MSFT - Better Passive Income Snowball: SCHD Or DIVO?

2023-10-12 08:00:00 ET

Summary

• Passive income snowball investing is a great way to build long-term wealth and save for retirement.
• We compare two potential core ETFs for building a passive income snowball.
• We share our thoughts on which is the better fit for this investing strategy.

The process of building a passive income snowball mirrors the growth of a snowball rolling down a mountain. Just like a snowball starts small, our passive income stream often starts off at a pretty meager level. However, as the passive income snowball begins its descent down the mountain, we start to collect dividends from the stocks we own, which further bolster our snowball's size. As more dividends come our way, our income snowball grows, building even more wealth and throwing off more passive income in the process. When we add additional funds from our earned income, it grows even faster.

The beauty of this exponential wealth-building process lies in our passive income's expanding size, just like a snowball gathers more snow as it rolls. The longer we allow our passive income snowball to roll, the more passive income it throws off, and the faster it grows. Before we know it, we find ourselves earning thousands of dollars every month from dividend payments.

Another benefit of passive income investing is that it simplifies the retirement planning process by enabling an individual to focus on dependable dividend stocks that cover living expenses and grow their payouts over time. This approach removes emotions - an investor's worst enemy - from the investing equation and also enables an investor to take advantage of market downturns rather than fearing them.

Moreover, dividend growth stocks typically have strong underlying businesses because a company that can throw off an ever-increasing amount of cash flow on a per-share basis over the course of many years typically has a very strong moat and exceptional management.

As a result, dividend growth ETFs like the Schwab U.S. Dividend Equity ETF ( SCHD ) and the Amplify CWP Enhanced Dividend Income ETF ( DIVO ) are popular funds among retirees. They pay out attractive dividends and also generate solid long-term total returns for investors. In this article, we compare them side by side and offer our take on which would make a better core holding for a passive income snowball.

SCHD ETF vs. DIVO ETF: Total Return Track Record and Expense Ratio

Since DIVO started trading back in 2016, both SCHD and DIVO have delivered solid - and near identical - total returns, with a notable correlation between their performances as well. However, DIVO has managed to outpace SCHD in terms of total returns. It is important to mention that DIVO's outperformance comes in spite of the fact that SCHD's very low expense ratio of 0.06% gives it a performance advantage in contrast to DIVO's significantly higher expense ratio of 0.55%.

This means that DIVO's underlying portfolio has outperformed SCHD's since DIVO's inception.

SCHD ETF vs. DIVO ETF: Dividend Growth Track Record

Dividend growth is a key metric for income-oriented investors seeking to build a passive income snowball because the ability of an ETF to consistently grow its dividend payments is indicative of the strength and stability of its underlying assets.

Over the past half decade, SCHD has consistently outgrown DIVO in terms of dividend growth, boasting an impressive 13.69% Compound Annual Growth Rate. In contrast, DIVO achieved a meager CAGR of 0.26% over that same time period.

This makes SCHD particularly appealing to investors looking to create a rapidly growing passive income snowball, as it signifies its ability to generate reliable and consistent income growth.

SCHD ETF vs. DIVO ETF: Dividend Yield

That said, dividend growth is just one part of the passive income snowball equation. In fact, some would argue that dividend yield is far more important, as it directly impacts the amount of income an investor can generate from their investment today. Moreover, they can always reinvest that income in order to grow their passive income stream faster in a manner similar to what would be accomplished by organic dividend growth.

SCHD offers a trailing twelve-month dividend yield of 3.70%, while DIVO offers a trailing twelve-month dividend yield of 4.91%. As a result, while SCHD grows its payouts much faster than DIVO does, DIVO does pay out a much more attractive current yield.

SCHD ETF vs. DIVO ETF: Portfolio Composition

One of the most significant differences between SCHD and DIVO is their sector allocation. SCHD's largest allocation is to Industrials whereas DIVO's largest allocation is to Financials. DIVO also has a greater allocation to technology stocks (its second largest position) as well as a larger allocation to energy and utilities relative to SCHD. In contrast, SCHD allocates slightly more funds to healthcare stocks and communication stocks.

As far as top ten holdings, SCHD has 40.42% of its portfolio tied up in these holdings, particularly in pharmaceutical/biotech stocks like Amgen ( AMGN ), AbbVie ( ABBV ), Merck ( MRK ), and Pfizer ( PFE ) which are its first, second, fourth, and sixth largest positions, respectively. DIVO, meanwhile, has a whopping 57.71% of its portfolio tied up in its top ten holdings. Interestingly, none of its top ten holdings include pharmaceutical/biotech companies, with it favoring a wider variety of companies including short-term government bonds ( AGPXX ), UnitedHealth Group ( UNH ), Visa ( V ), Chevron ( CVX ), Microsoft ( MSFT ), Apple ( AAPL ), Procter & Gamble ( PG ), JPMorgan Chase ( JPM ), Goldman Sachs ( GS ), and McDonald's ( MCD ) for its top positions. Overall, DIVO is not very well diversified at all compared to most ETFs - including SCHD - as its 35 total number of holdings is just one-third that of SCHD's 105 holdings.

This difference in portfolio composition largely stems from the fact that SCHD is a passive, rules-based ETF that enables it to charge less of a management fee while diversifying more broadly. In contrast, DIVO is an actively managed fund that places high conviction bets on its holdings. Moreover, it juices its dividend yield by generating a 2-4% yield per year in options premiums that it generates from tactically written covered calls in its portfolio.

SCHD ETF vs. DIVO ETF: Investor Takeaway

While both SCHD and DIVO are attractive dividend ETFs, SCHD emerges as the superior choice for investors focused on building a passive income snowball in our view. While they have generated basically identical total returns during the time that both have traded and DIVO does offer a higher current yield, SCHD's dividend is 100% backed by the dividend cash flow from its underlying holdings whereas DIVO's dividend is largely dependent on its skill at writing covered calls. Moreover, SCHD has delivered vastly superior dividend growth rates than DIVO, so over time we expect their yield on cost to meaningfully surpass DIVO's for shareholders buying at current levels. Last, but not least, the significantly higher expense ratio that DIVO charges shareholders will make it harder for DIVO to deliver superior total return performance over the long-term, while SCHD's superior diversification gives it better overall risk-reward in our view.

SCHD enables investors to sleep better at night with its ample diversification, enjoy much stronger dividend growth that should exceed the average pace of inflation over the long-term, and lose a very minimal amount of their total returns to management fees. As a result, we favor SCHD over DIVO for establishing a core position in a passive income snowball portfolio.

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