Whether you’re just out of school and starting to invest for the very first time or you’re retired and looking to live off of the wealth you’ve acquired, most people would agree that stocks should, in some form, be a part of your portfolio.

Young folks should be building their core portfolio around high quality dividend-paying stocks that have the potential to outperform the market over time. Retirees can use the steady, predictable income from these companies, while adding a little punch to their portfolio to keep ahead of inflation. Finding a fund that can deliver on both of these objectives, while charging one of the lowest expense ratios in the industry, is a recipe for an ETF that you can buy and hold forever!

The fund I’m referring to is the Schwab U.S. Dividend Equity ETF (SCHD).

SCHD follows the Dow Jones U.S. Dividend 100 Index, which provides exposure to high dividend yielding stocks with a history of consistently paying dividends and demonstrating relative fundamental strength. All index eligible stocks must have sustained at least 10 consecutive years of dividend payments. Note that the requirement isn’t for 10 consecutive years of dividend GROWTH, just 10 consecutive years of payments. In reality, this is a minor detail since most names that qualify for SCHD are indeed dividend growers and the financial strength screens help ensure that dividend payments are secure going forward.

Methodology

The index starts by identifying the companies meeting initial eligibility requirements (10 years of dividend payments along with size and liquidity screens). Those securities get ranked by dividend yield in descending order with the top half of that list eligible for selection.

Potential constituents get evaluated by four fundamental criteria:

  • Cash flow to total debt
  • Return on equity
  • Indicated dividend yield
  • Five-year dividend growth

Since 5-year dividend growth rate is a consideration, it’s likely that companies need to be dividend growers in order to qualify, even though it’s not specifically a requirement. The four rankings are equal weighted to create a composite score, and the eligible securities are ranked based on this composite score. The 100 top-ranked stocks by the composite score are selected to the index, subject to the following buffer rules that favor current constituents during the annual review. There is some flexibility in the inclusion criteria that allows current constituents to remain in the index as long as they remain in the top 200 according to the composite score. This allows SCHD to limit some of the turnover and tax issues that might occur had it chosen to strictly choose just the top 100 at each rebalance.

Once the final 100 names are selected, they are weighted using a modified market cap approach that limits individual holdings to no more than 4.5% of the index and no industry to more than 25%.

The resulting portfolio ends up looking like this:

SCHD

Not too many surprises here, as the portfolio is filled with mature, stodgy businesses from traditionally conservative growth sectors, such as consumer goods/services and industrials. The small allocation to the financial sector is probably at least partially a result of catching the tail end of the post-financial crisis period that comes from looking back over the past 10 years, not to mention the fact that financials don’t measure up particularly well to the broader market when comparing ROE or dividend yields.

One of the things that might be a little more surprising is the lack of utility and REIT names in the portfolio.

Where are the utilities and REITs?

The answer to why there’s no real estate in the portfolio is pretty straightforward. The underlying index excludes them right off the bat before any screening even takes place. It’s difficult to say why specific utility names are missing, but they’re likely coming up short on the ROE and cash flow to debt screens. Despite their high yields, utilities tend to carry high debt levels and generate pretty low ROEs.

I find the fact that SCHD has virtually nothing invested in utilities and real estate to be both a good and a bad thing. On the plus side, these two sectors are very interest rate sensitive. If interest rates continue to climb over the next couple of years, as expected, the dividend payments from those stocks start to look less attractive as income seekers look more to fixed income for yield. It’s reasonable to think that these two sectors would underperform, dragging the performance of any ETF holding these stocks down as well. Since SCHD is avoiding these sectors, there shouldn’t be that additional downward pressure.

On the other hand, utilities and real estate tend to be the two highest yielding areas of the market. Real estate was considered important enough to the overall economy that S&P Dow Jones Indices and MSCI in 2016 decided to elevate real estate companies to their own sector in the GICS classification system. Omitting real estate and utilities altogether eliminates exposure to two very important sectors of the economy, while reducing the fund’s dividend yield potential.

