SCHY - SCHY: An Objective That Should Align With Investors

2023-06-05 14:29:10 ET

Summary

• Schwab International Dividend Equity ETF is a promising investment vehicle for dividend investors seeking international exposure.
• SCHY's methodology, which favors better debt coverage, ROE, and lower volatility, has demonstrated capital preservation during rocky market conditions.
• Investors should be mindful of potential underperformance in different market conditions and high portfolio turnover related tax implications.

Thesis

Although in its relative infancy, Schwab International Dividend Equity ETF ( SCHY ) is a dividend ETF that investors can align with. We breakdown SCHY from the ground up to understand the drivers of performance and decide whether it is likely worth the higher management fee relative to a simple index and ultimately offering investors a vehicle for growing dividends.

Overview

SCHY is Charles Schwab’s international equivalent to their very popular Schwab U.S. Dividend Equity ETF (SCHD). Despite a very similar methodology, it hasn’t gained nearly the scale or following of its US focused sibling. The international ETF is now entering its third year of existence and remains under 1 billion in total assets. Similar to SCHD, SCHY exhibits a relatively focused set of holding with 132 individual positions (some of these are strictly currency positions). Additionally, it has been turning over the holdings rather frequently with a portfolio turnover % of 47.7%. The high turnover likely will contribute to SCHY being a less favorable asset in taxable accounts all else equal.

Index Methodology

SCHY tracks the Dow Jones International Dividend 100 Index (Net). The index is designed to measure the performance of 100 high-dividend-paying non-US companies that have a track record of consistently paying dividends, selected for good financial ratios and lower relative volatility.

Universe Construction:

• Exclude all REITs

• Minimum 10 consecutive years of dividend payments

• Minimum market cap of 500M USD

• Minimum median daily value traded of 2M USD

• Non-constituents must be domiciled in a country that makes up a weighting of at least 0.2%

Index Construction:

• Securities in the eligible universe are ranked by four fundamental metrics (composite score):

  • Free cash flow to debt

  • Return on equity

  • Estimated dividend yield

  • 5 year dividend growth rate

• Select the top 400 securities

• Screen out securities that have a volatility higher than that of the median of the 400

• Select the top 100 of the remaining securities by the composite score

The balance of capital structure, ROE, dividend yield and dividend growth should align very closely with what a lot of investors are seeking from a dividend ETF. Given all these factors, the preference to then apply a filter to higher volatility stocks has less merit, although still potentially valuable. As researches, we are supportive of this methodology over typical dividend yield only screens or dividend growth screens as they do not contain any predictive elements (such as financial strength or ROE). Weighting is done based on market cap, which provides higher liquidity and keeps small cap exposure minimal.

Portfolio

Comparing SCHY against the index from an industry exposure highlights some significant weighting differences. This is a snapshot in time and given that SCHY turns over the portfolio every 2 years, it may not be a consistent industry weighting.

However, we see a strong preference to Utilities and Communication Services, and an underweight Technology sector. Both Utilities and Communications likely scored high on dividend growth and dividend yield leading to their higher preference, whereas there are likely significantly less technology stocks exhibiting these attributes. Given the current market conditions, these sector weightings have likely proven to be rather favorable but that may not always be the case. It is reasonable to expect SCHY would suffer some underperformance in more boom times when Technology, Consumer Cyclical and Financials are likely to contribute stronger performance.

Performance

The short tenure of SCHY makes it too soon to reach any hard conclusions on performance, but taken into context, it can help inform our understanding of the ETF.

The initial couple years look promising so far for SCHY. A methodology that favors better debt coverage, ROE and lower volatility has certainly aided in the volatile recent years. Cumulatively SCHY is down just under 1% since inception, not exactly a star performer but the index is down just over 10%, a strong demonstration of capital preservation during a rocky market.

Factor Analysis

Due to the relatively short timeframe we have data for SCHY, we again must review the factor exposure data within context.

The data clearly shows a very stark contrast between SCHY and the index across multiple risk factors. As expected, a preference to larger caps, likely driven from the weighting methodology. Additionally, there are large differences represented by the preference for profitable value stocks that invest conservatively. The large risk factor exposures may be overstated given the short time period but clearly the fund is not a closet market indexer and is taking on exposure deliberately.

Dividend History

A semi-annual distribution cycle provides us fewer data points to measure growth but so far the trend is exactly what dividend investors are looking for. The best comparison is the Dec 2022 payout vs the December 2021 payout, nearly a 50% increase. The first half year distributions are less useful because SCHY would not have collected distributions from its holdings for the full first half of 2021.

Later this month, the distribution will be announced for the first dividend of 2023. This will be a very useful data point for investors who have been watching SCHY from the sidelines.

Risks

The largest risk we see with SCHY is the stringent index methodology that could lead to underperformance in different market conditions. Additionally, the high portfolio turnover could create undesirable tax considerations for some investors.

Upside

Investors should be relatively pleased if SCHY can build a track record of increasing dividends and providing a less volatile investment vehicle to generate cash flow. Since inception, market conditions have likely favored the SCHY strategy but there is no saying that this won’t continue for a number of years going forward.

Conclusion

In our opinion, SCHY is likely to be aligned with the objective many dividend investors are seeking but designed exclusively around international exposure. For those looking to balance out their portfolio while still maintaining a dividend strategy (investors should be mindful of tax considerations when structuring their portfolios), SCHY can be a good vehicle to do so.

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