By
Morningstar
:
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 (
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
.
Suitability
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 (
VIG
) but below the 4.07% yield for iShares Dow Jones Select Dividend
Index (
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 (
WMT
), Exxon Mobil (
XOM
), and Procter and Gamble (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.
Fees
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 (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.
Alternatives
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 (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 (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.
See also
Is First Solar On The Rebound?
on seekingalpha.com