ZION - SCHD's Annual Reconstitution Ignores Severe Deterioration In Financial Sector Health

2023-03-16 10:57:52 ET

Summary

• Investors in Schwab U.S. Dividend Equity ETF are confident that the valuation-based methodology it uses to select dividend stocks will eliminate poorly performing stocks and protect their investment.
• Here we explore the methodology that will be used to reconstitute its index on Friday, March 17, 2023.
• We see how the unfortunate timing of the current banking crisis will prevent its methodology from eliminating what are now very troubled stocks in the financial sector.

S&P Global maintains the Dow Jones U.S. Dividend 100 Index, which is the index that the Schwab U.S. Dividend Equity ETF ( SCHD ) tracks. Every year this index, and thus the holdings of SCHD, goes through an annual reconstitution where some stocks are removed and other stocks added. This annual reconstitution takes place the 3rd Friday in March. Thus, we can expect to see some changes in SCHD's holdings on Monday, March 20.

Investors in SCHD have expressed confidence that its annual reconstitution will eliminate companies whose ability to support their dividends has deteriorated. For example, back in September of 2020, when I first started covering SCHD, I noted in an article that its holdings were highly concentrated in the stocks of financial institutions, especially mid-sized regional banks. At that time, financials made up 24.48% of the total value of SCHD.

In response to my expression of concern that the ETF was so highly concentrated in that one sector, a fan of SCHD explained in the most liked comment in that article's comment stream:

If financial service companies (i.e. regional banks) start to falter, they will get screened out quickly.

That might have been true in any other year, but my study of how SCHD's reconstitution is conducted makes it painfully clear that that will not be the case this year. Multiple totally unexpected "black swan" events combined with the unfortunate timing parameters SCHD's index methodology uses have conspired to make it unable to remove what may very well be highly problematic stock holdings.

SCHD's Index Is Built Entirely By Algorithm, No Human Mind Touches It

To understand how SCHD's index is reconstituted, you need to understand how it chooses stocks. This is a complicated process which I described in depth in my article , "Is SCHD Still a Good Choice for Dividend Investors."

How SCHD's Index Methodology Conducts Its Rebalance

To summarize the process, which is described more fully in the Methodology document for the Dow Jones Dividend Indices, the index SCHD tracks is the Dow Jones U.S. Dividend 100 Index. It was created some time before 10/20/2011, when SCHD started trading. Its methodology for selecting its starting collection of stocks was as follows.

All stocks from a larger index that had a 10 year history of paying a dividend. Note that those dividends did not have to have grown each year of the past 10 years. The index these stocks were selected from included stocks of all sizes, excluding REITs.

The stocks in this group of dividend-paying stocks were then ranked against each other on each of the following factors:

• Their average dividend growth over the past 5 years: Note that it is the average dividend growth over that 5 year period that was ranked. Individual years did not have to have shown dividend growth.
• Free cash flow to total debt : This was calculated as annual net cash flow from operating activities divided by total debt. Companies with zero total debt were ranked first.
• Return on equity : This was Annual net income divided by total shareholders' equity.
• Expected forward yield: Unlike the case with the three earlier factors the index methodology document discusses, the document only lists Expected Forward Yield as a factor but does not give readers any other information as to how this metric is arrived at.

These 4 independent ranking scores are then added together. When the index was first constructed, the stocks that had the 100 highest total scores were placed in the index. Hence the name of the index is the Dow Jones U.S. Dividend 100 Index.

Timing Is Essential for Understanding The Limitations on the Reconstitution

The technique used to conduct SCHD's annual reconstitution uses the same ranking technique that we just described when discussing how the index was initially created, except for the very last step. But before we go into that difference, you need to pay attention to the dates used to determine the factors that are used in the screening.

• The values used for these rankings--which as we will see are the same as those used for the annual reconstitution, are the values as of the last business day of the previous December.

• The Indicated Annual Dividend ((IAD)) and the stock price used in the calculation of a company’s dividend yield are those current as of the last business day of February.

How the Annual Reconstitution Methodology Differs from the Creation Methodology

The methodology document tells us that when doing the annual reconstitution, the index provider goes through the same process it used to create the initial index, with two very important differences:

• The original creation methodology selected the top 100 stocks . But during the reconstitution process, any stock that is already in the index is allowed to remain in the index as long as its ranking places it in the top 200 stocks ranked by the sum of the 4 criteria described above.

• If there are no longer 100 stocks in the index after the stocks that remain in the top 200 stocks are accounted for, the highest ranking new stocks that made it into the top 100 rankings are added. If two new stocks have the same ranking, the one with the higher dividend is added.

