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High-Quality Dividends at a Low Fee

Thu, 22 May 2014

With a razor-thin expense ratio and 60% of its holdings sporting wide moats, this exchange-traded fund is suitable as a core holding.

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Video Transcript

Abby Woodham: Dividend-strategy ETFs fall into one of two categories. The first type seeks out stocks that are paying above-average yields in order to provide a high level of current income. These funds tend to delve into deep-value territory.

The second kind of dividend-strategy ETF looks for stocks that are paying moderate yields but are very durable and likely to sustain or grow their dividends into the future.

One such ETF is Schwab US Dividend Equity ETF. Stocks are only included if they've paid a dividend for the past 10 consecutive years, and they must also score well on four metrics, which are cash flow/debt ratio, return on equity, dividend growth, and dividend yield. What you get is a portfolio that yields only slightly higher than the S&P 500 but is very high-quality.

Quality is a topic that's been getting a lot of interest in investor circles. The thesis is that high-quality firms--those with above-average gross profitability, low leverage, and steady earnings--have historically outperformed junkier stocks over time. And that's exactly what SCHD does which is harvest the quality-risk premium.

We can quantify that in a number of ways. So if we regress SCHD's return on a number of risk factors, what emerges is that most of the fund's market-beating return over the years is explained by its exposure to the quality factor and value to a lesser extent.

And we can also look at the fund's exposure to wide-moat stocks which is a measure of a fund's competitive advantage. We see that about 60% of SCHD's holdings receive a Morningstar wide moat rating, which is extremely high.

When you add in the funds razor-thin 7-basis-point expense ratio, what emerges is a fund that's a suitable core holding for most investors. But as a word of caution the fund wasn't live in 2008 when the weaknesses of most dividend-strategy ETFs were exposed.

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