If you’re looking to round out your portfolio, you’ll need to add ETFs in these two sectors. In my ETF rankings that I make available to my ETF Focus subscribers, my top rated funds for these two sectors are the Vanguard Utilities ETF (VPU) and the Schwab U.S. REIT ETF (SCHH). Both of these would make ideal satellite holdings to a core SCHD position.

Expense Ratio, Dividend Yield and Risk

Investors should almost always target ETFs with low expense ratios, and in the dividend ETF universe, none comes lower than SCHD. At 0.07%, it’s the cheapest equity dividend ETF available.

The dividend yield of nearly 3% comes in well above the 1.8% yield of the S&P 500. Not surprisingly, the selection criteria produces a portfolio that’s more value than growth. The portfolio is a little pricier than you might expect, but standard deviation measures point to a more conservative equity fund.

Fund Characteristics

While the 3% yield is very solid, the history of the quarterly dividend has been somewhat inconsistent. The overall trendline since the fund’s inception is up, but there have been a few instances where the dividend has inexplicably dropped. Once such instance is in the most recent quarter, where the dividend dropped from $0.345 to $0.262.

I don’t have a good explanation as to why there was a 24% haircut in the dividend, but let’s hope it’s just a blip and not a trend.

From a risk standpoint, SCHD has done a great job of delivering superior risk-adjusted returns compared to its Large Value peer group, and has actually managed to hang tough with the S&P 500 (SPY), despite having the disadvantage of its style being out of favor for much of the past several years.

SCHD has managed to deliver about 200 basis points of extra return annually over the past five years with about 10% less risk compared to the Large Value group. Against the S&P 500, SCHD comes up a little short on both measures, but keep in mind that it hasn’t had the benefit of having the huge returns from names, such as Amazon (AMZN), Netflix (NFLX), Alphabet (GOOG) (NASDAQ:GOOGL), Microsoft (MSFT) and Facebook (FB), in its portfolio. It’s had to generate its returns using names, such as Procter & Gamble (PG), PepsiCo (PEP) and IBM (IBM) instead.

How SCHD Is A Fit For Younger Investors

The core of any good portfolio should be built around solid, strong, mature companies that pay above average dividend yields and can be held indefinitely. Younger investors may prefer a product, such as the PowerShares QQQ Trust ETF (QQQ) as a centerpiece, since it has more of the trendy names that they’re familiar with, but a fund, such as SCHD, is probably a better choice since it’s less impacted by the highs and lows of both the stock market and the economy, and should reduce volatility over time. More aggressive products can be added in pieces around the core at any time, but long-term dividend growers should be a large part of the foundation.

Any number of studies have shown that dividend growers have outperformed dividend payers, which, in turn, have outperformed non-dividend payers over time. That really hasn’t been the case lately as investors have generated big returns with plain beta without having to dive into smart beta or high beta. Value has been an underperformer for some time, but I expect that over the course of the next several decades, value will demonstrate its, ummm… value again, and lead lower beta products to strong returns once more. SCHD has managed to deliver strong returns without the benefit of this tailwind. Imagine what it could do with it?

How SCHD Is A Fit For Older Investors

Retirees and near-retirees will probably use fixed income products to generate the majority of their income, but quality dividend payments from equities should also be a part of that equation. I use the word “quality”, because at this stage of life you don’t want to allocate too much of your portfolio reaching for yield. High yields can be obtained through the use of quality fundamental screens without exposing your portfolio to excessive downside risk. In the past, I’ve used the FlexShares Quality Dividend Index ETF (QDF) as a prime example of a fund that can offer both yield and quality, but SCHD deserves to be right in that conversation as well.

Conclusion

Younger and older investors probably want to use SCHD in different ways for different purposes, but there’s no reason why it can’t fit into the portfolio of anyone at any age. Young folks can use it as a core foundational piece with which to build a diversified portfolio around, while older investors will find it appealing for its ability to diversify one’s income stream, while offering a conservative equity portfolio to help fight off the effects of inflation. Its 3% yield provides an appealing alternative to Treasury yields, and the 0.07% expense ratio is a number that you just can’t beat.

Quite simply, this is a fund that has a place in just about any portfolio.