Why This Vanguard ETF Doesn't Belong in Your Portfolio

Vanguard has developed a pristine reputation on Wall Street from its conservatively run business model and lineup of cheap investment products. The company is currently the second-largest exchange-traded fund (ETF) issuer in the world with managed assets of more than $4 trillion. At its current pace, it could top BlackRock for the No. 1 spot within the next year or two.

Vanguard currently offers more than 100 ETFs, most of them with expense ratios of 0.1% or less. That could lead most people to believe that all of Vanguard's ETFs are a smart choice, but they would be wrong.

Granted, most of them are. The ETFs focused on simply offering broad coverage at the market, sector, or geographic level probably fit the bill. The ones that use a selective strategy need to be examined more closely.

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One the funds I'm least impressed with is the Vanguard High Dividend Yield ETF (NYSEMKT: VYM). It's the third-largest dividend ETF with more than $72 billion in assets. It has an expense ratio of just 0.04% (which was recently lowered as part of another broad fee reduction at Vanguard), making it one of the cheapest funds in the category. The yield of 2.3% is more than double that of the S&P 500. It seems on the surface to check many boxes.

So what's wrong with the Vanguard High Dividend Yield ETF?

A bland and lax selection methodology

This fund tracks the FTSE High Dividend Yield Index, which consists of companies that pay an above-average dividend yield. That sounds good at a high level, but here's where it falls apart.

The definition of "high yield" is too loose

Starting with an all-cap universe of stocks, it ranks all of them according to indicated yield over the next 12 months and selects the highest 50% of yields for inclusion. That means if the average is 1.5%, this ETF would consider 1.51% as "high yield" and eligible for inclusion.

In my opinion, a high-yield strategy needs to be more selective. Either narrow the number of stocks that qualify or put some kind of floor on which yields qualify. Either way, the current strategy is far too bland and inclusive.

An extraordinarily large number of holdings

This ETF holds more than 500 stocks. Listen, diversification is a good thing, but it can also dilute a portfolio and a strategy if it's overdone.

There really shouldn't be 500 stocks that qualify as "high yield." This is essentially an extension of the point I made earlier. Be more selective, narrow down the universe of potential stocks, and make this more of a true high-yield portfolio.

The removal of real estate investment trusts (REITs)

Many REITs would qualify as high yield and offer yields of 4% or higher. Eliminating them right off the bat can make some sense from a volatility and quality standpoint. But it also eliminates the potential of giving this portfolio a boost in yield.

Market cap-weighting the portfolio

This is perhaps the most egregious part of the Vanguard High Dividend Yield ETF's strategy. Its use of cap-weighting doesn't emphasize dividend quality, history, or yield at all. The fund's willingness to include hundreds of stocks waters down the portfolio enough. Giving the biggest weights to the largest companies waters it down even further.

I'm not a big fan of pure yield-weighting a portfolio. That should be paired with a quality component to act as a cross-check. But even straight-up yield-weighting would be a better option than cap-weighting. At least you'd make the portfolio truer to its mission.

In summary, I'm not a big fan of this particular ETF. I believe some of the best dividend ETFs available do a better job of creating a targeted, well-thought-out strategy. Therefore, I would recommend keeping this ETF out of your portfolio. Vanguard does a lot of things right, but this fund really isn't one of them.

David Dierking has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard Whitehall Funds - Vanguard High Dividend Yield ETF. The Motley Fool recommends BlackRock. The Motley Fool has a disclosure policy.