Thus SCHD Now Actually Invests in What Should Be Called the Dow Jones U.S. Dividend 200 Index

SCHD's index was created using data going back to 1998. Since SCHD has been tracking that index since 2011, by now its index has been reconstituted many times. As stocks are only removed from the list of companies considered for SCHD's index when they fail to have a 10 year history of dividend payments. They only will leave SCHD if their ranking drops below that of the top 200 stocks ranked by the index's methodology.

That means that it is very likely now that many of the current stocks in the index may only have rankings in that top 200. However, as the actual rankings used to select stocks for SCHD is not made public, investors can have no idea which dividend stocks actually made it into the top 100 of all the dividend stocks ranked.

All we can learn by looking at the results of the annual reconstitution is which stocks' rankings have sunk below the 200th ranking of the index's U.S. dividend stocks. We can also be confident that any stock added to SCHD after its index's inception was high in the list of the 100 highest ranked U.S. Dividend Stocks at the time it was added.

It strikes me that this system of picking stocks makes the title of both the index and the SCHD ETF deceptive, as what we really have here by now may very well be the "U.S. Dividend 200 Index."

The Financial and Technology Sectors Crashed After The Dates SCHD's Index Methodology Uses for Its Rankings

As noted above, SCHD's methodology uses the valuation metrics as of December 31 of the previous year. At that time, this was the sector breakdown of SCHD:

SCHD Sector Breakdown as of December 31, 2022

But as anyone paying attention to markets is well aware, a lot has changed since December 31, 2022 The failure of Silicon Valley Bank of SVB Financial Group (SIVB) on March 8, 2023, sent shock has impacted the prices of stocks in both the Financial and, to a lesser extent, the Technology sectors. The subsequent failure of Signature Bank (SBNY) devastated the prices of stocks in the Financial sector as investors wondered what bad, interest rate-related bets were hiding in their balance sheets. As you could see from the sector breakdown presented above, The Financials and Technology sectors made up a whopping 41.39% of the total value of SCHD at the end of December, when the metrics used for the annual reconstitution's rankings were finalized.

Here you can see how the reverses suffered by SCHD's Financial and Technology stocks have impacted its price since December 31, 2022, a period during which it has severely underperformed the S&P 500. This reflects investors' fears that, just as was the case with Silicon Valley Bank, the fundamentals they were given by management and have relied on did not present a true picture of the risks involved in Financial.

SCHD's Price Deterioration After December 31, 2022

SCHD's Index's Dividend Date Also Preceded the Black Swan Bank Failures

SCHD's index's methodology computes the expected dividend yield of the stocks it screens for inclusion (or deletion) based on those stock's prices on the last day of February. That was before the failure of Silicon Valley Bank and Signature bank devastated share prices of most Financial Sector stocks.

On February 28, SCHD's price was only down 1.18% from where it had been at the end of December. By March 13, its price was down 4.61% from its December 31 level.

Since SCHD's methodology is strictly rules based and does not take into account anything but easily retrieved and manipulated numbers, SCHD's annual reconstitution is not likely to be jettisoning Financial and Technical sector stocks whose fundamentals may be very different now from what it was on February 28.

SCHD Will Likely Hold the Same Weight of Financial and Technology Stocks After Its March 20 Reconstitution

Last year, when I compared SCHD's holdings before and after its annual March reconstitution in this article , "SCHD's Yearly Reconstitution Adds 14 New Stocks And Eliminates 13," I found that though a significant number of stocks had been deleted and added to it, they were all stocks whose weight in the overall index was very low, and so the impact of the rebalance was minimal.

I expect the same will be true this year. The stocks that are most problematic in SCHD's holdings are not going to be screened out by its methodology. The only way that SCHD's index's methodology will eliminate any of them in the time between the index's quarterly rebalances will be if they cut or eliminate their dividends.

An investment in SCHD now is a bet that the Financial sector and, to a lesser extent, the Technology sectors will recover swiftly. The FAST Graph you see below depicts the performance of Zions Bancorporation, National Association ( ZION ). I present it as it is very similar to what you see if you looked up many of the regional banks currently held by SCHD.

As you can see, Zions' dividend now has surged, but as you can also see, its performance after a previous banking crisis was terrible and resulted in its dividend being eliminated.

And to remind you of just how recent its current struggles are, here is the graph of how confident investors were in its health, as reflected by its stock price, through the period that SCHD uses for collecting the data it uses in its rebalance. Note that Seeking Alpha's Quant feature red flags it with the headline, "Warning: ZION is at high risk of performing badly." Given the large weighting of Financial stocks in SCHD, the warning might be applicable to SCHD until its next reconstitution--or severe dividend cuts in the Financial stocks it holds.

Zions Bancorporation Price Action After February 28, 2023

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