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The Vanguard Dividend Appreciation ETF (VIG) is currently the largest dividend ETF there is with assets of more than $78 billion. The simple and straightforward strategy of targeting companies with 10+ years of dividend growth helps to combine the durable, mature nature of long-term dividend growers with the capital appreciation potential of younger "emerging" dividend payers.

That makes it a dividend ETF that a lot of people own. Unfortunately, if you want a well-rounded dividend portfolio, VIG isn't enough. Its dividend growth strategy works well in most portfolios, but it de-emphasizes other critical components, such as high yield and dividend quality.

Simply put, you need to augment a portfolio position in VIG with other dividend ETFs.

Understanding VIG

To understand how best to build around VIG, we need to know what VIG looks like; where it invests and where its strengths & weaknesses are. By having a good grasp on that, we could look for more dissimilar dividend ETFs that could provide the biggest diversification benefits and the best coverage of the three dividend pillars.

VIG invests primarily in large- and mega-cap U.S. stocks. Because it's market-cap weighted, the largest qualifying companies receive the largest allocations, regardless of how long they've been raising their dividends or how much they're paying. I'm not a big fan of the strategy of cap weighting a dividend portfolio because I think more emphasis should be placed on dividend status & history as opposed to company size (WisdomTree does a good job of this).

VIG does have a strong allocation to tech stocks, but the overweighted positions to both cyclicals and defensive sectors give it more of a well-rounded feel.

That's mostly a good thing because the last thing that people need in their portfolios now is an S&P 500 clone or a fund that overweights tech & growth stocks.

Because it's cap-weighted, we do get a pair of magnificent 7 names at the top of the individual holding list, but it's pretty diversified beyond that.

While sector allocations and individual holding information is useful, we get a better sense of how VIG operates by looking at its factor exposures. This tells us how the fund behaves and which type of environment it can excel in. By pairing VIG with a fund that has different factor exposures, we can reduce some volatility while maintaining long-term capital growth potential.

VIG looks kind of how you might expect it to. It's tilted more towards value than growth. It has an above average dividend yield (VIG only yields 1.8%, which is quite modest relative to the dividend ETF universe, but it is higher than the 1.3% yield of the S&P 500 I suppose). The momentum and quality factors are heavily tilted towards tech at the moment, so no surprise it's underexposed there.

All in all, it's a more defensive portfolio (beta consistently shows it's 15% less volatile than the S&P 500 over time) with only a modest yield that's filled with durable and mature companies. Its use of cap weighting gives it a little more of a growth feel at the top, but it's pretty defensive elsewhere.

ETFs That VIG Shouldn't Be Paired With

Of the three dividend investing style pillars - dividend growth, dividend quality and high yield - VIG addresses only the first in its strategy. By correlation, it does have a bit of a quality tilt to it (Morningstar shows less of a tilt right now, but Portfolio Visualizer shows a positive quality tilt).

Obviously, there wouldn't be much advantage to pairing VIG with another dividend growth ETF. The obvious candidate to rule out would be the ProShares S&P 500 Dividend Aristocrats ETF (NOBL). While they both use strategies that focus solely on long-term dividend growers, the overlap according to ETFRC.com is only 27%. Still, the similarity in strategies should lead us to look elsewhere. Other dividend growth focused strategies, such as the Invesco Dividend Achievers ETF (PFM), the Invesco High Yield Equity Dividend Achievers ETF (PEY) and the SPDR S&P Dividend ETF (SDY), should also be set aside.

The next thing to look at should be portfolio overlap. Even though two funds may have different strategies, if they look similar enough to each other, there's not much advantage to pairing them

Here are some of the ETFs that have at least a 50% overlap with VIG:

• iShares Core Dividend Growth ETF (DGRO) - With more than 70% overlap, DGRO is one of the closest comps to VIG. DGRO looks at payout ratio in addition to dividend growth history in order to add a slight quality component to the strategy, but the two portfolios are incredibly similar to each other.

• WisdomTree U.S. Quality Dividend Growth ETF (DGRW) - DGRW actually doesn't look at dividend growth history at all. It considers mostly quality metrics, including earnings growth, ROA and ROE. Even though the targeting methodologies are different, the two funds have a 52% overlap and that's a little too high for pairing with VIG.

• Vanguard High Dividend Yield ETF (VYM) - It might be natural to assume that you could just pair VIG with its Vanguard counterpart to get a well-rounded portfolio. Like DGRW, the two selection criterias are dissimilar, but there's a 59% overlap between the funds. Again, too much similarity in composition.

• WisdomTree U.S. Total Dividend ETF (DTD) - Maybe you should just pair VIG with a total dividend fund to tilt it towards dividend growth? You could do that if that's your goal, but it's not going to tilt it much. Even this ETF covering the entire dividend stock universe has a 56% overlap.

• Vanguard Value ETF (VTV) - While not a dividend ETF, this just reiterates how value-oriented VIG really is. It's got a 54% overlap, which means you should probably eliminate all pure value funds from consideration as well.

ETFs That VIG Should Be Paired With

Based on what we've discussed, we know there are a few things we should look for when searching for a fund to pair with VIG - different factor profiles, different targeting strategies, low portfolio overlap. All U.S. dividend ETFs are going to be highly correlated no matter what simply because they're all playing in the same sandbox, but searching out these differences can help maximize diversification benefits and help manage overall risk exposures.

Here are four ETFs that could fit that bill:

• Schwab U.S. Dividend Equity ETF (SCHD) - This is perhaps one of the best dividend ETFs out there and not just for its performance record. Its robust targeting strategy looks for components of dividend growth, dividend quality and high yield all in one place, making it ideal as a core or satellite holding. SCHD has greater factor exposures to yield and quality, two areas where VIG lacks, and it has just a 12% overlap.

• iShares Select Dividend ETF (DVY) - DVY's strategy is fairly similar to SCHD in that it employs a multi-factor strategy, but it really differentiates itself in terms of composition. DVY has just 26% of its assets in large-cap stocks compared to 84% for VIG. It scores higher in yield and lower in quality, which add a little more risk to a portfolio, but its 8% overlap (mostly through a reduction in tech and an overweight in utilities) makes it a great pairing.

• SPDR Portfolio S&P 500 High Dividend ETF (SPYD) - This is perhaps the most pure high yield play you can find, which usually makes for a great pairing to a pure dividend growth strategy. Targeting stocks based on yield alone makes me nervous because it opens up the possibility of including some bad apples, but the 3% overlap proves, based on both composition and targeting, that it's about as strong of a diversifier as you'll find.

• Invesco S&P 500 High Dividend Low Volatility ETF (SPHD) - This targets high yields like SPYD does, but I've always liked how pairing it with a low volatility component looks. Historically, this fund has delivered feast or famine returns, so there is some risk to holding it alone. The conservative investment factor is where this fund really pairs nicely with VIG and, of course, it has just a single digit overlap.

Final Thoughts

This is a good exercise in why it's important not to select investments for your portfolio based on returns alone. Especially in the ETF world, if you only choose the highest returners, you're probably just buying a lot of funds that look just like each other. That's the opposite of what you want to do in the portfolio construction process.

Each of the dividend ETFs I suggested above targets either a different dividend strategy or a multi-factor strategy that emphasizes diversification and differentiation. Pairing any one of those with VIG should manage overall risk and give your portfolio a smoother ride in different economic environments.

Until next week!

Dave