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High-Quality Income ETF at a Low Price

Investors have shunned stocks, creating opportunities for those with underweightings in equities.

Michael Rawson, CFA, 01/25/2013

The Federal Reserve's liquidity programs and their pledge to keep short-term rates low until the economy shows substantial improvement have brought down short- and intermediate-term bond yields, forcing income-oriented investors to look for yield in segments of the bond market that have traditionally been viewed as riskier. Last year, investors put $33 billion in high-yield bond open-end funds and exchange-traded funds. But at this point, yields on high-yield bonds have reached historical lows, as highlighted in this article by my colleague Timothy Strauts.

Meanwhile, investors have shunned equity risk, pulling $65 billion out of U.S. stock funds last year, despite the fact that large-cap U.S. stocks currently offer a decent dividend yield and have strong balance sheets that should help support that dividend or provide a boost to earnings through share buybacks. Those income-oriented investors who have underweightings in equities should consider a contrarian approach and invest in high-quality, large-cap stocks.

Morningstar has long advocated Vanguard Dividend Appreciation ETF VIG as a high-quality fund with a decent dividend yield. But there is another fund that investors should consider, Schwab U.S. Dividend Equity ETF SCHD. The fund has about the same percentage of assets in high-quality, wide-moat stocks yet offers a higher dividend yield. The fund costs just 0.07%, the lowest-cost dividend-themed fund, and those on the Charles Schwab brokerage platform can trade the ETF commission-free.

Chasing high-dividend-yielding stocks can skew a portfolio toward distressed companies that have high yields only because their fundamentals have deteriorated. Because these stocks may underperform during market downturns and remain out of favor for several years at a time, diversified dividend funds that balance yield with quality can provide a better way to gain access to equity income. In order to make the cut, each holding in Schwab U.S. Equity Income ETF must have made dividend payments in each of the past 10 years and have a market cap of at least $500 million, which tilts the portfolio toward large-cap companies. Stocks meeting these criteria must also score well on a four-factor model that screens for financial strength. In order to improve its diversification benefits, the fund applies a modified market-cap-weighting scheme that limits its exposure to any one company or industry.

Dividends Haven't Lost Their Luster
Over the past century, reinvested dividends have accounted for nearly half of stocks' total annualized returns. Although capital gains drive short-term performance, dividends increase in importance with the length of the investment horizon. Several researchers also found that dividend-paying stocks have consistently generated superior returns than non-dividend-paying stocks in most markets and time periods, with less risk. Dividend-paying stocks offer superior risk-adjusted performance, in part because they impose greater discipline on managers by reducing their capacity to engage in value-destructive empire-building.

Despite its relatively short history, SCHD has more than $500 million in assets, and it trades more than 100,000 shares per day. The fund's success is due to its high-quality portfolio, rock-bottom price tag, and potential for dividend growth. More than 60% of the fund's holdings carry a wide moat rating, which suggests they have greater capacity than their peers to increase their dividend payouts in the future. For example, many of the fund's top holdings, such as Chevron CVX, Wal-Mart WMT, and PepsiCo PEP, have consistently raised their dividends and are well positioned to sustain that growth. This quality tilt can damp volatility during market downturns but might also cause it to lag in bull markets when investors pile into riskier assets. There is some evidence that the market does not fully appreciate the long-term sustainability and predictability of high-quality firms' earnings more than a few years into the future. This inefficiency may arise because many investors have relatively short investment horizons. As a result, there may be an opportunity for long-term investors to profit from the market's myopic focus by holding the type of reasonably priced quality stocks that this fund tracks.

Nuts and Bolts
The fund tracks the Dow Jones U.S. Dividend 100 Index, which selects companies with strong fundamentals, high dividend yields, and a long track record of dividend continuity. This index starts with the largest 2,500 U.S. stocks, excluding REITs, master limited partnerships, preferred stocks, and convertibles. From this list, Dow Jones screens for companies that have made dividend payments for a minimum of 10 consecutive years, a market cap of at least $500 million, and a minimum average daily trading volume of $2 million. It then orders the stocks that pass these screens by dividend yield. The stocks in the top half of this list form the universe of eligible stocks for the index. Dow ranks these stocks on cash flow to total debt, return on equity, dividend yield, and five-year dividend growth rate. Elegantly bringing this information together through an equally weighted composite score, Dow orders the eligible stocks by their composite score and selects the top 100 names for inclusion in the index.

Dow Jones applies a modified cap-weighting approach that limits individual holdings to 4.5% and industry exposure to 25% of the portfolio. The index is reconstituted annually in March and rebalanced quarterly. In order to keep turnover low, Dow keeps stocks in the index as long as their composite score remains in the top 200 of the eligible universe. This approach not only promotes tax efficiency but also helps Schwab keep management fees low.

Fees and Alternatives
Schwab recently reduced the fund's expense ratio to a razor-thin 0.07%, making it the cheapest dividend strategy fund on the market. Although the fund's short history makes it difficult to gauge turnover, its index's buffer rules make it likely that turnover and trading costs will be relatively low. The fund's holdings are highly liquid, which should keep tracking error and market-impact costs to a minimum.

VIG (0.13% expense ratio) is the closest alternative to this fund. Like SCHD, VIG has a strong quality tilt. It screens for companies that have consistently increased their dividends in each of the past 10 years and that have the capacity to sustain that growth. Because it shares SCHD's quality focus, VIG's dividend yield is also relatively modest. Investors looking for higher yield might consider WisdomTree Equity Income DHS, despite its higher expense ratio of 0.38%. DHS focuses more narrowly on dividend yield in its stock-selection process but protects against overweighting distressed firms by weighting stocks according to the dollar value of total dividends paid. This approach balances market cap against yield.

iShares Dow Jones Select Dividend Index DVY effectively balances quality with yield. This fund selects the 100 highest-yielding stocks from a list of companies that have passed several quality screens, including a five-year dividend payout ratio of less than 60%, and that have paid and increased their dividends over the past five years. DVY applies a yield-weighting methodology, which can skew the portfolio toward out-of-favor companies. It charges a 0.40% expense ratio.

SPDR S&P Dividend SDY is a bit cheaper, with a 0.35% expense ratio. It applies a more rigorous quality hurdle, requiring its holdings to have increased their dividends every year for the past 25 years. However, SPY holds only 60 companies, which can introduce idiosyncratic risk.

Alex Bryan contributed to this article.

Michael Rawson, CFA is an ETF Analyst with Morningstar.
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