Better Buy: The Vanguard 500 ETF or the Vanguard High Dividend Yield ETF

Investors who want to track "the market" have one very clear choice: a fund that tracks the S&P 500 (SNPINDEX: ^GSPC). The index has become the de facto market gauge for U.S. stocks. But what if your goals are a bit different from just equaling the market's performance? There are a lot of options out there, but if you are an income investor, one possibility is the Vanguard High Dividend Yield ETF (NYSEMKT: VYM). Here's a look at why buying this exchange-traded fund instead of the Vanguard 500 ETF (NYSEMKT: VOO) could be a good call, but also why it might still leave you short of your goals.

What does the S&P 500 index do?

While the S&P 500 index is used to track stock market performance, that isn't its actual goal. The S&P 500 index is a curated list of 500 of the largest companies in the U.S. -- a set of businesses that the committee believes are representative of the U.S. economy. A few of those companies have more than one type of share class, so technically, there are 503 stocks in the index. It's market-cap weighted, meaning that larger companies account for proportionally larger shares of its value, and therefore have the biggest impacts on the index's performance. That's pretty much how the economy works, as well.

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All in all, the Vanguard 500 ETF is a pretty reasonable way to invest if you want to keep things simple. And its ultra-low 0.03% expense ratio is very attractive and lower than some other S&P 500 index tracking options. Investors would not be making a mistake buying Vanguard 500 ETF. That said, your investment goal might not be to simply track the market.

What does Vanguard High Dividend Yield ETF do?

Income investors focus less on the prospect of share price growth, and more on the goal of finding assets that will regularly and reliably distribute funds to shareholders. It's a common investment theme, particularly among retired investors, who are often using the dividends their portfolios generate to cover much of their living expenses. The Vanguard High Dividend Yield ETF's goal is, basically, to buy higher-yielding U.S. stocks. And, interestingly enough, it, too, owns roughly 500 stocks. The dividend yield on the Vanguard 500 ETF is around 1.3%, while the yield of the Vanguard High Dividend Yield ETF is a much higher 2.9%. So income investors might find it an attractive alternative.

VOO Total Return Price data by YCharts.

The portfolio's construction is fairly simple. The fund managers of the Vanguard High Dividend Yield ETF start by taking all of the dividend-paying companies that trade on U.S. exchanges. They then select the 50% of the list with the highest yields. The fund's holdings are market cap weighted. Its expense ratio of 0.06% is a bit higher than the Vanguard 500 ETF's, but most income investors probably won't stress out about that given its dramatically higher yield.

A viable switch despite diverging performance

The long-term total return graph above for the two exchange-traded funds is interesting. It clearly shows that the Vanguard 500 ETF has outperformed the Vanguard High Dividend Yield ETF over the longer term. But notice that the real divergence happened after the 2020 bear market that was triggered by the onset of the coronavirus pandemic. That was when the performance of a small number of megacap growth companies started to dominate the S&P 500 index's overall performance. Before that, the large number of stocks that both indexes had in common resulted in them trading in similar fashion.

VOO Total Return Price data by YCharts.

If you are an income investor, the current period of underperformance coming out of the latest bear market is probably the anomaly and not the norm. In fact, if you compare how the two ETFs fared in the year-to-date period -- a volatile time frame -- you'll notice that the Vanguard 500 ETF fell dramatically more sharply than the Vanguard High Dividend Yield ETF did as the tech stocks that had lifted the S&P 500 higher plunged. If you are a dividend investor looking for a broad-based index fund, the highly diversified Vanguard High Dividend Yield ETF would probably be a good replacement for Vanguard 500 ETF in your portfolio.

You can get more income than Vanguard High Dividend Yield ETF

The Vanguard High Dividend Yield ETF's strength is its large and diversified portfolio. But there's a trade-off that comes with that on the yield front. It owns so many stocks that the portfolio's overall yield gets diluted.

If yield is your key goal, you might be better off looking at an ETF like SPDR Portfolio S&P 500 High Dividend ETF (NYSEMKT: SPYD), which buys the 80 highest-yielding stocks from within the S&P 500 index. It has a roughly 4.5% yield. Just go in knowing that if you make this choice, you're giving up a large piece of the diversification safety net that both the Vanguard 500 ETF and the Vanguard High Dividend Yield ETF provide. Choosing the Vanguard High Dividend Yield ETF allows you to keep the high degree of diversification and still reap a more attractive income stream than the S&P 500 index offers.

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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard S&P 500 ETF and Vanguard Whitehall Funds-Vanguard High Dividend Yield ETF. The Motley Fool has a disclosure policy.