2023-03-27 06:46:25 ET
Summary
- DGRO is a popular dividend ETF that is often overshadowed by SCHD.
- However, the two ETFs are a lot closer than they are different.
- From our analysis we conclude that investors are likely overweighting recent performance by SCHD with no justified expectation of future outperformance.
- DGRO offers a more diversified portfolio with less inherent sector biases.
Thesis
iShares Core Dividend Growth ETF (DGRO) offers a diversified investment product for investors seeking equity income growth. DGRO offers a highly diversified portfolio of dividend paying stocks at a low management fee. We identify a nominal level of improvement with the index construction, focusing more on companies that are likely able to grow their dividend, but still suggest investors seeking this equity income growth exposure hold or buy DGRO.
Morningstar US Dividend Growth
Before diving into the details of DGRO's current portfolio and performance we need to evaluate the index that it is seeking to track, as this will dictate future portfolio changes and ultimately performance. DGRO seeks to replicate the Morningstar US Dividend Growth index .
Implications of the Index Approach
The weighting for DGRO is based on the dividend dollars (the dividend per share * number of shares available for purchase). Because larger companies have more dividends$ /share, more shares or both, the index is naturally skewed towards holding the largest companies that meet the indexing criteria. A disadvantage of this is that quality of the underlying company or dividend growth have no impact on weighting. As long as a company meets the criteria to be included in the index it will be included, with larger ones taking up proportionally more of the portfolio. The skewness towards larger cap stocks is somewhat mitigated by capping individual positions at 3% of the portfolio, but the impact is nominal as large caps make up the majority of the portfolio.
In addition to the weighting not reflecting the higher quality names, the index is based on some relatively light criteria when it comes to dividend growth going forward. It does seek to identify those names that are more likely to increase their dividend or outperform but rather simply exclude the obvious companies. We suspect that a filter that removes the 10% is likely too much of a lagging indicator to address the companies with outsized financial risk as their high yield is likely a reflection of their price declining relative to their dividend.
Portfolio Overview
Invested in 446 holdings, DGRO is a broadly diversified set of dividend paying stocks. The ETF has a market cap of c.22B and has ample liquidity for investors. DGRO's current portfolio is highlighted below. The sector exposure is of course subject to change over time as constituent companies enter and leave the index.
Currently, DGRO's portfolio reflects a noticeable underweighting of Information Technology and Communication, while an overweighting to financials. This is not unexpected given the different emphasis varying industries place on dividends. However, it does set a level of expectation regarding future performance. While we do not expect specific sectors to outperform others in the long run, there will certainly be cycles of under/overperformance between various industry sectors. Given the relatively poor performance of IT recently, DGRO forgoes the opportunity to invest in that sector at better valuations than recent years. Additionally, DGRO is overweight sectors that exhibit lower volatility, such as utilities and consumer staples, which may smooth out fluctuations in valuation, don't offer the same upside if economic conditions were to improve.
Below we see DGRO's underlying index exposure to a number of return factors . As we'd expect there is a weight towards value, yield and size. Although currently the portfolio exhibits a weighting towards momentum, this more likely the result of value/defensive stocks outperforming growth in recent years. The wide 5 year historical range for Momentum provides further support for momentum being an unintentional exposure.
Morningstar
Historic Performance
Since its inception in 2014, DGRO has done relatively well against the S&P 500. As mentioned above, recent volatility in growth stocks has provided more value oriented funds such as DGRO to close the gap. At the same time, DGRO has maintained a downside capture ratio of 85, while capturing 90 on the upside. During the 2020-2021 period, DGRO underperformed as growth stocks provided outsized returns for the S&P 500.
Understanding DGRO vs SCHD
Schwab US Dividend Equity ETF ( SCHD ) is the number one favorite for retail investors when it comes to dividend growth funds at the moment. But does it hold an advantage over DGRO and can they be used in conjunction? These are the questions we are here to answer.
Author
Is the herd correct in picking SCHD over DGRO? Or is there something more to the differences between these two ETFs.
Similarities
First let's start with the similarities between the two. SCHD and DGRO share many attributes in common. Both ETFs have significant assets, ample liquidity, focus on US dividend growth and are popular with dividend investors, all at a comparable cost. SCHD is more popular though at roughly double the assets under management. Additionally both have quarterly distributions, roughly the same market exposure. At a high level the differences stem from just the number of holdings and dividend yield.
