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This Vanguard Dividend Fund Still Solid Despite Downgrade

Silver-rated Vanguard Dividend Appreciation provides investors with a diversified portfolio of highly profitable U.S. dividend-paying stocks.

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The following is our latest Fund Analyst Report for Vanguard Dividend Appreciation Index Adm (VDADX). Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.

Vanguard Dividend Appreciation offers a diversified portfolio of highly profitable U.S. dividend-paying stocks. Its focus on dividend growth gives it a quality bent, which should help it weather downturns better than its large-blend Morningstar Category peers. In combination with its cost advantage relative to its category competition, this defensive tilt should help it outperform the Russell 1000 Index over the long term. However, it applies a stringent dividend growth screen, which may preclude it from owning high-quality emerging dividend stocks. We are downgrading the fund's Morningstar Analyst Rating to Silver from Gold, as we think the fund’s process is solid--just not best in class.

The fund fully replicates the Nasdaq U.S. Dividend Achievers Select Index. The index is designed to provide exposure to high-quality dividend-paying U.S. stocks with a history of increasing dividend payments. It selects stocks from its parent index, the Nasdaq U.S. Broad Dividend Achievers Index. It further winnows the field by putting those names through a proprietary quality screen after excluding REITS and limited partnerships. What comes out the other end is a well-diversified portfolio of high-quality, dividend-paying companies. The fund’s quality bent is evidenced by its higher return on invested capital compared with the Russell 1000 Index.

The fund weights its holdings by market cap, which helps further keep risk in check. Market-cap weighting tilts the portfolio toward the largest dividend-paying stocks. Bigger firms should be better able to maintain their dividend payments during a market downturn than their smaller counterparts.

The fund’s low fee gives it a durable edge versus the competition. The exchange-traded fund share class charges 0.06%, while the Admiral share class charges 0.08%, which is among the lowest of all funds in the large-blend Morningstar Category.

Process | Above Average 
This fund targets dividend-paying U.S. stocks that have increased their dividend for at least 10 years running. This stringent screen restricts the portfolio to high-quality stocks, which should enable it to weather downturns better than peers. This should give it an edge versus the index over the long haul. These considerations support an Above Average Process Pillar rating.

It tracks the Nasdaq U.S. Dividend Achievers Select Index. This is a subset of the Nasdaq U.S. Broad Dividend Achievers Index, which holds U.S. stocks that have grown their regular dividend payment for at least 10 consecutive years. From this broader list, the fund excludes REITs and limited partnerships and applies proprietary profitability screens to land on its final list. Nasdaq does not disclose its screens, but these filters seem to favor profitable companies with stable earnings.

By including names that pass the screen, it favors firms with durable competitive advantages and shareholder-friendly management teams that should weather downturns better than most. These firms are more likely to continue paying dividends than those that have cut or suspended dividends in the past; it does not guarantee that these stocks will maintain dividend payments.

It weights holdings by market cap, and individual positions are capped at 4% of the portfolio during quarterly rebalancing. The index reconstitutes annually in March; stocks with deteriorating fundamentals may be dropped at any time.

As of March 31, 2020, the fund held 187 stocks, the top 10 of which accounted for about 37% of its portfolio. The largest holding accounted for 5.8% of the portfolio. Top holdings include steady dividend-growing companies such as Walmart (WMT), Costco (COST), and Procter & Gamble (PG).

Like other dividend funds, the portfolio’s composition is different from traditional core benchmarks like the Russell 1000 Index. While no stock can represent more than 4% of the index at quarterly rebalancing, the fund has no sector constraints. If a company doesn't continue to raise its dividend, it is out of consideration for at least a decade. This can lead to large sector bets. As of this writing, the fund is overweight industrials and consumer defensive stocks and underweight technology names.

