SCHD: The Methodology Risks Aren't Worth It

Why Index?

Those familiar with our writing are no strangers to the idea that indexing is a great way to take the temperature of a market, and that the introduction of low-cost investing paved the way for indexes to transform from a quick barometer of markets or market segments and into investible vehicles. Anyone with even a passing familiarity of the markets knows that index funds have exploded in popularity: it is estimated that total assets under management at ETFs across the market have ballooned from $204 billion in 2003 to $9.6 trillion in 2022 according to Statista.

This sea of money has prompted a proliferation of index funds as money managers scramble to get a piece of the action, which can present investors with a bit of a conundrum: which index fund is best?

Of course, there's no way to answer that question definitively, but today we'll be exploring the Schwab U.S. Dividend Equity ETF (NYSEARCA:SCHD). Digging into the nuts and bolts of how it works, we think, is helpful for those wanting to understand exactly what it is they're buying (or selling, or holding). Let's get to it.

Why This Index?

Every index fund has a benchmark, or an underlying market segment or index whose performance it is attempting to match. Investors need to know how to evaluate that benchmark to determine whether or not it is likely to meet their individual goals. SCHD's goal, as stated in the fund fact sheet dated June 30, 2023, is as follows:

The Fund's goal is to track as closely as possible, before fees and expenses, the total return of the Dow Jones U.S. Dividend 100 Index.

Now, while most readers are likely familiar with the Dow Jones Industrial Average (INDU), it would not surprise us to know that far fewer readers are familiar with the Dow Jones U.S. Dividend 100 Index (hereafter Dow Dividend 100). The Dow Dividend 100 is a sub-index devised by Dow Jones, and in order to evaluate SCHD, we must first understand the benchmarked index and the methodology behind it.

The Dow Dividend 100 is, according to its own fact sheet dated August 31st, 2023, is intended to accomplish the following:

The Dow Jones U.S. Dividend 100 Index is designed to measure the performance of high-dividend-yielding stocks in the U.S. with a record of consistently paying dividends, selected for fundamental strength relative to their peers, based on financial ratios.

OK, so far so good. It makes sense that investors seeking dividends would want all of those things. However, we need to take it a step further and assess exactly how the fund selects its holdings.

According to the methodology of the index, which can be found on page 19 of the document, constituent securities must have a minimum of 10 years consecutive dividend payments, a float-adjusted market capitalization of at least $500 million, and a three-month daily traded volume average of $2 million.

Stock that makes this cut are then further sorted using a three-step raking process by which ranking are assigned in an equal-weight manner across four fundamental-based characteristics. Those four fundamentals are (we are paraphrasing a bit here for clarity):

1. Free cash flow to total debt.
2. Return on equity.
3. Indicated Annual Dividend Yield.
4. 5-year dividend growth rate.

Companies are then ranked on a composite score generated from these inputs, and the stocks with the highest 100 scores are included.

So, right off the bat investors can see that this is likely to screen for some fairly solid companies. However, we do have a bone to pick.

We don't think that it's controversial to say that the primary reason for existence of any company is to generate returns for its shareholders. The form of return we're most interested in, in this case, is a dividend.

We think, then, that free cash flow to total debt and return on equity are the weak links in the methodology.

Free cash flow to total debt is obviously important, but we are unconvinced that it is a top-four reason to include a stock in an index for dividends. Some industries are debt-light, which will inevitably skew to companies with a business sector advantage. What's more, if a company capitalizes expenses with equity or cash on hand rather than debt, the metric will further be skewed in its favor.

Further, it is not clear to us in the least that return on equity is in contention for the best metric against which dividends can be evaluated. For one, a return on equity ignores the inherent differences in capital structure between industries, and punishes reliable dividend payers whose equity is regulated (such as banks), or companies which pay dividends but rely on debt to fund operations (like utilities).

To top things off, the index is market capitalization weighted, with a single stock allowed to comprise no more than 4% of the index and no industry allowed more than 25% total. While the percentage weights make sense, we think that the decision to weight by market capitalization adds an additional layer that doesn't necessarily benefit shareholders.

AbbVie (ABBV), for example, is SCHD's largest position and has a current indicated yield of 3.86% as of this writing and occupies a little more than 4% of the fund (rebalancing is conducted quarterly). Altria Group (MO), meanwhile, sports a 9% indicated yield and makes up 2.5% of the index, while ONEOK (OKE) has only a 0.99% weighting in the index with a 5.65% yield.

In other words, when you select for a basket of stock with certain criteria and weight them on a market-cap scale in your index, you don't necessarily get the best dividend paying fund out there--you get a basket of stocks that simply comport with your methodology.

The Bottom Line

SCHD aims to replicate the returns of the Dow Dividend 100, and it does so quite well. As of this writing the fund has a current dividend yield of 3.55%, which looks a bit paltry compared to the 2-year Treasury which currently yields 5.05%.

While the constituent companies in the fund do not present a risk in and of themselves, we believe that investors should be fully aware of the methodology used to select these stocks, and it is our opinion that the methodology used is flawed for the reasons outlined above if investors are interested in maximizing their dividends or even in managing single stock risk since the weight by market capitalization means that investors are exposed to outsized swings in the index if the largest stocks experience heightened volatility (for reference, the top ten holdings in SCHD make up roughly 40% of the overall weight).