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How Vanguard High Dividend Yield Protects Against Payout Risk

Dividend investors like stocks that pay high yields, and the Vanguard High Dividend Yield ETF (NYSEMKT: VYM) is designed specifically to appeal to investors who want to maximize the income they get from their stock portfolio. Yet high-yield dividend stocks can be dangerous, and often, the situations that push their dividend yields so high can result in their having to make painful dividend cuts. Vanguard High Dividend Yield hasn't been invulnerable to those cuts, but the ETF does take steps to lessen their impact. Through the diversification that the fund offers and the methodology that its investment managers follow, the negative impact from stocks that reduce their dividends isn't as great as it might otherwise be.

The risks of dividend cuts

Vanguard High Dividend Yield aims to own shares of stocks with above-average dividend yields. The FTSE High Dividend Yield index that the fund tracks identifies stocks that have higher-than-average dividend yields based on an all-inclusive market index.

Inevitably, that process results in choosing some stocks that have unsustainable dividend yields. A couple of cases in point recently have come from the telecom sector. Earlier this year, Frontier Communications (NASDAQ: FTR) made a steep dividend cut, reducing its quarterly payout by more than 60%. Frontier's board determined that a better balance between paying down debt, investing in the business, and returning capital to shareholders demanded the reduction. Even after the cut, the stock yields more than 15%, as a reverse split has depressed share prices further. Vanguard High Dividend Yield owned shares of Frontier before the cut and still did as of June 30.

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More recently, Windstream (NASDAQ: WIN) made a move to eliminate its dividend entirely. For years, the company had maintained its dividend even in the face of extreme skepticism among investors, who believed that high payout ratios compared to earnings would eventually necessitate a cut. Yet the company would argue that it simply replaced one way of returning capital to shareholders with another, as it instituted a $90 million stock repurchase program in place of the dividend. Nevertheless, shareholders reacted negatively to the news, and Vanguard High Dividend Yield investors also felt the pain.

How diversification helps Vanguard High Dividend Yield

One reason to own an exchange-traded fund is to get the benefit of diversification, and that's definitely the case with Vanguard High Dividend Yield. Even though Frontier and Windstream made big moves when they made their respective announcements, the impact on the Vanguard ETF's share price was almost invisible.

The fact that Vanguard High Dividend Yield is highly diversified is a big part of the reason why. The ETF holds more than 400 stocks, and even the top holdings only make up a few percentage points of the overall assets of the fund. For smaller companies like Frontier and Windstream, the holdings that the fund had in the two stocks are inconsequential. As of June 30, the ETF had just $1.73 million in Windstream stock, and Frontier represented just $3.84 million. For a fund with $25 billion in assets under management, even big share-price declines in those small positions won't have a marked impact on performance.

How methodology helps Vanguard High Dividend Yield investors

In addition, Vanguard High Dividend Yield ETF benefits from the fact that its underlying index makes efforts to predict potential dividend cuts. The index managers at FTSE implement what it calls a forecast dividend yield ranking process, which looks at trends in the underlying companies to predict what a company's dividend yield will look like in the future. Often, that results in an even more favorable outlook, because many stocks have long histories of consistently raising their dividend payments over time. However, in a few cases, high-yield dividend stocks reflect at least the potential risk of a substantial dividend cut. To the extent that the FTSE methodology accurately identifies potential dividend-cutters before they reduce their payouts, it lessens the impact on shareholders of the Vanguard High Dividend Yield ETF.

Dividend cuts are always a risk, and dividend ETFs will suffer the brunt of share-price declines when those cuts come. For investors in Vanguard High Dividend Yield, the risk of a major dividend cut is always present, but the fund's efforts to protect shareholders from the worst of potential losses certainly help.

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Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.