Could Buying the Vanguard Dividend Appreciation ETF Today Set You Up for Life?

Key Points

• The Vanguard Dividend Appreciation ETF largely uses dividends as a screening tool, not as a way to identify income opportunities.

• The exchange-traded fund specifically avoids the highest-yielding stocks.

• If you have a long time horizon, the Vanguard Dividend Appreciation ETF could be a solid choice for your portfolio.

• 10 stocks we like better than Vanguard Dividend Appreciation ETF ›

The Vanguard Dividend Appreciation ETF (NYSEMKT: VIG) has a name that might confuse some investors. It includes the word "dividend," which makes it seem like it could be an income-focused exchange traded fund (ETF). But it also includes the word "appreciation," which suggests something entirely different. In the end, something entirely different is what you get -- but that's not necessarily bad if you have a lifetime of investing ahead of you. Here's what you need to know.

What does the Vanguard Dividend Appreciation ETF do?

As far as exchange-traded funds go, the Vanguard Dividend Appreciation ETF is fairly simple to understand. It tracks the S&P U.S. Dividend Growers Index. That index starts by only looking at the companies that have increased their dividends for at least 10 years. It then eliminates the highest-yielding 25% of the stocks and buys the rest using a market cap weighting methodology.

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Image source: Getty Images.

Thinking the selection process through highlights a few key factors. First, this is not an income-focused ETF, since it specifically removes the highest-yielding choices from the mix. But that makes sense, too, since the highest-yielding stocks are also likely to be the ones facing financial difficulty or the ones that tend to be slow-growing.

Second, by biasing the ETF toward the lowest-yielding stocks, the Vanguard Dividend Appreciation ETF is likely going to be focused on companies with more of a growth flare. Indeed, the fastest-growing companies often have the lowest yields, even though they may also have the fastest-growing dividends.

Third, the Vanguard Dividend Appreciation ETF is a growth ETF that uses dividends to screen for stocks. After all, getting to a decade of dividend hikes is a pretty impressive feat. This simple bar likely eliminates a lot of lower-quality investment options even before the highest-yielding 25% of the eventual candidates gets tossed out.

VIG data by YCharts

What are you really getting with the Vanguard Dividend Appreciation ETF?

As the chart above highlights, the Vanguard Dividend Appreciation ETF is delivering a generally growing dividend over time. And it is delivering a generally rising share price. So it offers income growth and capital appreciation. That's not a bad combination, especially if you are still fairly young and have a long time before you will need to tap your nest egg. Indeed, if you start early enough and hold on long enough, the dividend growth here could actually end up providing you with a fairly substantial income stream in the future.

You are also getting an easy-to-understand investment, since the index the Vanguard Dividend Appreciation ETF tracks is far from being complex. The cost is also easy to appreciate, given the expense ratio is a modest 0.05%. Essentially, the ETF isn't doing a lot of heavy lifting in the stock selection process, but you aren't paying a lot, either.

What you definitely aren't getting here, however, is a huge income stream today. The ETF's dividend yield is around 1.7%. That's higher than the 1.2% you'd collect from an S&P 500 index (SNPINDEX: ^GSPC) clone. But if you are looking to maximize the income you generate from your portfolio right now, well, there are far better choices out there. This highlights that the word "appreciation" is far more important with this ETF than the word "dividend."

The Vanguard Dividend Appreciation ETF does what it sets out to do

All in, if you are looking to maximize the income you generate today, buying the Vanguard Dividend Appreciation ETF will set you up to be disappointed. However, if you have a long time horizon, the mix of capital appreciation and dividend growth here could set you up for a solid outcome when you eventually retire.

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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 Dividend Appreciation ETF. The Motley Fool has a disclosure policy.