Monday, May 9, 2016

The Best Dividend ETF to Consider

I pick my own dividend paying stocks in my taxable accounts, and wouldn’t have it any other way. I know some of you have mentioned that they have absolutely no time to dedicate to picking stocks. It makes sense – if you are working 60 hours/week, and have a lot of other responsibilities, you might not have any time for picking stocks. I get it. I also know that some do not enjoy the process of developing and following their own plan. So when some readers have historically asked me for the best dividend ETF, I was unable to answer this question. And I was against dividend ETF's in general.

I have previously been unable to answer this question on the Best Dividend ETF, because most products out there had high expense ratios or have had dividend payments that were not growing overall. In my search for a good dividend ETF or fund I would be looking for something like:

- Look for consistently growing dividends

- Low portfolio turnover

- Low cost

- Some track record of regular dividend increases

For example, while I like the S&P Dividend Aristocrats index, the equal weight ETF based on it (NOBL) doesn’t have a long enough track record to consider, as it was launched at the end of 2013. I do like the fact that it was equally weighted. however, it has an annual fee of 0.35%, which is highway robbery if you ask me. An investor can easily create their own dividend ETF with Motif Investing and pay $9.95 in total to buy up to 30 individual stocks at once.

During my search, I found Schwab US Dividend Equity ETF (SCHD). This ETF includes 100 quality dividend growth stocks, and weights them by market capitalization. These companies are selected using measures of both fundamental strength and dividend performance. No company is allowed to have a weight higher than 4.50% - which is a good risk management procedure.

One of the requirements for companies in the fund is a 5 year history of annual dividend increases, and a ten year history of paying consecutive annual dividends. This should weed out some companies with inconsistent dividend payouts.

In addition, no sector is allowed to take more than 25% of the portfolio – which is another safety procedure to avoid concentration in one sector that goes bad. This is also the cheapest dividend ETF out there with an annual cost of 0.07%. This means that if you invest $100, you would pay 7 cents/year to the fund provider. If you purchase this ETF at broker Charles Schwab, you won’t pay a commission on the transaction.

The nicest thing is that the fund has managed to grow its annual dividends in 2012, 2013, 2014 and 2015. It is on track to have raised dividends for 5 years in a row by the end of 2016.

This is the description from Morningstar:

Schwab U.S. Dividend Equity is a passively managed exchange-traded fund that homes in on high-quality income-producing stocks. The fund's index is composed of large, liquid companies that have paid dividends in each of the past 10 years, and it requires constituents to earn high marks on four fundamental metrics: cash flow/debt, return on equity, dividend yield, and dividend growth. The resulting portfolio is one of the highest-quality among all large-cap dividend-oriented ETFs. Also, SCHD charges a 0.07% expense ratio, which makes it the least expensive dividend-oriented ETF available. This fund's high-quality portfolio and low cost make it a suitable core equity holding.

One downside that I see is the concentration of the largest ten holdings. The largest ten holdings account for almost 45% of the portfolio value. A few of them also have a weighting that is slightly higher than 4.50%. This diversification of the top holdings in most indexes, mutual funds or ETF’s is one of the reasons why I prefer to hold stocks directly, rather than pay money to someone else each year to hold them for me indirectly. These are well-known companies that I can easily purchase with a click of a button, and pay minimal if any commissions in the process. If you hold individual stocks directly in your account, you don’t pay any fees with most brokers out there.

Johnson & Johnson
Exxon Mobil
Procter & Gamble

The other downside is a 19% annual portfolio turnover. This means that the fund holds stocks for an average of 5 years. I have found that the higher the turnover, the higher the chances of making mistakes. One mistake could include selling future winners and buying something that does worse than the original component sold. Frequent churning of portfolio holdings also increases commission expenses and could result in realization of capital gains. Increasing your tax expenses is not a smart way to compound wealth – in fact some of the smartest investors out there hold on for decades in order to take advantage of the float like nature of deferred capital gains taxes.

The third downside is the fact that this ETF does not take into account valuations when it adds or removes portfolio components. This is another reason why I have not been a huge fan of passive investments or investment schemes which add investments without checking on valuations. This is because overpaying for an asset today could lead to terrible performance, even if the fundamentals improve as expected. In other words, it is better if you buy a stock that yields 3% and sells at 16 times earnings rather than buy a stocks that yields 1.50% and sells for 32 times earnings, if all else is the same in terms of actual fundamental performance ( fundamental performance = earnings per share growth and/or dividend growth)

Overall however, if an investor does not want to spend any time on their investments, the negatives would likely be offset by the instant diversification you receive. The portfolio today yields 2.90%, and sells for 18.70 times forward earnings.

As a side note, the Vanguard Dividend Appreciation ETF (VIG) was a second in line for the title of best dividend etf, but lost on a higher expense ratio of 0.10%/year and the fact that dividend income in 2013 was lower than the dividend income in 2012. In general, this ETF had dividend income that fluctuated more than it should have. My goal is to select a set-it-and-forget it ETF where my income will grow over time, and not fluctuate during a time of a general economic expansion.

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