The cheapest U.S. dividend-focused fund available

This low-cost fund uses profitability scoring to target high-quality dividend stocks.

Adam McCullough, CFA 6 November, 2018 | 6:00PM

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.

The fund tracks the Dow Jones U.S. Dividend 100 Index, which selects its constituents from 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 US$85 billion was 60% larger than the average U.S. large-cap value equity fund sold in the United States.

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, favourable overweighting to the technology sector and stock selection within the industrials sector contributed the most to its outperformance.

Schwab levies a low 0.07% management-expense ratio on this ETF, making it the cheapest dividend-focused U.S. equity fund in both Canada and the United States. Over the trailing three years ended September 2018, the fund lagged its underlying index by 13 basis points per year, a bit more than its average annual fee. As always when investing in U.S.-listed ETFs, make sure currency-conversion costs don't negate the benefit of lower fees.

Fundamental view

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 favours 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.

About Author

Adam McCullough, CFA

Adam McCullough, CFA  Adam McCullough, CFA, is a manager research analyst for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc. He covers passive strategies.