A Dividend ETF For Schwab: Has This Trade Become Crowded?

| About: Schwab U.S. (SCHD)

By Michael Rawson, CFA

Dividend-themed exchange-traded funds have been a popular choice among investors over the past year. The 42 dividend-themed ETFs that we follow raked in $16 billion in flows, nearly a third of every dollar going into equity ETFs, despite the fact that they make up just 5% by count of the 812 equity ETFs available.

With the dividend yield on the S&P 500 Index at 2.1%, well above the 1.7% yield on the Barclays Aggregate Bond Index, who could blame investors for looking to equities? But be cautious when hunting for yield, particularly when moving up the risk ladder from bonds to stocks. Over the past five years, the average dividend ETF has had a volatility of 23%, more than 6 times greater than the 3.6% volatility of the Barclays Aggregate over that same time period. The highest-yielding stocks are more volatile than stocks in general, so dividend ETF investors should consider the stock-selection process employed by the fund. One ETF that gets it right is Schwab U.S. Dividend Equity ETF (NYSEARCA:SCHD), one of the most successful ETF launches of the past year. While we like the approach of this fund, the valuations in some defensive sectors have become stretched. In addition, investors often pile into popular funds at the wrong time, as my colleague Adam Zoll outlines here.

Schwab U.S. Dividend Equity ETF is a suitable core holding for investors that want a focus on dividend-paying stocks and are comfortable with the large-value tilt this fund provides. This ETF holds 100 stocks that meet various criteria, including 10 years of consistently paying a dividend and a high composite score on a four-factor model of financial strength. Perhaps most important, it follows an adjusted market- cap-weighting approach, which results in a tilt toward large-value companies. Because of this tilt, investors should be aware of how this portfolio might overlap with existing portfolio holdings.

The rationale for investing in dividend-paying stocks is strong, as dividend-paying stocks have outperformed nonpayers over the long haul. There are many reasons for this. Glamorous stocks with high expected growth rates rarely pay dividends, so the excess returns to dividend-paying stocks might be explained by the value premium. Paradoxically, academics have found that firms with high dividend payouts actually experience faster earnings growth. Additionally, dividends can be a check on corporate governance. If firms do not have investment opportunities that will earn a rate of return above the cost of capital, they should refund capital to shareholders. Particularly in the current low-growth market, it might be better to return capital to shareholders than to invest it in risky ventures with low return prospects.

Fundamental View
In this environment where economic growth has slowed and there are fears that growth may slow further in Europe and China, investors are paying a premium for quality stocks. Defensive sectors such as consumer staples, health care, and utilities all sell at a premium price/earnings valuation multiple compared with the overall market and a premium to their trailing five-year average. Meanwhile, more economically sensitive sectors such as energy, industrials, and materials sell at discounts to their five-year average P/E multiple. The explanation for the valuation disparity is that if the economy slows sharply, the earnings of these economically sensitive sectors will get hit harder. It's important to remember that defensive sectors will not be immune, but the dividend yield on this fund should help cushion the blow.

Morningstar equity analysts cover 99% of the assets in this portfolio and 84 of the 100 holdings. They assign discounted cash flow based fair value estimates on each stock, which can then be aggregated to the fund level. They see the portfolio trading at a price/fair value of 0.93, compared to a more attractive 0.88 for the S&P 500. As for quality, 64% of the assets in the portfolio are rated as having a wide economic moat, Morningstar's measure of sustainable competitive economic advantage and a good proxy for quality. That compares favorably to the 44% in the S&P 500.

Since this ETF does not yet have a full year of trading history, the Morningstar.com quote page does not display a 12-month yield (which is always calculated net of the expense ratio). However, we can get some idea of the yield on its portfolio by looking under the Portfolio tab, which shows that the stocks in SCHD have a dividend yield of 3.31%. This is above the 2.28% yield on the stocks in Vanguard Dividend Appreciation ETF (NYSEARCA:VIG) but below the 4.07% yield for iShares Dow Jones Select Dividend Index (NYSEARCA:DVY).

Portfolio Construction
The fund tracks the Dow Jones U.S. Dividend 100 Index, a new index from Dow Jones that starts with the top 2,500 U.S. stocks after excluding REITS, master limited partnerships, preferred stocks, and convertibles. Only stocks that have paid a dividend for 10 consecutive years, have a market cap above $500 million, and have $2 million in average daily volume are considered. These stocks are then sorted by yield, and the bottom half is removed. From there, four factors of financial strength (cash flow/total debt, return on equity, dividend yield, and five-year dividend growth rate) are equal-weighted, and the top 100 stocks are included in the index but then weighted by an adjusted market-cap method. As such, this fund is dominated by large-cap behemoths like Wal-Mart (NYSE:WMT), Exxon Mobil (NYSE:XOM), and Procter and Gamble (NYSE:PG). An adjustment is made to ensure that no stock is more than 4.5% of the fund and that no sector (as defined by Dow Jones) is more than 25% at the annual reconstitution and quarterly rebalance. While weighting by market cap can lower the yield relative to other dividend weighting strategies, it also lowers the volatility. This fund has an average market cap of $62 billion, greater than the $55 billion of the S&P 500. Relative to large-value funds, this ETF has higher weightings in consumer defensive (30%), industrials (17%), and consumer cyclical (8%) and relatively lower weightings in financials (3%), utilities (3%), and telecom (1%).

Note that this index is different from the Dow Jones U.S. Select Dividend Index, which is tracked by iShares Dow Jones Select Dividend Index (DVY). That index weights stocks by dividend per share, which has resulted in some odd weightings, more of a mid-value tilt, and an untimely overweight in financials just before the crisis in 2008. While we prefer this new index followed by SCHD to the one followed by DVY, it is yet to be seen whether it will stand the test of time.

The fund charges a very low 0.17% expense ratio, which was the lowest among dividend-oriented ETFs until Vanguard recently lowered its fees on VIG and Vanguard High Dividend Yield Index ETF (NYSEARCA:VYM) to just 0.13%. However, as a new fund, SCHD is likely to have higher market impact cost, which eats into the return when trading frequently. While it does trade a respectable 166,000 shares a day on average, it is still advised to use limit orders, particularly for large trades or in volatile markets. Investors on the Schwab platform can trade this and other Schwab ETFs commission-free.

Many of the top holdings of this fund are also held in one of our favorite dividend- themed funds, the aforementioned VIG. VIG is really more of a quality fund than a dividend fund, as it has a high percentage of wide-moat firms and a dividend yield barely equal to the yield on the S&P 500. VYM offers a higher yield than VIG and has more of a value tilt compared with VIG's slight growth tilt. Both funds charge 0.13%.

SPDR S&P Dividend (NYSEARCA:SDY) charges 0.35% and seeks out firms with a 25-year track record of increasing dividends and weightings by yield, resulting in a narrow list of 60 companies with a mid-value tilt. WisdomTree LargeCap Dividend (NYSEARCA:DLN) charges 0.28% and weights stocks by total dividends paid. This results in a large-value tilt because the larger companies are able to pay the largest dollar amount of dividends.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

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