The fund’s small-cap bias relative to the category average speaks to the makeup of its selection universe, the Nasdaq U.S. Broad Dividend Achievers Index, which consists of large- and mid-cap stocks. That said, its market-cap profile is similar to the Russell 1000 Index. When smaller stocks lag larger stocks, it may present this fund with a performance headwind against most of its peers.

People | Above Average 
This fund is managed by a talented team of portfolio managers who employ a team-based approach to portfolio management. The extensive experience and strong trading infrastructure merits an Above Average People rating.

Walter Nejman and Gerard O’Reilly manage this fund. They took over the fund in May 2016 from Ryan Ludt, who had been the sole manager here since the fund’s inception in April 2006. O’Reilly joined Vanguard in 1992 and has been a portfolio manager since 1994. Nejman joined Vanguard in 2005 and has been working in investment management since 2008.

Index portfolio management at Vanguard is a team effort. Often one person takes responsibility for a single corporate action across all portfolios. Other portfolio managers are available to back up listed portfolio managers in their absence. At Vanguard, the portfolio management and trading functions are executed by the portfolio manager, which gives the managers a deeper understanding of the portfolio holdings than a dedicated trader might have.

The managers are supported by an Index Analytics team that communicates with index providers and researches upcoming changes to the underlying index. It briefs the portfolio managers, enabling them to focus solely on portfolio management and trading. Members of the Index Analytics team have been promoted by Vanguard to portfolio management and trading.

Parent | High 
The Vanguard Group entered a new era in early 2019 with the passing of its founder and conscience, John C. Bogle. Unlike its mid-1970s origins, when outflows were the norm and its survival was in question, Vanguard now wears the crown as the world's biggest retail asset manager. More than 90% of its USD 5.6 trillion in global assets under management, as of June 2019, are in the United States; but the firm has designs to grow its non-U.S. business, especially in the United Kingdom, Australia, Canada, Japan, China, and Mexico.

Vanguard gained its stature by following Bogle’s playbook: pairing relatively predictable strategies, both passive and active, with minimal costs. That’s enriched Vanguard’s investors, and those outside its flock who have benefited from industrywide fee compression. While Vanguard’s passive business now faces stiff price competition from its biggest rivals, inflows into its U.S. strategies still dominate.

Not content, Vanguard aims to transform investment advice, too. In May 2015, it launched Personal Advisor Services, a burgeoning discretionary asset-management business that pairs automation and human advice; and in September 2019 it disclosed plans to launch a digital-only counterpart. Vanguard’s industry leadership readily merits a High Parent rating, but the firm must stay on its guard to prioritize investor interests over merely expanding its kingdom.

Performance 
From its April 21, 2006, inception through April 25, 2020, the fund’s ETF share class outperformed the Russell 1000 Index by 28 basis points on an annualized basis while experiencing lower risk. Better stock selection and an overweight to basic materials and industrials stocks contributed to performance, as did an overweight to consumer defensive names. On the other hand, being underweight technology stocks hampered performance. Poor stock selection and an overall underweight to communication services stocks further detracted from the fund’s performance relative to the Russell 1000 Index.

The fund ranked in the top 5% of the large-blend category over the trailing five years through March 2020, outperforming the category average while exhibiting lower volatility. From its inception in April 2006 through March 2020, the fund also has tended to hold up better than most of its category peers, as evidenced by its lower downside-capture ratio. This owes to its quality tilt; quality stocks tend to hold up better in downturns.

This portfolio is always fully invested, which helps its category-relative performance during bull markets but could hurt in bear markets. As of the end of March 2020, the fund had 0.17% of its portfolio sitting in cash versus 2.64% for its average large-blend peer.

Price 
It’s critical to evaluate expenses, as they come directly out of returns. The share class on this report levies a fee that ranks in its Morningstar category’s cheapest quintile. Based on our assessment of the fund’s People, Process and Parent pillars in the context of these fees, we think this share class will be able to deliver positive alpha relative to the category benchmark index, explaining its Morningstar Analyst Rating of Silver.

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Venkata Sai Uppaluri does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.