This Low-Cost, High-Quality Dividend ETF Earns High Marks

Since its inception in October 2011, SCHD has managed to keep pace with its average peer in the large-value category. The fund's middling performance over this span can be largely attributed to the fact that high-quality stocks have lagged both the broader market as well as higher-beta, lesser-quality firms. So this is exactly the pattern of performance one would expect from this fund in light of prevailing market conditions. One can also expect that this fund will earn its keep in market downturns. Although SCHD's index has back-tested data dating to Dec. 31, 1998, its live calculation began in August 2011. Back-tested data show that the benchmark's maximum drawdown during the 2008-09 bear market was 44.5%. This compares with the S&P 500's 51.0% drawdown and the Russell 1000 Value Index's 56.3%. While this is a good indication of how this fund may have performed in the crisis period, investors should view back-tested data with a healthy dose of skepticism.

Relative to its large-cap dividend-oriented peers, this fund will likely generate an income stream that is more stable and that should grow with time. This is reflective of the methodology of its underlying benchmark, which specifically targets high-quality, steady dividend payers, and is not--as some of competing funds' benchmarks are--tuned to isolate constituents exclusively on the basis of high current and/or prospective payouts or yields.

Fundamental View Dividends have historically been the most meaningful and reliable contributor to long-run stock returns. But not all dividends, or dividend funds, are created equal. Long-term investors with either total-return or income-specific objectives should focus on the quality of the underlying enterprises, as this will ultimately dictate the long-term stability and growth of these firms' dividends.

In their 2013 paper "Quality Minus Junk," Cliff Asness, Andrea Frazzini, and Lasse Pedersen state that quality stocks are safe, profitable, growing, and have high payout ratios. Their research showed that high-quality stocks have generated better risk-adjusted returns over time and across 24 countries than their lower-quality counterparts, or "junk" stocks in the authors' words.

SCHD's quality tilt can be measured in multiple ways. Regressing the fund's historical returns against a variety of risk factors shows that SCHD's loading on the quality factor is greater than that of almost all other dividend-oriented ETFs. The moat rating is another useful way to gauge the quality of an equity portfolio. Wide-moat stocks are those that Morningstar analysts believe to possess sustainable competitive advantages, and as such, will likely earn returns on invested capital in excess of their cost of capital over the long term. During the past three years, stocks constituting 63% of the value of SCHD's portfolio received a wide moat rating from our analysts, on average. This is the highest allocation to wide-moat names among all dividend-oriented ETFs. Thus, it should be little surprise that the stocks in SCHD's portfolio have significantly higher returns on invested capital, on average, relative to the portfolios of large-value category peers. As of October 2016, the average ROIC for stocks in SCHD's portfolio was 15%, while the same figure for its average peer was 9%.

The prices of quality stocks tend to be less volatile than the broad market and are particularly resilient during times of crisis. However, the weaknesses of some dividend-oriented indexes were exposed in 2008, when many of them had concentrated exposure to the financial-services sector. These funds' dividends subsequently withered as the sector bottomed out in 2009.

Portfolio Construction 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 are then ranked in descending order by their indicated annual dividend yield, and those in the bottom half are eliminated. The remaining stocks are ranked 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 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%.

The index is reviewed quarterly and rebalanced annually. To keep turnover low, Dow Jones keeps stocks in the index as long as their composite scores remain in the top 200 of the eligible universe. The result is a high-quality portfolio of mega-cap names that is--as of this writing--massively overweight in the consumer defensive and technology sectors versus its category peers and category benchmark, the Russell 1000 Value Index. The index's rigorous and intuitive approach to marrying value and quality support a Positive Process Pillar rating.

Fees This fund's expense ratio is 0.07%. This is a fraction of the 0.90% median levy taken by its peers in the large-value category--meriting a Positive Price Pillar rating. Over the three-year period ended Sept. 30, 2016, the fund lagged its spliced benchmark by 14 basis points per year, indicating that turnover-related costs and other portfolio management-related frictions resulted in approximately 7 basis points worth of additional tracking difference per year incremental to the fee-related drag. For the period ended Aug. 31, 2016, 100% of SCHD's distributions were qualified dividends.

Alternatives

There's no shortage of dividend-oriented ETFs for investors to choose from.

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