VIG

Vanguard Dividend Appreciation ETF Isn't the Passive Income Machine You Think It Is

If you are an investor looking to generate passive income from your portfolio so you can use it to live, you'll want to be very careful with what you buy in the exchange-traded fund (ETF) world. For example, Vanguard Dividend Appreciation ETF (NYSEMKT: VIG) has the word "dividend" right in its name, but it won't be a great fit for most dividend-focused investors.

Let's look at the fund, who it is right for, and who it would let down. Plus, I'll discuss a higher-yielding alternative that might be a better fit.

What does Vanguard Dividend Appreciation ETF do?

Most investors who see the word dividend probably think about income. But with Vanguard Dividend Appreciation ETF, it really can't be separated from the word "appreciation," as in dividends that rise over time. That's because the key criterion for selecting stocks for this index-based ETF (it tracks the S&P U.S. Dividend Growers index) is equities that have a history of increasing their dividends annually for at least 10 consecutive years.

But that's not the only requirement for inclusion. For example, before even looking at a single stock, the S&P U.S. Dividend Growers index culls out real estate investment trusts (REITs). REITs are specifically designed to pass income on to shareholders in a tax-efficient manner and are generally known for offering high yields. That's not all, however, because the index takes a pretty drastic step on the income front when making its final list.

After getting a list of potential candidates with 10 or more years of dividend increases, the stocks are lined up by dividend yield, from highest to lowest. The index eliminates the highest-yielding 25% and buys the remaining 75% with lower yields. In other words, the goal is specifically to exclude the highest-yielding stocks. The remaining stocks are market cap weighted with a max possible weighting of 4%.

Vanguard Dividend Appreciation ETF isn't a yield vehicle

The impact of these decisions is pretty obvious when you look at the ETF's yield, which at roughly 1.8% probably won't be a huge draw for income seekers. It is only a bit higher on an absolute basis than the roughly 1.3% you could collect from an S&P 500 index fund. You could get a much more attractive yield of nearly 3.5% from Schwab U.S. Dividend Equity ETF (NYSEMKT: SCHD), which also includes dividend growth as a key screen but has a bias toward selecting stocks with higher yields.

VIG Chart

VIG data by YCharts

In fact, the higher-yielding Schwab ETF has done a smidge better than the Vanguard fund over time when looking at total return, which assumes dividend reinvestment. Although Vanguard's ETF has done better on a price-only basis, this comparison shows the value of the higher yield to overall performance.

So what are you really buying with Vanguard Dividend Appreciation ETF? Effectively, the dividend screen is being used to highlight financially strong companies that are growing their businesses over time. Dividends are a screening tool, not a goal. That's not a bad thing, but it is vastly different from what many dividend investors will be looking for.

Dividend growth? Sure. Dividend income, not so much.

Just stamping an ETF with the word dividend doesn't make it an income investment. Vanguard Dividend Appreciation ETF is most appropriate for investors who are looking to own dividend-growth stocks. While that might lead to an attractive yield based on purchase price over time, it isn't going to fill your wallet with income to spend today. Vanguard's fund will be a perfectly fine option for some investors but an absolutely wrong choice for others. The latter might prefer a higher-yielding alternative like Schwab U.S. Dividend Equity ETF.

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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard Specialized Funds-Vanguard Dividend Appreciation ETF. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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