Best ETF for 2012: Vanguard Dividend Appreciation

This article is part of our Best ETFs for 2012 series, in which we're seeking out the top-performing ETFs for the coming year.

Charles Dickens opened his classic book A Tale of Two Cities with this quote: "It was the best of times, it was the worst of times...we had everything before us, we had nothing before us, we were all going direct to heaven, we were all going direct the other way..."

Does that sound a lot like today's economy to anyone else? Wall Street has recovered nicely since the financial collapse of 2008. Main Street? Not so much. And frankly, I'm perplexed why Wednesday's European bailout notice would lead to such a gigantic surge. After all, doesn't the admission that such a bailout even looked necessary indicate that the real global economy still stinks?

Thanks to all the contradictions in the economy, I haven't a clue as to what 2012 will bring from a macroeconomic perspective, aside from continued inflation (and I actually predicted the disaster that was 2008). And it's precisely because the future is so incredibly cloudy right now, with nothing certain but inflation, that my top ETF Pick for 2012 is the Vanguard Dividend Appreciation (NYS: VIG) ETF.

Built in bias for income and growth
The fund is designed from the ground up with one thing in mind: paying its owners increasing dividends, year after year. Indeed, it's based on the Dividend Achievers Select Index, which requires companies to have at least a consecutive 10-year history of rising dividends to be considered. And unlike many funds where the advisors' fees chew up a huge chunk of the investors' potential dividend income, in classic Vanguard style, this fund only charges a minuscule 0.18% expense ratio.

While there are no guarantees in investing, companies know the market views their dividends as strong signaling devices of the overall health of their businesses. Not many companies would willingly downgrade what their investors thought of their operations unless it became absolutely necessary. In other words, when a company has an established track record of raising its dividend, it has a strong incentive to keep that record going if at all possible.

Diversification among strong companies
On top of the clear benefits from only investing in companies with solid histories of raising their dividends, Vanguard Dividend Appreciation brings with it a diversification benefit not seen in sector-specific funds. Remember that the recent meltdown took out the dividends of so many banks, once considered pillars of income-seeking investors' portfolios.

Just looking among the top 15 holdings of the fund -- you know, the holdings with enough influence to actively affect its performance -- you find very strong diversification across sectors:

Company Sector 2010 Dividend 2011 Dividend Year-Over-Year Dividend Change
IBM (NYS: IBM) Technology $2.50 $2.90 16.0%
Chevron (NYS: CVX) Basic Materials $2.84 $3.09 8.8%
Wal-Mart (NYS: WMT) Services $1.21 $1.46 (*) 20.5%
3M (NYS: MMM) Conglomerates $2.10 $2.20 4.8%
Caterpillar (NYS: CAT) Industrial Goods $1.72 $1.80 4.7%
Medtronic (NYS: MDT) Health Care $0.86 $0.94 8.8%

Data from Vanguard & Yahoo! Finance, as of Nov. 30. (*) Includes estimate for expected 2011 dividend not yet paid.

That diversification helps protect both your income stream and your overall portfolio balance from any one company's -- or industry's -- meltdown. That's an important factor to consider as we face a still uncertain economy.

Remember, too, that to make the cut and be part of this ETF, each and every company has had to pay a higher dividend each year than in the previous one. That means each started raising its dividend well before the recent financial meltdown, continued throughout the meltdown, and still kept on raising them in the aftermath of that meltdown. If that's not a clear definition of a strong company, I'm not sure what would be.

Like the companies? Consider the ETF
The financial strength and direct shareholder rewards provided by the individual companies in the ETF make them all worthy of consideration for your portfolio on their own. The diversification benefit and low 0.18% expense ratio of the ETF make a compelling case for bundling them together into a single investment.

To quote Dickens again, this time from David Copperfield: "Annual income twenty pounds, annual expenditure nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery."

When all that stands between happiness and misery is an income that keeps up with your expenses, wouldn't you want an investment that focuses on growing your income, year after year? In an era where the only certainty is inflation, there's nothing better than a fund like VIG, which attempts to do just that.

While I may be clueless on the overall direction of the economy in 2012, I'm confident enough in VIG's structural advantages to make a CAPScall in favor of the ETF. I'm putting my own CAPS All-Star Rating on the line by handing out a green thumb to this ETF in Motley Fool CAPS.

Stay tuned throughout our series on the Best ETFs for 2012 to find out about all of the picks our Foolish contributors have made. Click back to the series intro for links to the entire series.

At the time this article was published At the time of publication, Fool contributor Chuck Saletta did not own shares of any company or ETF mentioned in this article. The Motley Fool owns shares of Wal-Mart, IBM, and Medtronic. Motley Fool newsletter services have recommended buying shares of Wal-Mart, Chevron, and 3M, as well as creating diagonal call positions in 3M and Wal-Mart.Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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