IYM - Retirement Passive Income: SCHD's Flaws And How To Fix Them

2023-06-10 07:43:19 ET

Summary

• SCHD is a wildly popular ETF for retirees looking to generate passive income.
• It has a tremendous track record that makes it arguably the best all-around passive income ETF in the market today.
• That said, it has some clear flaws.
• We share three important moves investors can make to fix these flaws and build a near-perfect passive income portfolio with SCHD at its core.

The Schwab U.S. Dividend Equity ETF (SCHD) is a wildly popular ETF for retirees looking to generate passive income as evidenced by its large and growing assets under management:

It has earned investor trust through putting up a tremendous track record that makes it arguably the best all-around passive income ETF in the market today:

That said, it has some clear flaws that prevent it from being a perfect one-stop shop for a retiree's passive income portfolio. In this article, we share three important moves investors can make to fix these flaws and build a near-perfect passive income portfolio with SCHD at its core.

SCHD's Flaws

While it is hard to argue against SCHD's impressive total return and dividend growth performance over the past decade that pretty much leave it second to none when it comes to passive income ETFs, there are some flaws in the fund that keep it from being a true retiree's dream fund:

1. Its dividend yield is a bit low at just 3.7%, especially considering that most retirees try to plan around a 4% rule retirement and the Federal Funds rate is currently over 5%.
2. It is a bit weak in inflation protections with only ~11% of its portfolio invested in proven inflation hedges such as basic materials ( IYM ) (only 1.97% exposure), energy ( XLE ) (only 9.10% exposure), and real estate ( VNQ ) (0% exposure).
3. It is also very light on some of the most yield-oriented and defensive sectors such as communications ( IYZ ) (only 4.61% exposure), utilities ( XLU ) (only 0.28% exposure), and senior-secured floating rate corporate debt ( BIZD ) (0% exposure).

If SCHD were to incorporate more of the underweight sectors discussed in flaws two and three, its first flaw - namely its relatively weak yield - would be resolved without a doubt. As a result, we believe that retirees can build a dream passive income portfolio with SCHD at its core by complementing a core SCHD holding with the aforementioned sectors where it is underweighted in order to create a really well balanced and diversified, high yield portfolio.

Three Important Moves Investors Can Make

In our view, the three best ways investors can do this are:

1. Simply buy each of the ETFs mentioned about (IYM, XLE, VNQ, IYZ, XLU, and BIZD) in sufficient numbers to bring the portfolio into a reasonable balance and produce a yield sufficient for whatever the individual investor feels like they need to retire well. For a bit higher yield, investors may be better served purchasing a midstream energy ETF ( MLPA ) ( AMLP ) ( MLPX ) instead of XLE. While this approach is certainly the most passive and can work fine, the potential yield and total returns will be reduced somewhat.
2. The other approach is to pick a few sectors to focus on with personal research and pick the best individual stocks in those sectors while still leaning on the aforementioned sector ETFs for the areas where you are unable to focus and therefore not able to really build conviction in any individual picks.
3. Use quality and trusted third-party research to supplement your own due diligence to pick individual stocks in each of these aforementioned sectors to supplement your SCHD ETF. This approach has the greatest total return and yield potential, but also comes with the most work, depending on how much of the research you outsource and how much of it you do yourself.

Since we devote ourselves to full time investment research, we take approach #3 and focus primarily on picks where SCHD is underweighted (basic materials, energy midstream, real estate, communications, utilities and BDCs). While we own several picks in each sector and will sell some positions and then buy back in at later dates, some that we think are attractively priced at the moment that also significantly enhance SCHD's yield - and also overall exceed the yields offered by the aforementioned sector ETFs - are:

• Basic Materials: Rio Tinto ( RIO )
• Energy Midstream: Enterprise Products Partners ( EPD )
• Real Estate: W.P. Carey ( WPC )
• Communications: Cogent Communications ( CCOI )
• Utilities: ATCO ( ACLLF )
• BDCs: Ares Capital Corp ( ARCC )

Effectively, investors could simply buy SCHD and then supplement it with the aforementioned six picks (and perhaps a few other picks and/or ETFs in each sector) and have a well-diversified income portfolio for a rich, rewarding, and pretty secure retirement. Moreover, the yield from such a portfolio would easily exceed the 4% Rule while also very likely growing dividends at a pretty consistent and above-inflation clip well into the future.

Investor Takeaway

Dividend growth investing is a highly rewarding and effective way to build long-term wealth and also makes for a great retirement funding strategy. SCHD is arguably the best building block out there today. Moreover, with a few strategic additions, retirees can create an even better well-rounded portfolio with a higher current yield on top of it.

At High Yield Investor, we are focused on finding undervalued high yielding quality stocks that can round out passive income portfolios in a manner similar to what we discussed concerning SCHD in this article.

For further details see: