The word “dividend” appears in the Vanguard Dividend Appreciation ETFIt is (VIG -1.42%) name. This might lead some investors to believe that dividends are an important factor for exchange-traded funds (ETFs). And they are, but not in a way that most income investors will appreciate.

Before you buy the Vanguard Dividend Appreciation ETF, you should understand how it uses dividends to build its portfolio.

What is the Vanguard Dividend Appreciation ETF used for?

The Vanguard Dividend Appreciation ETF tracks an index. So, from an overall perspective, she simply owns everything in the index. So if you want to understand what you are buying here, you need to check out the index, which is the S&P US Dividend Producers Index.

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The name of this index already gives you an idea of ​​what it looks for: dividend producers. But even high-yielding stocks can increase their dividends. For example, Altria has increased its dividend every year for over a decade and it has a high rate of 8.1% dividend yield. You won’t find it among the 338 stocks that made it into the Vanguard Dividend Appreciation ETF. This would seem to be a glaring oversight. This is not the case.

The S&P US Dividend Growers Index is designed to measure the performance of US companies that have followed a policy of consistently increasing their dividends each year for at least 10 consecutive years. The index excludes the top 25% of eligible companies from the index.

The quote above is from S&P Global’s product description of the index, followed by the Vanguard Dividend Appreciation ETF. To highlight the most notable part: the highest yielding stocks that pass the 10-year dividend increase stage are specifically excluded from consideration. This helps explain why the Vanguard Dividend Appreciation ETF’s dividend yield is only 1.7%. Of course, this is higher than the S&P500 indexes (^GSPC -1.86%) 1.2%, but if you’re looking for dividend income, this exchange traded fund probably won’t suit you, even if it has the word “dividend” in its name.

What does the Vanguard Dividend Appreciation ETF actually do?

To put it bluntly, the Vanguard Dividend Appreciation ETF uses dividends as a selection tool. This happens in two important ways.

VIG data by Y Charts

First, focusing on a company’s annual dividend growth streak is one way to find companies that are financially strong and growing over time. This makes perfect sense; a struggling company likely won’t be able to increase its dividend year after year. So using dividends in this way is a good starting point. However, things can change and sometimes companies that have a strong business history fall on hard times.

This brings us to the second use of dividends, but this time it is dividend yield. Wall Street is forward-looking and if it believes a company is in trouble, it will lower prices. This, in turn, will increase the yield. In this way, yield acts as a rough measure of investor sentiment. But it also serves as a warning sign, as high yields often highlight struggling companies that could end up cutting their dividends. Altria, for example, was suffering from a long decline in the volume of cigarettes it sells. This is why the yield is so high.

So, by excluding the 25% of dividend growing stocks offering the highest yields, the Vanguard Dividend Appreciation ETF attempts to eliminate companies that may be yield traps. Or, perhaps to put it better, the business risk of a high-yielding stock may be too high to justify holding it. Overall, the methodology is simple but elegant. However, it is not an ETF that investors try to live off their income their portfolios will likely be particularly attractive.

The Vanguard Dividend Appreciation ETF is a growth fund

Investors looking at the Vanguard Dividend Appreciation ETF should understand why its name contains the word “dividend.” Using dividends as a selection tool is key. Trying to generate revenue really isn’t.

While there is a place for this ETF in many portfolios, you will need to consider it very carefully before purchasing. If you are a growth investor or an investor focused on growth and income, this could be the perfect fit. If you are an income-oriented investor, this probably won’t be a good choice for you.