Some exchange-traded funds (ETFs) are simple to understand. Others are more complex. One isn't necessarily better than the other, but sometimes adding complexity lets you do more with a portfolio and can lead to an exceptional fund structure. That's the case with the Schwab U.S. Dividend Equity ETF (NYSEMKT: SCHD).
Unlike many high-yield ETFs, this Schwab offering takes dividends to the next level, and it is worth buying, even if you only have $500 for a starter position.
Would you do this if you were looking to buy dividend stocks?
When it comes to ETFs, the biggest issue you need to consider is the portfolio methodology. That's not to suggest that returns don't matter, or that the yield is irrelevant. But these are pooled investment products where you are, effectively, giving someone else your money to invest on your behalf. You need to know what is being done with your money and why.
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As an example, the Vanguard High Dividend Yield ETF (NYSEMKT: VYM) has a 2.8% dividend yield. Meanwhile, the SPDR Portfolio S&P 500 High Dividend ETF (NYSEMKT: SPYD) has a 4% yield. Why are the yields so different when both have a goal of generating income? The reason is that they go about investing very differently.
The Vanguard High Dividend Yield ETF looks at all dividend-paying stocks except real estate investment trusts (REITs). The stocks that pay dividends are put in a list, organized by dividend yield. The highest-yielding half of the list gets into the fund using a market cap weighting. This results in a very large portfolio because the starting pool is all stocks. Having such a large portfolio means that lower-yielding stocks get into the list and drag down the overall yield of the ETF.
The SPDR Portfolio S&P 500 High Dividend ETF, in contrast, starts with the S&P 500 list of stocks and selects the 80 highest-yield ones, equally weighting its holdings. With a smaller starting list and a smaller ending portfolio, higher yields dominate and the ending portfolio offers more income.
While this shows two different ways of creating dividend portfolios, you probably wouldn't follow either of these approaches on your own. That's where the Schwab U.S. Dividend Equity ETF comes in.
The Schwab U.S. Dividend Equity ETF: More complex and more understandable?
The Schwab U.S. Dividend Equity ETF starts out looking at companies that have increased their dividends for at least 10 consecutive years, eliminating REITs from contention. This is a pretty typical screen for dividend investors, who often want to make sure they own companies that are committed to their dividends. Neither of the above ETFs considers this factor, but you probably would.
After getting the list of reliable dividend payers, the Schwab U.S. Dividend Equity ETF then creates a composite score and uses it to rank the stocks from best to worst. The score looks at cash flow to total debt (which highlights financial strength), return on equity (which highlights the strength of the business), dividend yield, and the company's five-year dividend growth rate. Basically, the Schwab U.S. Dividend Equity ETF is looking for financially strong, high-yield companies that have a history of increasing their dividends.
That's exactly what most dividend investors are likely to be trying to find, too. To be fair, the methodology here is far more complex than either of the above-mentioned ETFs. But it makes logical sense to do what the Schwab U.S. Dividend Equity ETF is doing. The ending dividend yield falls in between the two other dividend ETFs at 3.3%. That is still well more than the miserly 1.2% on offer from the S&P 500 index.
SCHD Total Return Price data by YCharts.
One more little nuance: You get all of the extra effort that the Schwab U.S. Dividend Equity ETF offers for the very low expense ratio of 0.06%. That's the same cost as the Vanguard High Dividend Yield ETF and less than the 0.07% of the SPDR Portfolio S&P 500 High Dividend ETF. If you are looking for a high-yield dividend ETF, the Schwab U.S. Dividend Equity ETF should be on your shortlist.
Sometimes adding a little complexity can be a good thing
The Schwab U.S. Dividend Equity ETF is not nearly as simple to understand as some other popular dividend ETFs. But that's not a bad thing. When you break it down, the Schwab U.S. Dividend Equity ETF is basically doing the same thing you would do if you wanted to invest on your own -- buying good companies with strong dividend records and attractive yields.
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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard Whitehall Funds-Vanguard High Dividend Yield ETF. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
