(PUB) Investing 2016

9

July 2016

Morningstar FundInvestor

High Dividend Yield Index, which is available through Vanguard High Dividend Yield ETF VYM , served as the benchmark for the income group. We used a blend of the two indexes for the income and growth group. Fees largely explain the low success rates among the surviving funds. Gross of fees, these success rates were considerably higher. It is difficult to select managers who can overcome their fees and improve performance through fundamental analysis. However, we set the bar high by using indexes rather than index funds, as index funds would be after an expense ratio, too. All the funds that did outperform had lower-than- average fees and tended to hold up better than most of their peers during market downturns. This suggests that strong risk management and reasonable fees are critical for success for dividend investors of all stripes. Fund Selection To illustrate the importance of low fees, we divided each of the three U.S. dividend strategy groups into three fee subgroups from cheapest to most expensive. We then tracked the performance of each fee group, reconstituting the groups at the end of each year. Among dividend growth funds, the cheapest cohort outpaced the most expensive by 2 . 1 percentage points per year. Cheaper dividend income and growth- income groups also prevailed over their more expen- sive counterparts. Here, the corresponding return spreads between the cheapest and most expensive cohorts were 114 and 60 basis points, respectively. Investors can gauge risk by comparing a fund’s perform- ance against an appropriate benchmark during market downturns and by monitoring the valuations, profitability, and dividend payout ratios of its hold- ings. Vanguard Dividend Growth VDIGX and American Century Equity Income TWEIX were among the best performers in down markets over the past decade in the dividend growth and dividend income groups, respectively. For those who don’t wish to select and monitor active managers, Vanguard Dividend Appre- ciation ETF and Vanguard High Dividend Yield ETF are good baseline U.S. dividend growth and income strategies, respectively. These index funds both charge a low 0 . 09% expense ratio. K Contact Alex Bryan at alex.bryan@morningstar.com

Exhibit 1 U.S. Dividend Funds: Portfolio Snapshot

Beta

ROIC % (TTM) (Long)

Historical Dividend Growth%

01/01/2011 to 12/31/2015

Dividend Yield % P/B

Forward P/E

Dividend Payout%

Wide Moat

Name

Dividend Growth

2.53 2.50 16.76 0.42

13.3 15.87 45.68

0.96 0.93 0.85 1.00

Dividend Growth and Income

3.17 2.17 15.86 0.50 12.44

5.66 43.96

Dividend Income

3.98 1.99 16.03 0.64 10.37 -1.96 36.06 2.22 2.35 17.38 0.39 12.48 12.18 48.49

Vanguard Large-Cap ETF

Source: Morningstar, Inc. Data as of 12/31/15.

rate than Vanguard Large-Cap ETF VV . Dividend growth funds also boasted the highest ROIC and greatest exposure to wide-moat stocks of the three groups. These strong and durable profits can potentially fuel future dividend growth. Performance Despite differences in their portfolios, we didn’t find a huge difference in performance among the three groups from January 2006 through December 2015 . During that time, the dividend income strategy group outpaced the dividend growth group by a small margin ( 49 basis points annualized), with comparable volatility. This result is interesting because large- value stocks underperformed over this period and income-oriented funds tended to have greater expo- sure to these stocks. However, these long-term averages mask short-term variability in relative performance. The return gap between the income and dividend growth funds was larger over shorter horizons. For example, the divi- dend income group outpaced the dividend growth group by 1 . 9 percentage points annualized from January 2006 through December 2011 . But dividend growth funds outperformed income funds by 1 . 8 percentage points from that point through December 2015 . Dividend growth funds also tended to hold up a little better during the bear market from October 2007 through February 2009 , beating their income counter- parts by 1 . 4 percentage points annualized. Overall, one approach isn’t uniformly better than the other. Very few funds in any of the groups beat corresponding market-cap-weighted dividend benchmarks. We used Nasdaq U.S. Dividend Achievers Select Index to benchmark dividend growth funds. Vanguard Divi- dend Appreciation ETF VIG tracks that index. FTSE