A New Dividend ETF Comes to Town

10/25/2012 8:00 am EST

Focus: FUNDS

The Big Three dividend exchange traded funds better pay attention, because this new competitor is looking very impressive, writes Samuel Lee of Morningstar ETFInvestor.

Schwab’s new dividend fund, Schwab US Dividend Equity ETF (SCHD), is the most serious competitor to the big three incumbent dividend funds, Vanguard Dividend Appreciation (VIG), iShares Dow Jones Select Dividend (DVY), and SPDR S&P Dividend (SDY).

The upstart’s levy is a mere 0.07% per annum, making the multi-billion-dollar DVY and SDY’s fees look embarrassingly avaricious. Even at-cost Vanguard’s VIG can’t compete when Schwab is pricing SCHD as a loss-leader for its higher-margin products.

The bargain-basement pricing doesn’t mean you’re getting a bargain-basement product. SCHD’s strategy is well constructed, striking a nice balance of yield, market representation, and quality.

DVY and SDY may have high yields, but are heavy in smaller, more-distressed stocks. SCHD achieves quality by requiring stocks have paid dividends for a minimum of ten consecutive years, and ranking stocks by a composite score of cash flow to total debt, return on equity, divi­dend yield, and five-year dividend growth rate.

It achieves representativeness by market-weighting its holdings while capping sector- and stock-level expo­sures at 25% and 4.5%, respectively, so distressed mid-cap firms don’t dominate its portfolio. Finally, it achieves yield by owning the highest-yielding of the stocks that pass its quality screens.
The resulting portfolio is high-yield quality. According to Dow Jones, the index’s dividend yield is 3.2% as of the end of September. In contrast, our perennial favorite VIG’s yield is only about 2%.

Time to ditch VIG? Absolutely not. They complement each other beautifully. SCHD is a value fund; VIG is a blend fund, shading toward growth. Both are top-heavy, with about 40% weightings in their top ten holdings, but they only share about half of their top ten names in common.

While each fund alone is good enough for a core holding, together they’re even better.

Morningstar’s Thesis
Despite its short history, the fund’s growth has been astonishing. More than 60% of the fund’s holdings carry a wide-moat rating, which suggests they have greater capacity than do their peers to increase their dividend payouts in the future.

For example, 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 dampen 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.

If Congress does not take further action, qualified dividends will lose their preferential tax treatment at the end of this year. Starting January 2013, all divi­dends will be taxed at ordinary rates.

Consequently, this fund may lose its appeal for investors in higher tax brackets, though it may still be a good option for tax-sheltered accounts. Taxes on long-term capital gains are also slated to increase to 20% from 15%. (This rate will fall to 10% for investors in the 15% tax bracket.)

As a result, dividends will become a less tax-efficient method to return capital to shareholders than share buyback programs. Under this new tax regime, many companies may pursue share buyback programs more aggressively in lieu of raising their cash dividends, which may reduce the dividend yield investors can expect from this fund in the future.

Portfolio Construction
The fund tracks the Dow Jones US 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 US 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 ten 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.

Schwab recently reduced the fund’s expense ratio to a razor-thin 0.07%, making it the cheapest dividend-strategy fund on the market.

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