Battle of the Vanguard Dividend Funds: Does Active or Index Investing Win?

For years, Vanguard was at the leading edge of the mutual fund industry, with a heavy focus on index mutual funds, though it also offered a large selection of actively managed funds.

When exchange-traded funds (ETFs) were introduced, Vanguard quickly started to offer index-focused ETFs, which makes complete sense. However, there are often overlapping offerings in the company's mix.

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One of the most interesting is in the dividend growth camp, with the Vanguard Dividend Appreciation Index ETF (NYSEMKT: VIG) clearly overlapping with the niche of the Vanguard Dividend Growth Fund (NASDAQMUTFUND: VDIGX). Which is better?

The difference between an ETF and a mutual fund

Mutual funds are far older than exchange-traded funds. They are an easy way for individual investors to pool their money and hire professional money managers. This helps to keep the costs down for each individual investor and allows for material diversification in the portfolio that might not be possible otherwise.

Vanguard offers both index-based mutual funds and actively managed ones, where human beings make all of the day-to-day decisions.

Image source: Getty Images.

The one big caveat here is that a mutual fund can only be bought at the end of the trading day. This is because the net asset value (NAV) of the fund has to be calculated to determine the proper price.

It isn't a difficult process, simply requiring that the value of the portfolio be divided by the number of shares outstanding. However, that can't happen during the trading day because the values of each individual portfolio holding are constantly changing.

Exchange-traded funds address this problem in a unique way. Large shareholders of an ETF can be paid in kind by an ETF's sponsor, effectively receiving all of the underlying stocks. That creates an arbitrage opportunity if the ETF's price diverges too far from the value of the portfolio. And, thus, ETFs can trade all day and trade very close to their NAVs.

Although there are now actively managed ETFs, the core of the ETF world is index-based products where the portfolios don't change randomly. In fact, most index ETFs have very strict rules around portfolio construction and maintenance. That makes it easier for the structure to work.

With that background, which is better? The answer is probably "It depends," but a look at two Vanguard products with similar goals but very different managers provides some interesting food for thought.

Two dividend growth options at Vanguard

The Vanguard Dividend Appreciation Index ETF and Vanguard Dividend Growth Fund both seek to invest in stocks that increase their dividends over time. As the chart below highlights, over the long term, these two products have tracked fairly closely. But over the past year or so, performance has diverged a little bit, giving the ETF the edge.

VIG Total Return Level data by YCharts.

The Vanguard Dividend Appreciation Index ETF tracks the S&P U.S. Dividend Growers Index. To get into that index, a company must increase its dividend annually for a decade. From that list, it excludes the highest-yielding 25%, which is an effort to remove stocks that may be facing financial difficulties that would lead to a dividend cut.

The stocks are market-cap weighted, so the largest companies have the biggest impact on performance. That's basically the entire screening process.

The Vanguard Dividend Growth Fund is far more eclectic, with active human managers overseeing its stock holdings. The overarching theme, according to Vanguard: "The fund focuses on high-quality companies that have both the ability and the commitment to grow their dividends over time." After that, its management can do just about whatever it wants regarding which stocks to pick and what weighting to give each stock. This leads to a different portfolio compared to the Dividend Appreciation Index ETF.

For starters, the Vanguard Dividend Growth Fund holds just over 40 stocks versus the ETF's 330 or so. But the ETF has a far more concentrated portfolio when you look at sector diversification, with technology accounting for around 25% of the portfolio. The mutual fund's tech exposure is about 16%, while it has chosen to put more emphasis on healthcare stocks, which stand at nearly 20% of assets, representing its largest sector exposure. The ETF's healthcare exposure is 14% or so, making it the third largest segment of the portfolio.

XLK Total Return Level data by YCharts.

The top three industry categories (tech, financials, and healthcare) make up just over 60% of the ETF's portfolio. The top three sectors in Vanguard Dividend Growth Fund (healthcare, industrials, and tech) account for about half of its portfolio.

All of this may seem like mere nuance, but it is actually important, when you also consider that only five of the top 10 holdings in each of these investment vehicles are the same. The humans are clearly making very different decisions. That currently means a tilt away from the giant technology stocks that have driven the market higher and toward healthcare, which has not been performing nearly as well.

There's no way to know exactly what those in charge of the actively managed mutual fund are thinking here, but it could be an attempt to lower risk or to shift toward a sector that they believe presents more value. Given the ETF's index-based structure, it can't make shifts like that.

And that's the biggest selling point for the mutual fund, since the ETF can't make changes to its portfolio at all until it rebalances it once a year. It always has to track the index, while the actively managed mutual fund can adjust on the fly to changing market conditions.

If the next bear market is driven by a technology free fall, the human touch will become pretty handy. There are two reasons for this, as the mutual fund is not only choosing to be less exposed to technology, but it is also cherry-picking tech stocks in a way that the ETF can't. For example, if three technology stocks pass the ETF's screening process, it has to buy them all. The mutual fund can select the one that it believes has the best risk/reward balance.

XLK Total Return Level data by YCharts.

There is no clear-cut winner

Index funds have proved to be very successful relative to actively managed funds over long periods of time. However, the similarity in the performance of the Vanguard Dividend Appreciation Index ETF and the Vanguard Dividend Growth Fund up until the last few years suggests that indexes aren't the be-all and end-all for every investment approach.

And while the last few years have leaned in the ETF's favor, the mutual fund is clearly making a choice to limit its exposure to the very sector that is driving the ETF higher.

You'll pay more for the human touch: The mutual fund's expense ratio is 0.29% versus an expense ratio of 0.05% for the ETF. But that cost may be worth the price if you appreciate the value of letting your managers adjust to market conditions as they crop up. Even if that can leave them out of step with the market over the short term.

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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.