Investors have some great reasons to love dividend stocks. They provide truly passive income as you simply need to hold them in your portfolio and then watch as the dividend checks come rolling in.

Opt to have these payouts automatically reinvested, and you can amplify your returns by collecting more shares that then deliver ever-increasing income. Repeat this process over decades, and you give yourself a great chance at building an impressive income stream.

Yet picking individual dividend stocks can be hard, and owning shares of just a few businesses can expose you to greater risk if one or more of them suffer big declines. That’s why many income-seeking investors prefer an exchange-traded fund (ETF) that targets dividend stocks. You can achieve passive income and wide diversification with just one purchase.

An excellent example is the Vanguard High Dividend Yield ETF (VYM).

Why it works
The fund owns some of the highest-yielding large-cap stocks on the market — 451 in total — which allows it to stand out from other popular index funds like the Vanguard Total Stock Market ETF. A high dividend is one of its main criteria, making its sector weighting look much different than that of other types of funds.

Targeting yield means the Vanguard High Dividend Yield ETF counts the financial sector as its single biggest industry with 21.8% of the fund’s holdings, followed by industrials (12.4%) and then consumer staples (11.9%). The tech industry (9.3%) is far less represented in this ETF than you see in other popular funds.

That’s good news for investors who already have exposure to the “Magnificent Seven” stocks that dominate many other index funds.

You’ll also get some excellent income starting from day one. The Vanguard High Dividend Yield ETF pays out 3.0% annually, or more than double the 1.4% yield you would get from an S&P 500 index fund. So invest $5,000 in the ETF, for example, and you can expect $150 per year of passive income.

Costs and strategy
As is common with Vanguard ETFs, this one is available at an extremely reasonable price. Because it’s a passive fund built to track the FTSE High Dividend Yield Index, it avoids the expenses that come with a high-paid portfolio manager making decisions about what to buy or sell. The ETF features a low expense ratio of 0.06%, while other dividend ETFs may charge fees of 0.5% or more, eating away at your long-term returns.

Yet there are still risks to keep in mind. The biggest is the fact the Vanguard High Dividend Yield ETF is weighted away from tech growth stocks and toward established companies in mature industries. That means the fund will tend to underperform during rallies like the one investors have seen in the past year. The ETF offered a total return of just 6.6% in 2023 versus 26.3% for the S&P 500.

On the flip side, it tends to outperform during downturns like the 2022 bear market. That year, the S&P 500’s total return sank 18.1% while the Vanguard High Dividend Yield ETF ended the year flat. Consider it a more defensive option that delivers income and stability.

It might fit best in a portfolio that carries a few high-growth stocks or one that has exposure to a growth ETF like the Vanguard Growth ETF. Having both of these funds on your side can ensure you get the best mix of capital appreciation and dividend income.

— Demitri Kalogeropoulos

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Source: The Motley Fool