3 Things You Need to Know Before You Buy the Schwab U.S. Dividend Equity ETF

The S&P 500 index currently yields a tiny 1.2%. You can get roughly three times the yield if you buy the Schwab U.S. Dividend Equity ETF (NYSEMKT: SCHD). The big benefit, however, is that the stocks it holds are vetted for quality and yield. Here's what this exchange-traded fund (ETF) does, and three things you need to consider before you buy it.

What does the Schwab U.S. Dividend Equity ETF do?

It may seem simple, but the first cut for the Schwab U.S. Dividend Equity ETF is to eliminate any company that hasn't increased its dividend for at least 10 years. That squarely focuses the ETF on an elite list of companies. Real estate investment trusts (REITS) are excluded from consideration, for example.

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The second cut is way more complex, involving the creation of a composite score that looks at cash flow to total debt, return on equity, dividend yield, and a company's five-year dividend growth rate.

SCHD data by YCharts.

Companies are lined up from best to worst by their composite score, with the 100 highest ranked stocks making it into the portfolio. The stocks are weighted by market capitalization, so the largest companies have the biggest impact on performance.

And the list gets updated annually, so investors can rest assured that the companies with the best mix of quality and yield are in the ETF. All of this comes with the relatively modest price tag of a 0.06% expense ratio.

If you are looking for a foundational dividend investment, this Schwab ETF is a very good choice. Performance will vary over time, just as with any investment, but the core approach it takes is generally very sound. You could buy it and probably sleep very well at night while only checking in on the fund a couple of times a year.

Potential challenges to consider with the ETF

No investment is perfect, and there are three material issues to consider before you add this Schwab ETF to your portfolio.

1. Don't go in thinking that the quarterly dividend is somehow set in stone or that it will always go higher. That isn't how ETFs work. The Schwab U.S. Dividend Equity ETF owns 100 companies, and they pay dividends at different intervals. And every company it buys doesn't perform as well as hoped, so sometimes dividends will be cut. The dividend has been fairly consistent over time, but it has not been steady by any stretch of the imagination.
   
   If you need a specific amount of income each month to survive, you should build a bit of leeway into your expectations to account for the inherent variations in this ETF's dividend.

SCHD dividend data by YCharts.

2. You might buy and hold a dividend stock for decades, but the Schwab U.S. Dividend Equity ETF's portfolio is updated annually using a preset screen. Stocks fall out of the portfolio and new ones get added every year. This isn't inherently bad; the portfolio updates ensure that the ETF is always doing what it says it will. However, you need to keep in mind that the portfolio changes and that those changes may have implications for your personal portfolio.
   
   As an example, you might buy a stock in June after it has achieved 10 consecutive years of annual dividend increases. Months later, that same stock might end up in the Schwab ETF when it updates its portfolio. And that may mean you have more exposure to the company than you want. It will be important to at least review the ETF's portfolio once a year just to see how it overlaps with your other investments.
   
   
3. The screening approach used by the ETF tends to lead to concentrations in a few industries. To be fair, the fund is fairly well diversified, but roughly 50% of its assets are still allocated to the financial, healthcare, and consumer staples sectors.

If you are trying to build a dividend portfolio around this ETF, you'll want to keep these concentrations in mind, or you could end up with more exposure to a sector than you want. That said, utilities and REITs (which are completely excluded from the fund) are two dividend-heavy sectors that together have very little representation. So this caveat is also an opportunity if you specialize in the sectors where the Schwab U.S. Dividend Equity ETF doesn't have a heavy weighting.

No investment is perfect

When you add it all up, this ETF provides investors a low-cost and well-thought-out foundation for a broader dividend portfolio. But you have to consider the ways in which this ETF interacts with your portfolio, or you could end up with more variation in your income stream than you expect or be overweight in specific stocks or in specific sectors.

Used thoughtfully, the Schwab U.S. Dividend Equity ETF is a great dividend tool, but it may not be the perfect tool for all situations.

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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.