The key to picking dividend funds is to focus on total return and not only dividend yield. The highest-yielding stocks likely have worse prospects than lower-yielding names. Market participants identify firms with declining fundamentals, and these stocks' prices reflect their slumping prospects ahead of them cutting or stopping dividend payments.
Schwab U.S. Dividend Equity ETF (SCHD) is a compelling fund for exposure to profitable, large-cap U.S. stocks with attractive dividend yields. Focusing on profitability and yield lowers the risk that the portfolio holds companies that cannot support their dividend payments. A low fee adds to this sensible strategy's edge over its peers. It earns a Morningstar Analyst Rating of Silver.
This fund starts with the 2,500 largest U.S. stocks, removes REITs, and keeps the higher-yielding half that have consistently paid dividends for the past decade. Next, it scores these remaining stocks across four fundamental metrics: cash flow/debt, return on equity, dividend yield, and five-year dividend growth. The 100 top-scoring stocks make the final cut and are weighted by market cap.
The fund uses several tactics to avoid owning firms at higher risk of cutting their dividend payment. It only includes names that have consistently paid dividends during the past decade, considers profitability metrics to select its holdings, weights its holdings by market cap, and limits single-stock and sector bets. The profitability metrics and market-cap-weighting approach are evident in its portfolio composition. As of this writing, the fund's return on invested capital (a profitability metric) measured more than double the average fund in the category. And its average market cap of nearly $85 billion was 60% larger than the average fund in the large-value Morningstar Category.
This fund's average indicated yield since its inception through September 2018 measured 3.2%, about 20% higher than that of the category index. The fund's profitability screen doesn't catch all dividend cutters. For example, the fund held ConocoPhillips (COP) when the company cut its dividend in February 2016.
From its inception in October 2011 through September 2018, the fund outpaced its average peer by 1.5% annualized with slightly less risk. The fund's low fee, favorable overweighting to the technology sector, and stock selection within the industrials sector contributed the most to its outperformance.
Investors may benefit from dividend-paying stocks because these payments can offer stable income and provide a cushion to stay invested during turbulent markets. But chasing dividend yield can be dangerous. The highest-yielding stocks may be under financial distress and at risk of cutting their dividends. Many pay out a large share of their earnings and have a narrow buffer to cushion these payments if their business deteriorates compared with lower-yielding counterparts.
This fund mitigates this risk in several ways. First, it screens out stocks that haven't consistently made dividend payments for the trailing 10 years. This screen is backward-looking, so it doesn't guarantee that a stock will maintain its dividend payment, but it demonstrates a commitment of returning cash to shareholders. Lengthy backward-looking hurdles, like this one, preclude companies like Apple (AAPL) that initiated their dividend payment less than 10 years ago but are profitable with stable cash flow.
The fund balances a firm's profitability level and yield so that it selects names that are more likely to be able to support their dividends. The fund assigns half of its equally weighted scoring metrics to profitability measures: cash flow/debt and return on equity. If a stock is more profitable, then it should be better equipped to maintain its dividend during a market drawdown or increase its dividend payment in the future.
Like most dividend-oriented strategies, this fund has a pronounced value tilt. Mature, slow-growing firms tend to trade at lower valuations and pay out a larger share of their earnings as dividends than their faster-growing counterparts, which invest aggressively to expand. Both characteristics can lead to higher dividend yields. Not surprisingly, the fund's holdings were expected to pay out a larger share (49%) of their earnings as dividends at the end of September 2018 than the Russell 1000 Value Index (37%), based on calculations from earnings and dividend forecasts presented in Morningstar Direct.
Because the fund targets mature dividend-payers and weights them by market cap, it favors larger stocks than the average large-value peer. As of September 2018, the fund's average weighted market cap measured nearly $85 billion compared with an average of $50 billion for the category. Limiting its portfolio to 100 stocks contributes to its larger size tilt.
Finally, the portfolio caps single-stock weightings at 4.5% and sector bets at 25% of the portfolio at each quarterly rebalancing. Despite these caps, the fund makes outsize sector bets. Its industrial and consumer staples sector weightings are double those of the category index, while its financial and healthcare weightings are a fraction of the Russell 1000 Value Index's. These bets have paid off since the fund's inception in 2011, but that won't always be the case.
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 have lagged their growth counterparts over the fund's life, detracting from its performance. But its profitability tilt has given it a small return boost.
The fund targets profitable, dividend-paying U.S. stocks while taking steps to reduce the risks of narrowly targeting high-yielding names. Investors end up with a portfolio that favors high-yielding stocks with strong fundamentals. It earns a Positive Process Pillar rating.
The fund tracks the Dow Jones U.S. Dividend 100 Index, which selects its constituents from the 2,500 largest U.S. stocks, excluding REITs, master limited partnerships, preferred stocks, and convertibles. Eligible names must have paid dividends for 10 consecutive years and meet minimum market-cap and trading volume thresholds. The remaining stocks are ranked in descending order by their indicated annual dividend yield (excluding special dividend payments). Stocks that rank in the bottom half are removed. The remaining stocks are assigned a composite score based on four equally weighted fundamental characteristics: cash flow/total debt, return on equity, indicated dividend yield, and five-year dividend-growth rate. The top 100 stocks are included in the index (subject to buffering rules) and weighted by market cap. Individual stocks are capped at 4.5% of the index, and ICB industries (Dow Jones' GICS sector equivalent) are capped at 25%. To keep turnover down, 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 0.85% median toll that the fund's large-value peers charge and supports its Positive Price Pillar rating. Over the trailing three years ended September 2018, this fund lagged its underlying index by 13 basis points per year, a bit 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 metrics. 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 cap. VYM's low fee and broad market-cap-weighted approach support its Silver rating.
Bronze-rated Invesco 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 excluding the most-volatile high-yielding stocks. SPHD may offer a higher dividend yield than SCHD, but it is less diversified.
WisdomTree U.S. LargeCap Dividend ETF (DLN) (0.28% fee) selects the largest 300 stocks by market cap 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.
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Adam McCullough, CFA has a position in the following securities mentioned above: AAPL. Find out about Morningstar's editorial policies.