Dividend ETFs can serve as core holdings in well-balanced portfolios and as income-producing holdings for more conservative investors. These funds are typically less volatile because they contain established, profitable companies that are less volatile than those stocks generally contained in growth funds.
The best core holdings for investors with at least 5 to 10 years to go before collecting income are those that focus on growth, such as Vanguard Dividend Appreciation (VIG). Those funds have historically paid lower yields than the broader market or other dividend funds, but grow their payments at a more rapid pace.
At the other end of the spectrum are high-yielding funds such as iShares Select Dividend (DVY), which rely on slower-growing utilities or telecom sectors to deliver a high yield. These funds offer high current income, but investors may be receiving a substantially similar payment 5 years from now, making these funds unattractive for those seeking rising income.
This month we’ll look at a fund that straddles these two markets, with a portfolio that lookssimilar to VIG, but has a yield almost 0.80 percentage points higher: Schwab US Dividend Equity (SCHD).
Investment Strategy
Featuring a three-star rating from Morningstar, SCHD invests at least 90 percent of assets in stocks contained within the Dow Jones US Dividend 100 Index, the underlying benchmark. The ETF endeavors, before fees and expenses, to track the returns of the index as closely as possible. The index is composed of high-dividend-yielding domestic stocks, that have shown a consistent history of paying dividends and have stronger finances than do similar stocks. The index also requires a float-adjusted market cap of at least $500 million and a 3-month average daily trading volume of $2 million. Stocks are ranked by several factors, such as return on equity, dividend yield and dividend growth rate. The index is rebalanced quarterly.
SCHD is a suitable core holding for investors looking for higher yields without the added risk and volatility that are often associated with dividend ETFs that buy beaten-down stocks or are overweight utilities and telecom. Companies that have paid dividends for at least 10 years, provide a high return on equity and deliver strong dividend growth are favored. Firms must also have competitive yields and wide Economic Moat Ratings from Morningstar. The selected holdings are market capitalization weighted, and the result is a portfolio composed of growing, quality large-cap companies. While the tilt toward larger companies with stronger growth potential often results in a lower overall yield, the 3.30 percent yield of SCHD exceeds that of the underlying index, which pays 2.70 percent.
Although SCHD has a yield similar to that of other broad funds, it shies away from the utility and telecom companies that tend to dominate dividend ETFs. Instead, SCHD has a higher concentration of consumer staples. As consumer staples is the largest sector within the portfolio, SCHD tends to out- or underperform the market based on how well this particular sector is doing. Investors already overweight consumer staples should consider another dividend fund, or consider reducing consumer staples exposure elsewhere.
Portfolio Composition and Holdings
With $2.5 billion in assets, SCHD is allocated 100 percent in domestic stocks. The portfolio has a 69 percent exposure to giant-cap companies. The fund also has a 23 percent, 7 percent and 1 percent exposure to large-, mid- and small-cap issues, respectively. The portfolio features a price-to-book ratio of 3.0 and a P/E ratio of 16.9. The average market cap weighting is $97 billion compared with the $52 billion of the Russell 1000 Value Index.
The portfolio is overweight the consumer staples, industrial and technology sectors while being underweight financials, telecoms and utilities. The relative absence of telecoms and utilities makes SCHD perform closer to a typical broad market index fund. The lack of exposure to the financial sector is a significant drawback.
The top 10 holdings in SCHD constitute 42 percent of assets. These holdings in descending order are Exxon Mobil (XOM), Microsoft (MSFT), Procter & Gamble (PG), Johnson & Johnson (JNJ), Pfizer (PFE), Verizon (VZ), Chevron (CVX), Coca-Cola (KO), Home Depot (HD) and Intel (INTC).
Historical Performance and Risk
In addition to an average Morningstar return rating, SCHD has delivered 1- and 3-year returns of 4.86 percent and 12.69 percent, respectively. These compare to the category averages over the same periods of 5.71 and 12.69 percent. While its benchmark index compared favorably to the broader S&P 500 during the financial crisis, the fund’s recent performance relative to the index has been less compelling. Over the past 3 years, SCHD has had a downside capture ratio of 99.45. This is worse than the large value category average of 94.17. The ETF is still able to garner a below-average risk rating from Morningstar due to its 0.91 beta and 9.64 standard deviation, which are both less than the category averages of 0.95 and 10.03, respectively.
Fees, Expenses and Distributions
The fund has a 0.07 percent expense ratio, making it one of the least expensive dividend-paying ETFs available. One drawback is the fact that the fund lagged the underlying benchmark by more than the expense ratio over the past 1- and 3-year periods. This may indicate higher implementation costs for the ETF that began trading in October 2011, something we have seen with new ETFs.
Outlook
Investors looking for growth should stick with dividend growth funds such as VIG, but those wanting to avoid utilities and telecom can still get a solid yield considering SCHD. The one drawback is the fund’s limited financial exposure, but that can be rectified with a financial sector ETF. Financial stocks haven’t outperformed over the past 10 years and have been kept out of the index due to slashed dividends in 2008; however, balance sheets are strengthening as banks regain profitability. Regulators may relax the rules put in place after 2008 that restrict banks to lower dividend payout ratios. We don’t know if or when those rules will be softened, but if they are, financials will likely be some of the fastest dividend growers in the market and should be a consideration when evaluating SCHD. The abundance of consumer staples presents the opposite issue; high concentration in the sector may require some lightening of separate consumer staples holdings. While we like the low cost of the fund, VIG remains our preferred holding, despite the slightly lower yield.