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By Abby Woodham

Suitability
The enduring popularity of dividend-strategy funds means exchange-traded funds like Schwab U.S. Dividend Equity ETF (SCHD) are competing in one of the most crowded areas of the industry. Schwab recently cut this relatively young fund's expense ratio to 0.07%, making it the cheapest dividend ETF available. Its price isn't the only thing that recommends it, however. This dividend-focused ETF targets stable stocks that pay moderate, sustainable income. The resulting portfolio is one of the most quality-oriented among dividend ETFs, with almost all holdings earning either a wide or narrow Morningstar Economic Moat Rating. SCHD's portfolio also has high projected earnings growth relative to competitors and a conservative payout ratio of under 50%. We think this fund is an appropriate core holding for most investors, even in the face of rising interest-rate concerns.

Strategy
Dividend-strategy ETFs can take very different approaches. SCHD tracks the Dow Jones U.S. Dividend 100 Index, which selects 100 stocks after screening for strong fundamentals, high dividend yields, and a long track record of dividend continuity. The index starts with the 2,500 largest United States companies by market cap, excluding REITs, master limited partnerships, preferred stock, and convertibles. The stocks are then screened for size and liquidity, and only companies that have paid dividends in the past 10 consecutive years are allowed. Once a firm skips a distribution, the clock resets. The remaining stocks are put in order by annual dividend yield, and the bottom half are cut.

Next, the stocks are scored and ranked based on four fundamental characteristics: cash flow/total debt, return on equity, dividend yield, and five-year dividend growth rate. Each stock is ranked based on an equal-weighted composite of these four scores. The top 100-ranked stocks are included in the index and weighted by their modified market cap. Individual stocks are capped at 4.5% of the index, and sectors are capped at 25%. We like sector caps, as dividend funds without them were overweight in financials leading up to the crisis in 2008 and dramatically underperformed. In order to keep turnover low, stocks keep their place in the index as long as their composite scores remain in the top 200 of the eligible universe. We expect SCHD to have minimal turnover, especially compared with funds that weight by yield.

The resulting portfolio tilts to large, established companies like Microsoft Corporation (MSFT) and Procter & Gamble (PG), which are SCHD's two largest holdings. Three fourths of the fund's constituents are found in the S&P 500 and make up 97% of SCHD's portfolio. SCHD's sector composition is quite different, however. The fund gives a 40% weighting to defensive stocks compared with the S&P 500's 26%, largely because it has a 16% greater weighting in consumer defensive stocks and twice the exposure to industrials. SCHD's exposure to stocks from the sensitive supersector is one of the highest among dividend ETFs.

SCHD yields 2.52% compared with SPDR S&P 500's (SPY) 1.87%. The fact that SCHD's yield is not significantly higher than the S&P 500's may surprise investors who expect high yield from a dividend strategy. However, we prefer ETFs like SCHD that balance slightly above-average yield with stability. Targeting the highest-yielding companies dilutes the benefits associated with a dividend strategy. Stocks usually provide high yields when their prices have been lowered because of distress in the economy or in anticipation of bland earnings growth or dividend cuts. Too high a yield can also indicate the market's skepticism as to whether a payout is sustainable, and the market is usually right. Over the past 85 years, the highest-yielding quintile of stocks did not produce the best return or risk-adjusted return.

Investors should not forget that SCHD was not live in 2008, when the weaknesses of other dividend-strategy indexes were exposed. The fund's index began calculation in 2011, and although it has a back-tested track record of below-average volatility relative to other dividend strategy indexes, investors should always take back-tested data with a grain of salt. Since inception, SCHD's total return and volatility have been on par with some of our other favorite dividend ETFs, like Vanguard Dividend Appreciation ETF (VIG).

The Looming Specter of Rates
Fears of rising interest rates can weigh on dividend ETFs. Although dividend-paying companies provide stability and tend to have stable cash flows regardless of the interest-rate environment, they also have less growth potential than non-dividend-paying stocks from cyclical and speculative sectors. If the economy is booming, stable stocks don't generate as much investor demand as those from sectors like manufacturing or durable goods, which stand to benefit the most from economic growth. Dividend payers tend to outperform in stable or declining interest-rate environments but struggle when rates are on an upswing. Sorting the market for dividend yield shows that the highest-yielding third of stocks had the worst historical performance in rising interest-rate environments. When rates rise because the economy is growing at a healthy clip, defensive-sector stocks in particular become an expensive trade. SCHD's allocation to defensive stocks is about average among dividend ETFs.

Regardless of the market cycle, there's a lot to recommend dividend investing. By paying a dividend, companies let investors share in their growth: Dividends are paid from a firm's free cash flow, making a consistent and steadily increasing dividend a good indication of a company's strong financial health. Over time, dividend-paying stocks tend to outperform those that do not pay, and with less volatility, because of the compounding effect of dividends on total return. The effect is particularly strong during bear markets, when dividend income can cushion a decline in price. Dividends are also the primary driver of historical stock returns. After adjusting for inflation, dividend income has accounted for nearly 75% of annual U.S. stock market returns over the last century. Since the inception of SCHD's index in 1999, dividends accounted for more than a third of the index's average monthly return.

Keep an Eye on the Valuation
As of this writing, the U.S. stock market is looking pricey compared with its historical average. The Shiller P/E is currently 25 compared with the long-term historical average of 16--suggesting the market is 50% overvalued. For more on valuation, Sam Lee recently discussed long-term expected return in a video for Morningstar.com. Morningstar equity analysts cover 97% of the stocks in this fund, building detailed cash flow projections and assigning a price/fair value estimate for each stock that they cover. These estimates can then be aggregated to the fund level. According to their findings, this fund's holdings are trading at a price/fair value ratio of 1.01, compared with the S&P 500's ratio of 1.02.

Alternatives
SCHD's closest alternative is VIG, which charges 0.10% and selects stocks that have increased their dividends over the past 10 consecutive years. VIG has a quality tilt and yield similar to SCHD's. Another offering from Vanguard is Vanguard High Dividend Yield Index ETF (VYM), which also charges 0.10%. This fund sorts U.S. stocks by yield and market-weights its holdings. VYM has a smaller quality tilt than SCHD or VIG but has a higher yield.

SPDR S&P Dividend ETF's (SDY) screens are even more stringent, requiring firms to have increased dividends for the past 20 consecutive years. S&P overhauled the index in 2012 to reduce idiosyncratic risks and prevent this huge fund from moving the market. SDY charges a 0.35% expense ratio.

WisdomTree Equity Income (DHS) costs 0.38% a year and focuses more narrowly on dividend yield in its stock-selection process. Because it tilts to defensive-sector stocks like utilities, DHS is sensitive to interest-rate changes. iShares Select Dividend (DVY) is also heavy on defensive-sector stocks. It selects companies that pass a variety of quality screens and requires constituents to have raised dividends for five years. DVY charges 0.40%, which is expensive.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: Quality Pays Dividends With This ETF