Unveiling the Power of the SCHD ETF: What can we Learn from their Inclusion Criteria?

I think you have all noticed it, the Schwab U.S. Dividend Equity ETF ( SCHD ETF ) is by far the most popular dividend growth ETF on social media right now. As an example, I bet you must have heard some people saying “$SCHD and Chill”.

Unfortunately, this ETF isn’t available to most European citizens, because it isn’t a UCITS ETF. There are some $SCHD alternatives out there, but none of them is able to compete and provide an attractive alternative to dividend growth investors.

However, this doesn’t mean that we can’t learn from it and improve our own investment process. And this is exactly what this short blog post is about today, so let’s get into it.


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Simply said, it’s a combination of the following:

  • A good dividend yield (3%+)
  • Supported by proper dividend growth
  • At a low 0.06% expense ratio
  • And a nicely diversified set of blue-chip stocks

At this time of writing, the SCHD ETF trades at $71.23 with a 3.64% dividend yield.

This sounds almost too good to be true, so let’s have a look at how this ETF is set up and what we can learn from it.

How is the Schwab U.S. Dividend Equity ETF set up?

Let’s actually start with the most important topic in this blog post to get a better understanding of this ETF.

In fact, $SCHDโ€™s goal is to track as much as possible the Dow Jones U.S. Dividend 100โ„ข Index, corrected for fees and expenses. In other words, we need to go a level deeper into our research. This is quite common for ETFs.

About the Dow Jones U.S. Dividend 100โ„ข Index ($DJUSDIV); it measures the performance of high-yielding US dividend growth stocks, selected for fundamental strength relative to their peers, based on financial ratios.

And this is where it gets interesting because SP Global has nicely documented its methodology (page 19). Hence, I took the time to study it and I will now share some of my biggest learnings.

Index Screener Criteria

First of all, the only eligible stocks are the ones that are part of the Dow Jones U.S. Broad Stock Market Index which is again a subset of the Dow Jones U.S. Total Stock Market Index (Yay! another index in what is becoming a complex nested loop ๐Ÿ˜‰).

This index currently consists of 2512 stocks ranging from small-cap to large-cap stocks. Hence, this forms a nice basis to look for 100 high-yielding dividend growth stocks to compose the SCHD ETF.

So let’s start with their first selection criteria (aka screener) to filter out most of the stocks:

  • At least 10 consecutive years of dividend payments
  • A market cap of at least 500 million USD
  • An average daily trading volume of 2 million USD

However, this is not where it stops. SP Global then ranks the stocks that passed the screen in descending order via their trailing-twelve-month yield (they call this IAD yield – IAD stands for Indicated Annual Dividend). The top half of these stocks (thus the highest yielding) are then eligible for further stock selection.

By now, there are probably a few hundred stocks left for inclusion in the Dow Jones U.S. Dividend 100โ„ข Index.

๐Ÿ’ก 1: these selection criteria are set up to filter out small-cap stocks with low trading volumes because they bring in additional risk. Secondly, it filters stocks that have at least some tradition of paying consistent dividends but not necessarily growing dividends. It also means that, for better or worse, if companies like Alphabet would start paying a dividend that they won’t be included in the upcoming 10 years.

Index Inclusion Criteria

This is where the fun part starts and where we can learn the most as value-oriented dividend growth investors. Because in reality, this is as much about buying high-quality businesses as it is about dividend growth investing.

Having said that, their approach is to select stocks based on the following 4 equally-weighted criteria:

  • Free Cash Flow to Total Debt ratio
  • Return on Equity
  • Indicated Annual Dividend Yield
  • Five-Year Dividend Growth Rate

All of these are ranked high-low and then equally weighted based on their scores. As a result, the top 100 ranked stocks are selected to be in the index.

They are then reviewed annually in December, but it doesn’t mean that if a company scores lower next year that they are automatically dropped. As an example, stocks will continue to be in the index as long as they stay in the top 200 the following year.

I like this because sometimes a stock can have a one-off profit drop and impact its Return on Equity quite severely. It would be a shame to kick out such a company for a single bad year if all else is still looking very good.

๐Ÿ’ก 2: This index is looking for cashflow-rich companies with the ability to generate high returns on equity for their shareholders. This sounds a lot like the approach Warren Buffett and Charlie Munger stand for. On top of that, it’s looking for the highest-yielding stocks with proven dividend growth track records over the last 5 years. Doesn’t this sound a lot like the chowder rule?

Index Diversification Rules

SP Global has some rules in place which are pretty much similar to my dividend portfolio allocation strategy.

As an example, a single stock can’t represent more than 4% of the total index. It will be trimmed off on a quarterly basis if it so happens that a stock becomes larger than that.

A similar approach applies to the sector weighting. A single sector can not represent more than 25% of the entire index.

Last but not least, they also look at their diversification on a daily basis. For instance, the sum of stocks representing more than 4.7% each and exceeding 22% of the total index together will trigger a rebalancing activity. This should protect shareholders in the event of rapid and exuberant share price increases for some of their holdings.

๐Ÿ’ก 3: these are good fail-safe mechanisms for preventing elevated single-stock risks within this ETF.

My Learnings about the SCHD ETF

Simplicity is the ultimate sophistication said the great artist Leonardo Davinci and I must wholeheartedly agree with that statement.

I must confess, I’m really impressed by the simplicity of these selection criteria as they really stimulate the inclusion of high-quality dividend growth stocks. I actually can’t imagine that Buffett isn’t a great fan of the SCHD ETF, because I’m sure he would’ve created something like this if he would’ve been the owner of an index fund.

