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This Dividend Fund's Quality Screen Gives It a Leg Up

This exchange-traded fund offers profitable dividend-paying stocks with durable competitive advantages at a low fee.

Adam McCullough, CFA, 06/09/2017

Schwab U.S. Dividend Equity ETF SCHD offers a low-cost portfolio of profitable stocks with attractive dividend yields. This dual focus reduces the fund's exposure to firms with weak fundamentals that may not be able to sustain their dividend payments, which is a risk that can accompany a narrow focus on yield. The fund's sensible strategy and low fee should contribute to its edge over the long run, but its short live track record limits its Morningstar Analyst Rating to Silver.

This fund's index starts with the higher-yielding half of U.S. stocks that have paid dividends for the past 10 years. Next, it scores these stocks on four fundamental metrics: cash flow/debt, return on equity, indicated dividend yield, and five-year dividend growth. The 100 top-scoring stocks are included in the portfolio and weighted by their market capitalization. By targeting more-profitable dividend-paying stocks, this fund avoids some of the risks of chasing yield. The index also caps stock and sector weightings, which should reduce concentration risk. Despite its profitability criteria, this fund lands in the large-value Morningstar Category and offers an attractive yield. From its inception in October 2011 through April 2017, this fund's yield averaged 3.2%, nearly 20% higher than the Russell 1000 Value Index.

This fund's holdings skew larger versus its peers. Its weighted average market capitalization is over $100 billion, compared with $85 billion for the category average. And 90% of its holdings register as giant- or large-cap stocks. The fund's profitability tilt is evident. Its return on invested capital has been nearly double the category average since the fund's inception. Its return on equity and assets have also been higher than the category average since its inception.

This strategy launched in October 2011, so it has not been through a bear market. From its inception through April 2017, the fund returned 13.9% on an annualized basis, outpacing its category by 0.9% annually with less risk. Its favorable overweighting to the technology sector and stock selection within the industrials sector have contributed the most to its outperformance.

Fundamental View
In a theoretical frictionless market, dividend payout policy shouldn't have any impact on stock returns (for further reading, see the Modigliani-Miller Theorem). A dividend payment should reduce the firm's stock price by an offsetting amount. But in practice, dividends often matter because they can impose greater discipline on managers in their capital-allocation decisions, leaving less money for low-return investments. And managers may use these payments to signal their confidence in their firms' prospects. Dividends can also help address some behavioral issues, including many investors' reluctance to realize capital gains to meet income needs, and may give them the fortitude to weather market volatility.

Investors can benefit from owning dividend-paying stocks, but chasing yield can be dangerous. The highest-yielding stocks could be under financial distress and more likely to cut their dividends than their lower-yielding counterparts. Many of these stocks pay out a large share of their earnings as dividends, leaving a small buffer to cushion these payments if their business deteriorates. This fund strives to sidestep this risk by balancing profitability, debt coverage, and yield. If a stock is more profitable and able to cover its interest payments, it should be able to maintain its dividend during a market downtown or raise its payout ratio in the future. Although this fund's profitability tilt steers it away from the riskier, highest-yielding stocks, it still offers an attractive yield. Indeed, its yield has consistently topped the Russell 1000 Value Index's by 20%.

This portfolio looks and behaves differently from value benchmarks like the Russell 1000 Value Index. It holds a much higher percentage of consumer staples stocks and has much less exposure to the financial-services and energy sectors. Not surprisingly, the fund's holdings were expected to pay out a larger share (59%) of their earnings as dividends at the end of April 2017 than the Russell 1000 Value Index (46%), based on calculations from earnings and dividend forecasts presented in Morningstar Direct. They also tend to generate higher average returns on invested capital than those in the index. High profitability, coupled with conservative capital investment and low valuations, should allow the fund's holdings to offer high free cash flow returns on capital.

The fund's value and profitability tilts should continue to influence its performance. Both of these characteristics have been associated with higher returns over the long term, but they don't always pay off. For instance, in the United States, value stocks lagged their growth counterparts over the fund's life, which detracted from its performance. But its profitability tilt gave it a small return boost.

The fund skews toward larger stocks on average than the large-value category. As of April 2017, the fund's average weighted market capitalization measured over $100 billion compared with $85 billion for the category. This is likely because the fund targets mature, profitable companies, limits its portfolio to 100 stocks, and market-cap-weights its holdings. Although this fund holds fewer stocks than other dividend-targeting funds, its profitability tilt helps it mitigate some of the risks of a sole focus on yield.

Portfolio Construction
This fund targets profitable, dividend-paying U.S. stocks and limits single stock and sector weightings to reduce unintended bets. Investors end up with a diversified portfolio that favors high-yielding stocks with strong fundamentals. It earns a Positive Process Pillar Rating.

This fund tracks the Dow Jones U.S. Dividend 100 Index. The index selects its constituents from a universe of the 2,500 largest U.S. stocks, excluding REITs, master limited partnerships, preferred stocks, and convertibles. Constituents must have 10 consecutive years of dividend payments, a minimum float-adjusted market cap of $500 million, and a minimum three-month average daily trading volume of $2 million. Stocks that clear those hurdles are ranked in descending order by their indicated annual dividend yield, and those in the bottom half are eliminated. The index then ranks remaining stocks by 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 market cap. Individual stocks are capped at 4.5% of the index, and sectors are capped at 25%. To keep turnover low, Dow Jones keeps stocks in the index if their composite scores remain in the top 200 of the eligible universe. The index is reviewed quarterly and rebalanced annually.

Schwab levies a low 0.07% expense ratio on this fund. This fee is a fraction of the 0.90% median toll that the fund's large-value peers charge, and it earns a Positive Price Pillar rating. Over the trailing three years ended March 2017, this fund lagged its benchmark by 12 basis points per year, more than its average annual fee.

Bronze-rated FlexShares Quality Dividend ETF QDF (0.37% fee) is a close peer. Like SCHD, it balances dividend yield with profitability. QDF targets large-, mid-, and small-cap dividend-paying stocks but applies a proprietary quality scoring model to compare stocks within each sector to avoid those with a higher risk of cutting their dividends. Its process is more opaque than SCHD's, and its portfolio reaches much further down the market-cap spectrum.

Vanguard High Dividend Yield ETF VYM (0.08% fee) offers a better-diversified portfolio and higher yield than SCHD, but VYM does not screen its holdings based on their profitability, so it may be more prone to hold stocks with deteriorating fundamentals. VYM sorts U.S. dividend-paying stocks by yield, targets those representing the higher-yielding half, and weights them by market capitalization. VYM's low fee and broad market-cap-weighted approach support its Analyst Rating of Silver.

Bronze-rated PowerShares S&P 500 High Dividend Low Volatility ETF SPHD (0.30% fee) selects 50 high-yielding stocks from the S&P 500 but seeks to reduce risk by targeting stocks with low volatility, rather than high profitability. SPHD launched about a year after SCHD and offers a higher yield but is less diversified.

WisdomTree LargeCap Dividend ETF DLN (0.28% fee) selects the largest 300 stocks by market capitalization from a proprietary index that weights its holdings by the value of dividends each stock is expected to pay over the next year relative to the aggregate value of the portfolio. DLN's broad diversification and weighting by dividend payment reduce its risk and support its Bronze rating.


Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.


Adam McCullough, CFA, is an analyst on Morningstar’s manager research team, covering passive strategies.

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