The Right Reason to Buy Into Vanguard's Classic Dividend Strategy

While high-yield assets are generally expensive, Vanguard High Dividend Yield Index (VYM) is a fine holding that avoids gorging on the most overvalued sectors: real estate and utilities, a vice of more-aggressive high-yield strategies. By design the fund excludes real estate investment trusts, and its holdings are market-weighted, keeping its utilities allocation from growing big. The fund strikes a balance among market representation, yield, and quality. Its construction is straightforward: Each year it ranks stocks by their forward dividend yield according to consensus analyst estimates and includes the highest-yielding ones in its portfolio until 50% of the eligible universe's aggregate market capitalization is reached. VYM excludes stocks forecast to not pay a dividend in the coming year.

I've talked a lot about VYM's return on top of the stock market. But the U.S. stock market's returns will determine most of VYM's behavior. I've said this before, and I'll say it again: U.S. stocks are expensive. A reasonable way to estimate long-run returns is to sum current dividend yield with expected real per-share dividend growth. The market's dividend yield right now is 2%. There's also a hidden yield boost thanks to net share buybacks. Let's say 0.5%. Real per-share dividends have historically grown about 1.5%. So you're looking at a 4% expected real return, after inflation, over a decade-plus horizon. This simple analysis assumes the market's valuation multiple and profit margins stay constant. With interest rates so low and profits juiced by high margins, I think the market's long-term expected real return is lower than 4%. A 3% real expected return seems reasonable. Of course, there's a lot of uncertainty around this forecast.

Source: Morningstar

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