However, to make this sub-paragraph a bit more to the point. I now know better how to improve my own process in the pursuit of more high-quality dividend growth stocks (which is my goal for this year after composing this year’s annual report):

  • Free Cash Flow is King
  • Strong Balance Sheets provide protection and flexibility
  • Return on Equity matters!
  • The Chowder Rule tells you something about valuation if the above three bullets are all in the green.

Having said that, I will start to put much more weight on these criteria when adding new dividend growth stocks to my portfolio.

There is one more thing though: should I also rebalance stocks in my portfolio on a regular basis? I am doing my annual spring cleaning, but I wouldn’t consider that a rebalancing exercise.

As an example, should I start trimming my Apple and Microsoft positions as they became large and provide hardly any dividend yield? I’m still on the fence with this one, because I’ve also learned in the past to let my winners run.

Hence, I’m very curious to learn how you look at this. Are you rebalancing your dividend growth portfolio based on a set of predefined rules?


SCHD Holdings

Talking about food always makes me hungry! Hence, it’s about time to check out the current top-10 SCHD holdings:

  1. Broadcom ($AVGO)
  2. PepsiCo ($PEP)
  3. Merck & Co Inc ($MRK)
  4. Cisco Systems Inc ($CSCO)
  5. Coca-Cola ($KO)
  6. Texas Instruments Inc ($TXN)
  7. Home Depot Inc ($HD)
  8. Verizon Communications Inc ($VZ)
  9. Pfizer Inc ($PFE)
  10. Chevron Corp ($CVX)

The top 4 are currently weighing more than 4% of the index, so as per their rules, they will all be rebalanced at the end of this quarter.

Also, together these 10 make up about 47% of the entire index which does feel a bit too concentrated. That’s where also one of the negatives of this index comes in because they have a 30.33% turnover rate!

That’s really a lot and in my own experience, the more you touch your portfolio, the more subject to mistakes you are. And definitely, as individual investors, we would also be exposed to a high amount of commissions.

In the end, your portfolio is like a bar of soap and you don’t want it to disappear by touching it too much. So maybe rebalancing is not such a good idea then? #doubts

Having said that, I own $PEP, $TXN, and $CVX from this list. It’s interesting how biased I am towards some of these stocks like Verizon and Pfizer. On the other hand, I would love to own some $HD and $KO at the right price.

๐Ÿ’ก 4: Maybe this is where I could improve by looking more at a diversified setup based on a set of rules rather than mostly valuing individual stocks. A high-quality decent-yielding dividend growth stock (i.e. 2%) in combination with a high-yielding dividend stock (i.e. 8%) still gives me a 5% dividend yield on average. #thoughts

Has the SCHD ETF beaten the SP 500?

While it isn’t at all my goal to beat an index but rather focus on beating my own dividend growth investing plan, I do know this matters to many of you.

Hence, it’s interesting to see that the SCHD ETF is trailing the $SPY 500 over the last decade by ~70% and I think that this has to do with the lack of exposure to Information Technology stocks like Microsoft, Alphabet, Apple, Meta, and Tesla.

SCHD vs SPY 2012-2023

On the other hand, I’m pretty sure that the $SCHD ETF has beaten $SPY ETF when it comes to dividend income and dividend reinvestments. And I believe that this is way more important to us as dividend growth investors ๐Ÿ˜‰

Final Thoughts

Honestly, it surprises me that there are no other companies, i.e. iShares, that are tracking the same Dow Jones U.S. Dividend 100 Index. It shouldn’t be too hard to create a UCITS version of this and to provide European investors with an opportunity to also invest in this index via a low-cost ETF.

Hence, if you want to change this, then please help me by retweeting the hell out of this:

Last but not least, I will add the SCHD holdings list as an element of my dividend stock screener, because the approach of the underlying index is very similar to my own dividend growth investing philosophy. It makes it even easier to find high-quality US dividend growth stocks.


That’s it from my side!

If you enjoyed this post, then feel free to consider buying me a coffee ๐Ÿต so that I get ready for the next blog post ๐Ÿ˜‰

Now tell me, do you have the luck to own the SCHD ETF in your portfolio? If so, how important is it to your portfolio composition?

And what are your learnings when studying the SCHD ETF? Are you taking or have you taken any actions to improve your own dividend growth portfolio?

Let me know, I’m very curious!

Having said that, I hope you found this blog post insightful and I’m wishing you a great week!

Yours Truly,

European Dividend Growth Investor

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European DGI

I am European DGI and it's my desire to retire early via Dividend Growth Investing as a passive income stream. This is not easy and especially when living in Europe. That's why I started this blog because I truly believe we can learn a lot from each other by sharing our journeys!

Disclaimer

Iโ€™m not a certified financial planner/advisor nor a certified financial analyst nor an economist nor a CPA nor an accountant nor a lawyer. Iโ€™m not a finance professional through formal education. Iโ€™m a person who believes and takes pride in a sense of freedom, satisfaction, fulfillment and empowerment that I get from being financially competent and being conscious managing my personal money. The contents on this blog are for informational and entertainment purposes only and does not constitute financial, accounting, or legal advice. I canโ€™t promise that the information shared on my blog is appropriate for you or anyone else. By reading this blog, you agree to hold me harmless from any ramifications, financial or otherwise, that occur to you as a result of acting on information provided on this blog.

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