VYM - VYM ETF: The Tailwinds Outweigh The Headwinds

2023-10-11 10:02:12 ET

Summary

• VYM's screening mechanism is rather shallow and it could do with supplemental screeners.
• However, VYM's volatility profile is rather low and it has performed well off late in the face of harmful volatility.
• Valuations look cheap and we like the risk-reward on the charts even if this product appears to be a trading play for the last couple of years.
• VYM's top exposure is towards the financial sector, which could be susceptible to a lower threshold of distributions given higher capital requirements.

ETF Snapshot

Investors on the lookout for cheap access (expense ratio of just 0.06%) to a diversified pool of high-yielding US stocks may consider the Vanguard High Dividend Yield Index Fund ETF Shares ( VYM ), a $47bn sized passively managed product that has been around for close to 17 years.

Even though this product currently tilts towards large-caps (three-fourth of the portfolio), note that VYM's constituents are initially procured from an all-cap universe- The FTSE US All Cap Index. Stocks that either currently don't pay a dividend or those that are not expected to pay a dividend over the next 12 months are weeded out (also note that during the quarterly review, constituents that give up their dividends will be taken out immediately); REITs too don't make the final cut. Eventually, the stocks that make the cut (currently there are 465 names) are selected on the basis of the forward yield (the 1-year DPS forecasts as a function of the share price).

Some Commendable Qualities, But Screening Mechanism Could Be Better

Since VYM is basing it selection purely on the forward yield (which in turn is a function of the current yield), and does not consider a supplemental screener such as the longevity of the dividend track record (stocks with a long history of paying dividends are loathe to renege on this and would rather make downward adjustments with buybacks and M&A spend), there's an element of risk involved, as it could be signing up for stocks that maybe witnessed a bumper one-off year, and chose to be generous by paying out a special dividend which may not necessarily be repeated.

As we also saw during the initial pandemic days, a lot of companies can be quick to slash or trim their distributions in the blink of an eye, and over the next 12 months a lot can happen, when the cost of borrowing will be at a consistently elevated threshold, curtailing the elbow room with which ample distributions can be facilitated.

However, so far, VYM's relatively shallow screening mechanism hasn't proved to be too troublesome (in terms of frequent churn) as exemplified by an extremely low turnover ratio of 9% . This relative stability of the portfolio implies that not too many stocks have turned out to be shockers in terms of their distribution plans. We also appreciate the fact that this is not a top-heavy portfolio with the top 10 stocks accounting for just a quarter of the total portfolio.

VYM should also be commended for the fact that its risk profile is relatively low, and it also fares quite well when risk sentiment turns for the worse. Compared to the total market, note that its rolling volatility profile has been lower by 200bps.

Meanwhile, over the last 3 years, when faced with harmful volatility, VYM has fared exceedingly well relative to the total stock market. The Sortino ratio provides some context on the ability of a portfolio to facilitate excess returns (over the risk-free rate) while considering only downside deviations, and note that VYM's ratio has been well over 1x, much better than VTI.

Should You Buy VYM Now?

If you're contemplating a position in VYM, here are a few important themes that may help you with your decision.

Those who've followed our work in recent years will note that we tend to gravitate to trades that offer decent scope of positive mean reversion, and in that regard, VYM has a few things going for it.

Firstly, note that this is essentially a value-themed ETF, and we think that after having nearly mean-reverted to the mid-point of its long-term range at the start of 2023, the opportunity for value stocks to gain ahead of growth stocks has opened up once again, with the value-to-growth ratio dropping off by another 27% in recent months.

It isn't just value stocks, even the entire VYM portfolio looks a tad oversold (admittedly, not as enticing as it was in late 2021/early 2022) relative to the total markets, and could perhaps benefit from some rotation interest.

VYM's case could be abetted by the fact that its valuations are currently quite attractive. According to Morningstar, the portfolio is currently priced at only 13.6x P/E, which translates to a 25% discount over the total stock market. Considering this is a dividend theme, one also needs a decent yield to get in, and we believe the current figure of 3.28% is relatively decent, as it is not only around 67bps better than the median rate of all ETFs, but it is also around 16bps better than VYM's own 4-year average.

Then if we look at VYM's weekly chart, it appears that this has become more of a trading play since the turn of 2021. Basically, the ETF has chopped around within a certain range, and what we're currently seeing is a narrowing of the range, as exemplified by the slope of the two black lines which appear to be converging.

VYM may well break out from this range at some stage, and we think it would make better sense to buy in at the lower end of the range, which is not far from where the price is currently (rather than buying close to the upper boundary).

Interestingly enough, last week we saw a hammer candlestick, right at the end of the lower boundary, which reflects some degree of bargain hunting. Nonetheless, even if VYM is unlikely to break out from this range, even as a trading play we think an entry at current levels offers good risk-reward as VYM is currently around ~7% off the upper boundary and ~3% off the lower boundary.

Financial Sector Exposure Risk

If there's a slight risk to be mindful of, it would perhaps be VYM's exposure to the financial sector (a fifth of the total holdings, making it the largest sector exposure). Financial stocks have been a relatively dependable source of dividends for years, but considering this is a large-cap tilted play, investors may want to be mindful of the fact that large banks may increasingly have lesser capital to distribute to shareholders as the US Fed wants them to set aside additional capital relative to their risk-weighted assets. Granted, these banks will have time to make adjustments, but if one erodes the long-standing distribution facet of financial stocks, we think this sector may find it difficult to attract ample shareholder interest.

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