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

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

What does the Vanguard High Dividend Yield ETF do?

The Vanguard High Dividend Yield ETF makes things simple. The first step in creating your portfolio is to look at all dividend-paying stocks. It removes real estate investment trusts (REITs) from the list. It then determines the returns of the remaining stocks and buys stocks in the top 50% of the list, ranked by their returns.

Apart from eliminating REITs, a sector known for high returns, this is very simple and understandable. It also clearly focuses the portfolio on high yielding stocks.

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

Is it really much? The answer comes from a comparison with S&P 500 index, which is generally considered to be representative of the market. Using Vanguard S&P 500 ETFs (VOO -1.67%) By 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 almost three times the exposure to utilities and about 60% more exposure to finance.

Large portfolio differences can lead to large performance differences

There’s another interesting difference here, with the Vanguard High Dividend Yield ETF’s technology exposure of 10.7% versus the Vanguard S&P 500 ETF’s 31.4%. Not surprisingly, the High Dividend Yield ETF remained lagged the S&P 500 as tech stocks soared. Additionally, rising interest rates have been a problem for utilities and finance companies for a bit.

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Utilities are capital intensive and tend to use debt materially, so higher interest rates mean higher operating costs. Meanwhile, financial stocks have to deal with the negative impact of higher rates on customers’ ability to repay their loans and willingness to take out new loans, especially mortgages. But what happens when interest rates start to fall?

In a falling interest rate scenario, utilities and financials could suddenly start looking more attractive to investors (they’ve already started to rally from their lows). Utilities, as their costs will decrease, may increase earnings prospects; financially, because customers will be financially healthier and perhaps the demand for loans will increase.

If this leads to even higher stock prices, then the Vanguard High Dividend Yield ETF, because of its heavy weighting in these sectors, will benefit disproportionately from the broader market.

In other words, the Vanguard ETF could be on the verge of an outperformance when interest rates start to fall again. 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 that would be better for this. However, if you’ve been considering buying this ETF but have been put off by its lagging performance, falling interest rates could be a catalyst for better performance.

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