Dividend Income Investing: If You Own SCHD, Here's How To Build Around It

SCHD is a great dividend ETF on its own, but there are some opportunities to enhance it.

If there's one dividend ETF in the marketplace that has captured investors' admiration, it's probably the Schwab U.S. Dividend Equity ETF (SCHD). Over the past three years, it's taken in $27 billion of net new money, nearly triple that of the next closest dividend ETF, the Vanguard High Dividend Yield ETF (VYM). Why is it an investor favorite? Its triple-focused strategy that incorporates elements of dividend growth, dividend quality & high yield has allowed it to narrow a broad dividend stock universe to just the best of the best and comfortably beat the performance of the WisdomTree U.S. Total Dividend ETF (DTD) over the past 5 and 10 years.

Unfortunately, SCHD has stumbled over the past couple of years as tech and the magnificent 7 dominate the market and the fund finally experiences its first real stretch of underperformance. That hasn't deterred many investors, nor should it be. SCHD's all-around approach fits into investors' portfolios as well today as it ever has.

It also makes for a unique investment "problem". How do you build around a dividend ETF that already touches on every major strategy?

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Understanding SCHD

To understand how best to build around SCHD, we need to know what it looks like, where it invests and where its strengths & weaknesses are. By having a good grasp on that, we could look for more dissimilar dividend ETFs that could provide the biggest diversification benefits and the best coverage of the three dividend pillars.

source: ETF Action

SCHD tracks the Dow Jones U.S. Dividend 100 Index. It's designed to measure the performance of high yielding stocks issued by U.S. companies that have a record of consistently paying dividends, selected for fundamental strength relative to their peers, based on financial ratios.

After eliminating REITs, MLPs and preferred stocks from consideration, it looks for stocks that meet the following criteria:

• Market cap of at least $500 million

• 10 consecutive years of dividend payments

• Minimum liquidity requirements

Eligible components are then evaluated based on four criteria:

• Cash flow to total debt

• Return on equity

• Dividend yield

• 5-year dividend growth rate

The 100 highest yielding qualifying components are then selected and weighted by market cap. No single stock can have greater than a 4% weighting and no sector can have more than a 25% weighting.

While I'm all in on the selection criteria, if there's one thing I have a minor complaint about, it's the market cap weighting. With such a robust selection strategy, I'd prefer to see a weighting methodology where stocks that score more highly on the selection criteria receive greater weighting. Or maybe even yield weight the portfolio. Market cap weighting just rewards the biggest companies regardless of whether they score highly or just OK. And there's plenty of cap weighting strategies out there already.

From a sector standpoint, SCHD is quite diversified and looks quite a bit different than the S&P 500.

source: Schwab

The single digit weighting to tech stocks stands out immediately, but the mix of cyclical and defensive sectors at the top of the portfolio, all receiving 10%+ weightings, is especially attractive. When augmenting a core holding, such as the S&P 500, you want satellite holdings that look substantially different in order to maximize diversification benefits and exposures. SCHD has only an 8% overlap to the S&P 500, which makes it an ideal ETF to consider.

When looking at the top 10 holdings, one characteristic becomes obvious. These are all durable, cash rich companies with long histories of rewarding shareholders through dividends.

source: Schwab

Every one of these companies has the ability to survive almost any economic environment, which makes them well-suited for dividend investors. These folks are looking for predictable income streams, whether they're living off of their portfolios or simply accumulating long-term wealth, and each one of these stocks (as well as the others in SCHD's portfolio) is perfect for that.

When deciding what to potentially pair SCHD, we have to get a good understanding of factor exposures, not just individual holdings. This will give us a sense of how these funds actually behave in different environments.

source: Morningstar

SCHD actually has some extreme factor exposures. It's considered a deep value portfolio (although a P/E of 16 doesn't necessarily suggest that). Its 3.8% yield ranks highly in the dividend ETF universe. Momentum is low, which isn't all that surprising given that many momentum strategies are at least 30%+ tech right now. Quality is higher than average, again not terribly surprising.

All in all, it's a firmly defensive portfolio that has historically been about 15% less volatile than the S&P 500. Its emphasis on yield and quality along with its stellar track record (up until recently at least) has made SCHD the core in many investors' portfolio. It's understandable too. SCHD simply has one of the most robust selection criteria of any dividend ETF.

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ETFs That SCHD Shouldn't Be Paired With

Given that SCHD uses a strategy that considers dividend growth, quality and yield, it's honestly hard to think of a dividend ETF that it couldn't be paired with.

When I did this analysis for VIG, we know that it exclusively uses a dividend growth strategy. Therefore, it's easy to say that another dividend growth ETF would be redundant and a dividend quality or yield ETF would make much more sense.

Since SCHD plugs so many holes, this is more of an exercise in making enhancements wherever possible and eliminating overlap. A look at Portfolio Visualizer shows that SCHD has above average factor loads for value, profitability and conservative investment. That makes SCHD perfect as a fund that stands on its own!

