PRS - SCHD Vs. SPHD: Only One Is A Worthy Passive Income Snowball

2024-01-10 17:52:32 ET

Summary

• Warren Buffett said that passive income snowballs are the key to financial independence.
• ETFs can be a great vehicle for building a passive income snowball.
• We compare two popular dividend ETFs and share our take on which one makes for a better passive income snowball.

Both the Schwab U.S. Dividend Equity ETF ( SCHD ) and the Invesco S&P 500 High Dividend Low Volatility ETF ( SPHD ) are popular dividend ETFs that boast attractive long-term total return performance track records, good current dividend yields, and strong dividend growth histories. As a result, it's not surprising that both have enjoyed robust assets under management growth over time:

In this article, we will discuss what makes a dividend ETF a good passive income snowball vehicle and then share why we only think that SCHD measures up to these qualifications.

What's A Passive Income Snowball?

Warren Buffett once pointed out that building a passive income snowball is the key to achieving long-term financial independence. Building a passive income snowball consists of gradually building a steady stream of income from investments that require little to no active involvement, such as dividends from stocks, interest from bonds, or rental income from real estate.

This approach is crucial for achieving long-term financial independence as it creates a growing flow of funds independent of active work that generally grows exponentially over the long term. This is because - by reinvesting passive earnings from investments - the income potential compounds over time, akin to a snowball growing larger as it rolls downhill. Eventually, this income becomes so large that it covers living expenses, freeing the investor from having to rely on active income sources.

What Are The Qualities Of An ETF That Make It A Good Passive Income Snowball?

While building a passive income snowball sounds - and is - simple, the two keys to success are:

(1) Ensuring that your passive income snowball consists of quality underlying holdings .

(2) You have the discipline to continue consistently investing and reinvesting in your passive income snowball until it finally begins to throw off enough passive income to comfortably cover your living expenses.

We're building our passive income snowball out of individual stocks because we believe that in doing so we can:

1. Maximize our risk-adjusted yield
2. Maximize our risk-adjusted return

However, for the many investors who lack the time and/or expertise to sufficiently research and build a sufficiently diversified portfolio to accomplish this purpose, investing in ETFs is a viable alternative. When assessing a dividend ETF's viability as a passive income snowball, three key factors are paramount:

1. Sufficient diversification
2. A low expense ratio
3. A balance of yield plus growth potential.

Sufficient diversification is crucial because it helps to reduce risks that come with being concentrated in any single sector. For example, investors who were completely invested in technology stocks in the late 1990s suffered tremendous losses that took a long time to fully recover, investors who were completely invested in bank stocks right before the Great Financial Crisis lost nearly everything, and investors who were heavily invested in retail and hospitality stocks when the COVID-19 outbreak hit also suffered tremendous underperformance relative to the broader market. As a result, a well-diversified dividend ETF should encompass a range of sectors and geographies, reducing the risk associated with specific market segments.

Second, an ETF's expense ratio also is very important given that lower expense ratios translate to higher net returns for investors. Since dividend ETFs typically employ simple or even passive investing strategies, they should inherently have lower management costs, making them relatively efficient wealth creators over the long term. In contrast, a higher expense ratio can significantly erode the ETF's long-term returns:

Last but not least, the ETF's combination of current yield and growth potential is an extremely important quality to evaluate when determining if an ETF would serve as a good passive income snowball. While a high current dividend yield is obviously very useful when building a passive income snowball, it's also important to balance this with the long-term growth prospects of the underlying stocks in the ETF. A high yield with no growth potential might indicate companies struggling to expand or maintain their dividends. Conversely, a moderate yield with strong growth prospects suggests a sustainable and potentially increasing dividend over time, enabling the fund to generate phenomenal long-term total returns while also generating inflation-beating dividend growth. This balance is key to ensuring both immediate income and future appreciation.

Why SCHD Is A Much Better Passive Income Snowball Than SPHD

Based on these three criteria, we believe that SCHD is a much better passive income snowball than SPHD is:

1. Diversification: SCHD's diversification is significantly better than SPHD's in terms of the number of holdings, though SPHD has less concentration within its top holdings.

SCHD has 104 individual holdings , more than double those of SPHD, which has only 51 individual holdings in its portfolio. Meanwhile, the top 10 holdings represent 40.86% of SCHD's portfolio:

1. AbbVie Inc. ( ABBV ) - 4.37%.
2. Merck & Co., Inc. ( MRK ) - 4.33%.
3. Amgen Inc. ( AMGN ) - 4.25%.
4. Broadcom Inc. ( AVGO ) - 4.17%.
5. The Home Depot, Inc. ( HD ) - 4.12%.
6. Texas Instruments Incorporated ( TXN ) - 4.03%.
7. Verizon Communications Inc. ( VZ ) - 3.98%.
8. Chevron Corporation ( CVX ) - 3.90%.
9. Cisco Systems, Inc. ( CSCO ) - 3.89%.
10. The Coca-Cola Company ( KO ) - 3.83%.

