This ETF Pays You Now -- and Pays You More Later

Exchange-traded funds focus on many different corners of the market. You can find ETFs that match popular indexes like the S&P 500 or Nasdaq 100, and they generally do a good job of doing whatever their respective benchmark does. You can also find ETFs that track other types of investments, such as precious metals or cryptocurrencies, again with the goal of matching the performance of their target asset.

Another benefit of ETFs is that you can generally find funds that are designed to match up with a specific investing style. In particular, dividend ETFs have become extremely popular, as there are many ways to find stocks that pay shareholders regularly through dividends. For investors who need or want income from their portfolios, dividend ETFs can be a great addition.

Not every dividend ETF is set up the same way, though. That's why, as part of this month's examination of exchange-traded funds for the Voyager Portfolio, you'll be learning more about how Vanguard Dividend Appreciation ETF (NYSEMKT: VIG) does things a little differently from many of its peers in the dividend ETF universe.

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Avoiding the high-yield dividend trap

For many income investors, the advent of dividend ETFs made it possible to invest in a diversified basket of dividend-paying stocks with the maximum possible yields. Compared to broader stock indexes like the Nasdaq 100 or S&P 500, these ETFs paid out much more in income, allowing those who rely on getting money from their investment portfolios to do so without selling off assets.

However, the problem with focusing solely on high-yield dividend stocks is that investors face heightened risks. Often, the reason a stock's dividend yield rises is that its price has fallen dramatically due to business challenges, yet it hasn't made any adjustments to its quarterly dividend payment. Companies can occasionally bounce back from a difficult situation and sustain its dividend going forward. On numerous occasions, though, such companies eventually have to cut their dividends. That often leads to a double-hit for investors: not only do they lose their income, but the share price of the stock often falls dramatically following an announcement that the company is reducing or eliminating its dividend.

Less now, more later

Instead, the Vanguard Dividend Appreciation ETF follows a different philosophy. Instead of trying to maximize its current yield for investors, the Vanguard dividend ETF concentrates on investing in stocks that have demonstrated a track record of raising their dividend payments to shareholders over long periods of time.

In particular, the index that the Vanguard ETF tracks stocks that have increased their dividends on an annual basis for at least 10 straight years. It also excludes real estate investment trusts from consideration. That has an impact because REITs are required to distribute the vast majority of their income in the form of dividend distributions to obtain favorable tax status, so they often are among the highest-yielding stocks listed on U.S. markets.

The methodology that Vanguard Dividend Appreciation ETF uses specifically avoids problems as well. In addition to the requirement for regular dividend increases, the ETF automatically eliminates the highest-yielding 25% of stocks. This mechanical process isn't perfect, as it excludes some companies that would likely be OK and leaves in some that still have the potential to become dividend traps. Nevertheless, it's a simple and generally effective way of dramatically reducing the risk of including stocks that are more likely to perform poorly.

The proof is in the payments

Long-term investors can appreciate the value of deferring immediate gratification in order to get better results over time. But do the numbers bear that out? In the second article of this three-part series on Vanguard Dividend Appreciation ETF for the Voyager Portfolio, you'll get a closer look at how this fund has actually stood up against its dividend ETF peers.

Dan Caplinger has positions in Vanguard Dividend Appreciation ETF. The Motley Fool has positions in and recommends Vanguard Dividend Appreciation ETF. The Motley Fool has a disclosure policy.