If we look at dividend ETFs with the greatest overlap, even that's not an issue in most cases. VIG had more than a dozen funds with at least a 50% overlap. SCHD has just five with more than a 35% overlap. That number is still a little on the high end, but not necessarily so egregious that it should be struck from consideration immediately.

For the record, those five ETFs with the 35% overlap:

• Federated Hermes Strategic Dividend ETF (FDV)

• First Trust Morningstar Dividend Leaders ETF (FDL)

• VanEck Durable High Dividend ETF (DURA)

• Franklin U.S. Low Volatility High Dividend ETF (LVHD)

• iShares Core High Dividend ETF (HDV)

Even though overlap isn't huge with these funds, we can probably steer away from them because there are better diversification options available.

Here are a few more ETFs that make for less than ideal pairings:

• iShares Select Dividend ETF (DVY) - DVY is one of the few ETFs out there that also considers all three of dividend growth, yield and quality in its strategy. The targeting strategies are a little too similar and an historical regression of results shows SCHD doing better by itself than with DVY at all risk levels.

• Vanguard High Dividend Yield ETF (VYM) - Of all the dividend ETFs I looked at, VYM has the highest correlation to SCHD at 0.99. While most U.S. dividend ETFs are generally highly correlated, a factor of 0.99 means they move in a virtual lock-step with each other. Not much sense in adding an ETF that essentially performs identically.

• Invesco S&P 500 High Dividend Low Volatility ETF (SPHD) - Morningstar shows that this fund has nearly the same factor profile as SCHD. While pairing this fund with SCHD would add diversification through heavy additions of utilities & real estate and there are some risk reduction benefits, the hot and cold history of SPHD's annual returns gives me pause.

• Global X S&P 500 Quality Dividend ETF (QDIV) - I would have thought that adding more of a pure quality-focused dividend ETF would make sense, but QDIV has historically generated lower returns with higher risk when compared to SCHD. Plus, overlap is on the higher end of the range.

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ETFs That SCHD Should Be Paired With

Again, SCHD has been a stellar performer on its own, it's one of the cheapest dividend ETFs available and its well-rounded targeting strategy makes it perhaps the best dividend ETF to own by itself without augmenting it with another holding. Looking for ways to improve on it is a bit challenging in this case, but there are few ETFs that can help build around the edges.

Here are four ETFs that could fit that bill:

• Vanguard Dividend Appreciation ETF (VIG) - SCHD technically requires a dividend payment history, not a dividend growth history, so there is an opportunity for a pure dividend growth play to help out. Over the past decade, a pairing with VIG would have actually improved on SCHD's risk-adjusted returns. It's got just a 12% overlap of holdings and comes with one of the lower correlations to SCHD. Plus, it would add tech exposure back to SCHD's relatively minimal position if that's something you're looking for.

• VictoryShares U.S. Equity Income Enhanced Volatility Weighted ETF (CDC) - I'm breaking my rule a bit by pairing SCHD with a fund that has a higher overlap, but the strategy is different enough that I think it makes sense. As the name suggests, the volatility weighting of CDC gives it a different feel and it has a significantly lower correlation to SCHD, especially in recent years. Perhaps the biggest advantage is that CDC reduces equity exposure as stock prices are falling, but buys back at specific trigger points. The "buy low, sell high" strategy employed by CDC is unique within the dividend ETF space.

• Fidelity High Dividend ETF (FDVV) - In isolation, FDVV is riskier than SCHD, but the portfolios are different enough that they complement each other well. According to Portfolio Visualizer, the ideal allocation to maximize risk-adjusted returns (historically, at least) is at 81% SCHD and 19% FDVV. That suggests these dividend ETFs actually pair well together and the modest 15% overlap helps confirm this idea.

• Schwab International Dividend Equity ETF (SCHY) - If you're a fan of SCHD, why not consider the international version of the fund as well? SCHY uses essentially the same strategy for foreign stocks and adds a volatility screen as well. Its expense ratio of just 0.14% is also one of the cheapest you'll find in the international dividend ETF space. I know that international investing isn't something that people are excited about right now, but this would certainly help expand a winning strategy globally, especially when the S&P 500 finally starts lagging the world again.

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Final Thoughts

SCHD is a unique case because it's one of the very few ETFs that I'd say could stand alone in a portfolio. If this fund is your sole dividend ETF holding, I don't think I'd have an issue with it, but there have been cases, such as over the past 18 months, where adding a little enhancement would have helped.

Very broadly, I think more of a pure dividend growth play has proven to work best as a pairing with SCHD as it strengthens that component of SCHD's three-pronged strategy, but the fund is strong enough that you really have to look at ETFs on a case-by-case basis to see which ones fit best. SCHD doesn't really have a glaring weakness or omission in terms of the security selection process.