Better dividend buy: Telstra shares or Vanguard Australian Shares High Yield ETF (VHY)?

Which option would be smarter to call on for passive income?

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Telstra Group Ltd (ASX: TLS) shares and Vanguard Australian Shares High Yield ETF (ASX: VHY) are both known for paying dividend income to investors. In this article, I'm going to look at which one could be the better choice for passive income.

Most readers probably already know of the ASX telco share Telstra as Australia's leading mobile provider.

The Vanguard Australian Shares High Yield ETF is an exchange-traded fund (ETF) focused on ASX blue chip shares that provide investors with a higher dividend yield relative to other ASX-listed companies.

VHY ETF is more diversified

The ASX ETF obviously provides investors with more diversification because it's currently invested in 76 positions. These include names such as BHP Group Ltd (ASX: BHP), Commonwealth Bank of Australia (ASX: CBA), National Australia Bank Ltd (ASX: NAB), Woodside Energy Group Ltd (ASX: WDS), Westpac Banking Corp (ASX: WBC), ANZ Group Holdings Ltd (ASX: ANZ), Wesfarmers Ltd (ASX: WES), Macquarie Group Ltd (ASX: MQG), Telstra, and Transurban Group (ASX: TCL).

If the choice was to have only Telstra shares or the VHY ETF in a portfolio, then the ETF could make a lot more sense.

However, it's not the most diversified ETF out there. As it stands, more than 60% of the portfolio is invested in ASX financial shares and mining shares. Of course, this reflects the nature of the ASX and which of its larger businesses pay large yields.

Dividend yield

Vanguard helpfully provides a monthly update about the forecast dividend yield of the ASX ETF.

According to the fund provider, the Vanguard Australian Shares High Yield ETF currently has a forecast grossed-up dividend yield of 6.6%.

So how does that compare to Telstra shares? Commsec numbers currently suggest that Telstra could pay an annual dividend of 18 cents per share. The ASX telco is projected to pay a grossed-up dividend yield of 6.4%, which is a very similar yield.

But Telstra is projected to keep growing its annual dividend in FY25 to 19 cents per share, which would be a grossed-up dividend yield of 6.8%.

I don't think we can expect the VHY ETF will be as likely to grow its dividend payout. This is because of the unpredictable nature of dividends from ASX mining shares (due to variable commodity prices) and the competitive nature of the banking industry. An ETF simply passes through the dividend income it receives to its investors.

The banking sector's profit has benefited over the past 12 months from a higher interest rate environment, but I believe the next couple of results could show pain from high arrears and bad debts if more borrowers struggle to make loan repayments.

Capital growth

For me, there's more to what makes a good dividend buy than just the passive income.

I want to see capital growth over time. Certainly, I don't think there's much point in getting dividends if we're seeing long-term capital losses. Dividend dollars are worth just as much as capital dollars.

Telstra recently handed in its FY23 result, which included net profit after tax (NPAT) growth of 13% to $2.1 billion and earnings per share (EPS) growth of 16% to 16.7 cents.

The telco company's T25 strategy involves cost reductions, which are being challenged by high inflation, although it's still expecting to achieve the majority of them by FY25. It said it remains "absolutely committed" to delivering its underlying earnings before interest, tax, depreciation and amortisation (EBITDA) and EPS growth targets.

Estimates on Commsec suggest EPS can keep growing to FY25 to 20 cents, which would put it at 20 times FY25's estimated earnings.

I think Telstra's profit can keep rising thanks to mobile price increases, a growing number of subscribers (thanks largely to Australia's growing population), and an effort to grow margins.

Over the past 10 years, the VHY ETF has only delivered capital growth of an average of 1.1% per annum, according to Vanguard.

Foolish takeaway

For me, I'd rather choose to add Telstra to a portfolio of other ASX dividend shares as opposed to the VHY ETF portfolio that owns a number of ASX shares I wouldn't want to have in my own portfolio. Telstra seems as though it's set to provide an attractive mixture of capital growth and dividends.

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Motley Fool contributor Tristan Harrison has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has positions in and has recommended Macquarie Group, Transurban Group, and Wesfarmers. The Motley Fool Australia has positions in and has recommended Macquarie Group, Telstra Group, and Wesfarmers. The Motley Fool Australia has recommended Vanguard Australian Shares High Yield ETF. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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