Can the Vanguard High Dividend Yield ETF Thrive on Interest Rate Cuts? #NewsETFs

The Vanguard High Dividend Yield ETF (VYM -1.41%) is a popular exchange-traded fund (ETF) with roughly $70 billion in assets. The fund’s approach is easy to understand and ensures that it is focused squarely on yield. Will that also lead to a net benefit if interest rates decline?

What does the Vanguard High Dividend Yield ETF do?

The Vanguard High Dividend Yield ETF keeps things simple. The first step in creating the portfolio is to look at all dividend-paying stocks. It removes real estate investment trusts (REITs) from the list. Then it determines the yields of the remaining stocks and buys shares in the top 50% on the list as ranked by their yields.

Aside from eliminating REITs, a sector known for high yields, that’s very straightforward and understandable. It also clearly focuses the portfolio on high-yield stocks.

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There are material implications to such a simple approach. Some sectors tend to have higher dividend yields than others. For example, utility and finance stocks are two areas that are well known for their dividends. And, as you might expect, the Vanguard ETF is heavily weighted in these two areas, which account for 6.9% and 21.1% of its portfolio, respectively. Together that’s 28% of the portfolio.

Is that really a lot? The answer comes from a comparison to the S&P 500 index, which is generally considered to be representative of the market. Using the Vanguard S&P 500 ETF (FLIGHT -1.67%) as the comparison, the S&P 500 has just 2.4% of its assets in utility stocks and 13% in financials. So the Vanguard High Dividend Yield ETF is indeed heavily weighted in some key sectors. To put a number on that, it has nearly three times as much exposure to utilities and about 60% more exposure to financials.

Big portfolio differences can lead to big performance differences

There’s another interesting difference here, with the Vanguard High Dividend Yield ETF’s technology exposure at 10.7% versus the Vanguard S&P 500 ETF’s 31.4%. Not surprisingly, the High Dividend Yield ETF has lagged the S&P 500 as technology stocks have rocketed higher. Adding further to the headwinds, rising interest rates have been a problem for utility and finance companies for a little bit.

VYM data by YCharts.

Utilities are capital-intensive and tend to make material use of debt, so higher interest rates mean higher operating costs. Financial stocks, meanwhile, have to deal with the negative impact of higher rates on the ability of customers to pay their loans and the desire for new loans, particularly mortgages. But what happens when interest rates start to fall?

In a scenario of falling interest rates, utilities and financials could suddenly start to look more attractive to investors (they have already begun to bounce off of their lows). Utilities, because their costs will fall, perhaps boosting earnings prospects; financials, because customers will be healthier financially, and maybe demand for loans will rise.

If that leads to even higher stock prices, then the Vanguard High Dividend Yield ETF, thanks to its heavy weighting in these sectors, will benefit disproportionately relative to the broader market.

In other words, the Vanguard ETF could be on the cusp of a performance boost when interest rates begin to come back down. But that depends on what the Federal Reserve does with interest rates, which is hard to predict.

Not a reason to buy it, but a reason to be positive about the future

You probably shouldn’t buy the Vanguard High Dividend Yield ETF as a way to play falling interest rates. There are products out there that would be better for that. However, if you have been thinking about buying this ETF but have been turned off by its laggard performance, falling interest rates could be a catalyst for better performance.

With a nearly 2.9% yield and a portfolio of roughly 500 companies, the simple-to-understand Vanguard High Dividend Yield ETF is worth a second look today as interest rates appear likely to shift.