadly, or you can fine-tune your selections to better meet your specific needs. The first way largely means widely diversified index funds; the second means cherry-picking stocks or selecting an exchange-traded fund (ETF) that does that for you.
This is the dichotomy on offer in the dividend niche when you compare Vanguard High-Dividend Yield ETF(NYSEMKT: VYM) to Invesco S&P 500 High-Dividend Low-Volatility ETF(NYSEMKT: SPHD). Here's how to decide which option is right for you.
What does Vanguard High-Dividend Yield ETF do?
Vanguard High Dividend Yield ETF is an index-based exchange traded fund. The index it follows is the FTSE High-Dividend Yield Index. The fund charges a minuscule 0.06% expense ratio for doing this. The real question for investors is, what does the index do?
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FTSE High-Dividend Yield Index is pretty simple to understand. First, it selects all the dividend-paying stocks in the stock market. Then it removes real estate investment trusts (REITs), which seems odd, since they are specifically designed to pay dividends.
After this step, it lines up the dividend stocks it has left, from the highest yield to lowest, selecting the highest-yielding 50% of the list for the final portfolio. The portfolio is then market cap weighted, so the largest stocks have the greatest influence on the ETF's performance.
This is akin to taking a shotgun to dividend investing, noting that the Vanguard High-Dividend Yield ETF owns over 500 stocks. That provides broad diversification, but with so many stocks, it ends up diluting the ETF's dividend yield, which is only around 2.8%. That's higher than the tiny 1.2% you'd get from the S&P 500 (SNPINDEX: ^GSPC), but you are definitely giving up yield to get diversification with this ETF.
SPHD Dividend Yield data by YCharts
What does Invesco S&P 500 High-Dividend Low-Volatility ETF do?
Invesco S&P 500 High-Dividend Low-Volatility ETF lives at the opposite extreme, as it is highly selective. For starters, as its name implies, it fishes within the S&P 500 pond for its holdings. This index is hand selected to include the largest, most economically representative (and important) companies in the United States. From the start, then, Invesco S&P 500 High-Dividend Low-Volatility ETF is doing something radically different from the Vanguard High-Dividend Yield ETF.
The next step for the Invesco S&P 500 High-Dividend Low-Volatility ETF, which tracks the S&P 500 Low-Volatility High-Dividend Index, is to rank the S&P 500 stocks from the highest yield to the lowest yield. The 75 highest-yielding stocks are selected, with a limit of 10 stocks from each sector.
If that limit is reached, other sectors are added until the list is back up to 75 stocks. These 75 stocks are then ranked by standard deviation, a measure of volatility, with the least volatile 50 making it into the ETF. The ETF is weighted by trailing dividend yield.
This is radically different, with Invesco S&P 500 High-Dividend Low-Volatility ETF clearly focused on emphasizing high yield over diversification. And given the selection process, the ETF is more like cherry-picking stocks than Vanguard High Dividend Yield ETF's scattershot approach.
But there are trade-offs. For starters, all the fine-tuning leads to an expense ratio that's a bit high at 0.3%, which is a negative. However, you get a higher yield at nearly 3.5%. That said, the ETF's historical performance hasn't been as good over time.
That outcome, however, makes logical sense for two reasons. First, Invesco S&P 500 High-Dividend Low-Volatility ETF is looking for low-volatility stocks, which are more likely to be slow and steady dividend payers than growth-oriented investments. Second, it is focused on larger high-yield stocks, which will likely be slower growing, as well. The broad approach taken by Vanguard High-Dividend Yield ETF basically lets in more growth-oriented stocks.
Which is right for your portfolio?
The selection you make between these two ETFs is obviously highly personalized. However, if you are trying to maximize the income you generate, perhaps to supplement Social Security in retirement, you will probably prefer Invesco S&P 500 High-Dividend Low-Volatility ETF's more focused approach. The higher yield and low-volatility design will let you sleep well at night while collecting larger dividend checks.
That's not to suggest that Vanguard High-Dividend Yield ETF is a bad choice, but its design is more appropriate for investors looking for diversification first and yield second.
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