VYM Is a Popular Dividend ETF for Passive Income. But Is It the Best?

Key Points

• The Vanguard High Dividend Yield ETF has $70 billion in assets.

• The exchange-traded fund says it is focused on high income, but the yield is modest at 2.8%.

• The ETF is offering investors more than yield.

The Vanguard High Dividend Yield ETF (NYSEMKT: VYM) is a great example of why investors need to examine more than just the name of an exchange-traded fund (ETF) before hitting the buy button. Dividend yield is an important part of the story here, but the real benefit of this ETF actually lies elsewhere.

Here's what you need to know about the Vanguard High Dividend Yield ETF before you buy it for passive income.

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What does the Vanguard ETF do?

Just going by the name might lead you to believe that this ETF is all about dividend yield. And yet the yield is fairly modest at just 2.8%. To be fair, that's more than twice what you would collect from an S&P 500 index fund, but there are other exchange-traded funds with much higher yields that you could buy.

Image source: Getty Images.

The truth is, the use of "dividend yield" in the name is simply signaling that yield is an integral part of the screening process. And that process is what investors need to fully understand before buying the Vanguard High Dividend Yield ETF. It's actually pretty simple.

In reality, the ETF tracks the FTSE High Dividend Yield index. So what the index does, the ETF is basically doing, too.

First, it creates a list of all dividend-paying companies on U.S. exchanges. Then it arranges that list by yield, from highest to lowest. Step three is to select the top half of that list in terms of yield for inclusion in the index. The last step is to weight the stocks by market cap, so the largest companies have the biggest impact on the Vanguard High Dividend Yield ETF's performance. All of that comes for a very modest expense ratio of 0.06%.

Data by YCharts.

So if the Vanguard ETF buys high-yield stocks, what's the problem?

At this point, you may be wondering what the issue is since the ETF's selection process is focused entirely on dividend yield. The key step that is easy to overlook is the first one. The Vanguard ETF's fishing pool is gigantic, which leads to a very large portfolio. It currently owns over 550 stocks (more than the S&P 500!), which is a gigantic number and shows that the selection process may be a bit indiscriminate.

With that many stocks, the Vanguard High Dividend Yield ETF has no choice but to move lower and lower down the yield spectrum as it adds to the portfolio. Every added "lower" yielding stock reduces the overall yield that the ETF can provide to investors. So if you are specifically trying to highlight yield, this ETF probably won't be the best fit for your portfolio.

Data by YCharts.

That said, what the Vanguard ETF does very well is provide diversification, given the huge number of stocks in the portfolio. For conservative dividend investors who might otherwise buy an S&P 500 index tracker, the Vanguard High Dividend Yield ETF could be a solid alternative. However, it won't fully maximize the income your portfolio generates. For that, as the chart above highlights, you'll need to look elsewhere.

A solid foundation, but perhaps not the "best" passive income ETF

There's nothing inherently wrong with the Vanguard High Dividend Yield ETF. It does exactly what it sets out to do: buy a large and diverse list of higher-yielding stocks. The real question is whether or not that is what you want for your portfolio.

If income generation is your primary goal, this ETF will probably leave you feeling shortchanged. But if you want diversification with a bias toward income, well, it could be just right.

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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 Whitehall Funds - Vanguard High Dividend Yield ETF. The Motley Fool has a disclosure policy.