In contrast, SPHD has only 28.25% of its portfolio invested in its top 10 holdings:

1. Verizon Communications Inc. - 3.46%.
2. AT&T Inc. ( T ) - 3.40%.
3. Simon Property Group, Inc. ( SPG ) - 2.95%.
4. International Paper Company ( IP ) - 2.80%.
5. Altria Group Inc. ( MO ) - 2.75%.
6. ONEOK, Inc. ( OKE ) - 2.72%.
7. Kinder Morgan, Inc. Class P ( KMI ) - 2.69%.
8. 3M Company ( MMM ) - 2.60%.
9. Prudential Financial, Inc. ( PRU ) - 2.51%.
10. International Business Machines Corporation ( IBM ) - 2.38%.

Overall, we think both ETFs are reasonably well diversified, though SCHD's more than double number of total holdings gives it the edge. Yes, its top 10 holdings have considerably more invested in them than in SPHD, but these companies are weighted based on a methodology that emphasizes dividend sustainability and business quality, providing investors with optimized exposure to stocks that are most likely to continue paying and growing their dividends in the future.

SCHD selects its constituents from the SPDR Dow Jones Industrial Average ETF Trust ( DIA ) U.S. Dividend 100 Index, which is composed of stocks exhibiting high dividend yields. Its portfolio construction methodology includes a market capitalization and liquidity screen to ensure that the companies are sufficiently large and actively traded. SCHD then prioritizes stocks with a strong record of paying dividends by setting thresholds for dividend yield as well as historical consistency and growth in making dividend payments. Additionally, fundamental business quality indicators such as payout ratio and return on equity are considered to ensure that only strong businesses that have sustainable dividends are included in the portfolio.

In the end, the final portfolio is weighted not purely by market capitalization but through a modified approach that takes into account each of these different aforementioned dividend characteristics, including capping measures to avoid over-concentration in any single stock or sector, thereby providing a sufficiently diversified dividend income stream that's still focused on the best dividend growth stocks available.

In our view, this makes its greater conviction in its top 10 holdings - balanced by their broad diversification into over 100 individual positions - an attractive trait relative to SPHD's broader and blander approach to portfolio composition, which focuses entirely on balancing higher yields with lower volatility.

In contrast, SPHD's methodology begins with the SPDR S&P 500 ETF Trust ( SPY ) and identifies the 75 stocks with the highest dividend yields. From this subset, the 50 stocks with the lowest stock price volatility over the past year are chosen. These stocks are then weighted according to their dividend yield rather than their market capitalization, meaning those with higher dividends are given more weight in the ETF. This strategy leads to a focus on income through dividends while seeking to minimize exposure to price fluctuations. Moreover, the fund undergoes a semi-annual rebalancing process, during which adjustments are made to reflect any changes in dividends and volatility.

While this approach is fine for the stated goal, as passive income snowball investors we ultimately do not care too much about short-term stock price volatility and instead want to maximize our long-term passive income by focusing on the ultimate combination of current yield and dividend growth. SCHD's selection process focuses on this goal much more than does SPHD's.

2. Expense Ratio: In terms of expense ratio, SCHD wins here as well, with a mere 0.06% expense ratio compared to SPHD's five times higher 0.30% expense ratio. That means that over the long term, investors will pay a much higher percentage amount in fees for investing in SPHD compared to investing in SCHD.

3. Yield Plus Growth:

Last, but not least, SCHD's yield plus growth (and ultimately total returns) are better than SPHD's:

While SPHD does have a higher TTM dividend yield of 4.39% compared to SCHD's 3.46% dividend yield, SCHD's dividend growth is significantly stronger than SPHD's. Over the past decade, SCHD's dividend has grown at an impressive 11.39% CAGR whereas SPHD's dividend has grown at a much slower CAGR of 6.37%. In our view, a 3.46% dividend yield combined with an 11.39% CAGR is much more attractive for a passive income snowball than a 4.39% CAGR combined with a 6.37% CAGR.

Investor Takeaway

SCHD offers a more compelling option for building a passive income snowball compared to SPHD primarily due to its superior overall diversification and portfolio composition methodology, lower expense ratio, and a better balance of yield and growth potential. SCHD's approach, which emphasizes dividend sustainability and growth, aligns more closely with the long-term financial independence goals of dividend-focused investors than SPHD's greater emphasis on minimizing short-term stock price volatility.

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