Dow Jones U.S. Dividend 100 Index
Similar to DGRO, SCHD is based around a defined index, in this case the Dow Jones US Dividend 100 Index . To be eligible for this index a stock must meet the following criteria:
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Not be a REIT (same as DGRO)
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Minimum 10 years of consecutive years of dividend payments (no requirement for growth or stability such as in DGRO)
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Minimum float adjusted market cap of 500M USD (no specific equivalent requirement for DGRO, but the starting universe does have some liquidity / trading requirements)
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Minimum 3 month average daily volume traded of 2M USD
Stocks passing these 4 requirements are then ranked by their Indicated Annual Dividend yield (excluding special dividends).
Following the universe selection, stocks are ranked by each of the following four ratios:
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Free cash flow to total debt
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Return on equity
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Dividend yield
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Five year dividend growth rate
The four rankings are then averaged to create a composite score, the top 100 are then selected for the index subject to a few buffer rules. Fundamentally we see quite a different approach to DGRO, SCHD attempts to identify higher quality (less debt to free cash flow, higher return on equity) stocks that are increasing their dividends (dividend growth rate). The smaller portfolio size of roughly 100 holdings provides a more narrow portfolio exposure to these ratios.
It is also important to note that although the ratios selected look relatively unbiased they are likely to introduce unintended biases towards certain industries/sectors. In particular it would be easy to see that higher leveraged industries (such as utilities) would be more likely excluded from the top 100 than others.
Holdings are then weighted by the float adjusted market cap, which achieves a similar objective of DGRO, skewing towards large cap stocks.
Inherently, we tend to have a slight preference towards the SCHD index as it attempts to identify those that are likely to continue increasing dividends and not just those that have done so historically. The specific approach could likely use some adjustments to avoid certain biases, as mentioned above. But we believe the SCHD approach is more likely to represent what investors are seeking from a dividend growth ETF as a whole.
Current Portfolio Differences
It is important to take the current holdings with a grain of salt, as these are subject to change over time as different micro and macro-economic factors influence the index constructions. However, at the moment as can see that in most cases the two ETFs are aligned in their industry exposures with the exceptions of Consumer Staples, Communications, Health Care and Utilities.
As investors we don't have a view that specific industries are more likely to outperform in the long run than others but it is also important to know what we are exposed to at the moment. As expected SCHD tends to not like Utility based stocks, one of the more defensive sectors. But on the other side, is underweight another defensive sector Consumer staples.
Looking at the actual holdings themselves, we see 12.2% of DGRO's holdings are also held by SCHD (which largely makes sense as DGRO has 4x the holdings) and 55.1% of SCHD's holdings are also held by DGRO. Again, this is a point in time and these % 's are subject to grow and shrink over time.
Return Factor Exposure
Taking a more academic/quantitative approach we reviewed how the two funds have been exposed to the Fama-French 5 factor model since 2014. Results are very consistent across market exposure, size, and profitability. Moderate differences can be seen within value exposure and conservative aggressing firms.
Both ETFs have a sizeable alpha, or return unexplained by the factors, which highlights that these returns factors may not be fully capturing the drivers of return over this period. It may also highlight value-add by the portfolio manager but given the fact that both funds are index based and focus on the most different area to outperform consistently (US large cap), we conclude the alpha is driven by inadequacy of the model itself.
Performance
Having started in 2014 we can look at the annual performances for the two ETFs since 2015. The last few years have skewed towards SCHD outperformance on a relative basis but looking at the full time period available shows a much more balanced return between the two. This is largely as expected as there is not significant enough attributes in their portfolio constructions to think that one ETF would significantly outperform the other in the long run.
Distributions
Equity income investors are often, and really should only, seek income for tax and/or cash flow requirements. Because of this the regularity and consistency of distributions should be evaluated when determining which ETF is best for your situation. The graph below highlights the historical distributions of both ETFs. They are separated on to separate axes so we can clearly see their relative growth and consistency. The correlation is uncanny, with both dividends following the same trajectory at relatively the same pace.
Risks
While we do not expect either DGRO or SCHD to outperform the broader index in the long run, the short run can provide significantly more volatility. In a shorter timeframe this risk is very real; a preference reversion back to growth stocks and subsequently stocks without distributions would result in underperformance for both DGRO and SCHD.
Additionally, DGRO could see further underperformance against SCHD given differences in sector returns, particularly for those where the funds exhibit variances in their allocations.
Conclusion
While based on our analysis we have a slight preference for SCHD, for investors seeking equity income in an easy to invest, diversified product, they cannot go wrong with either DGRO or SCHD. Both offer similar return profiles, market exposures and take on the same risk of underweight more growth oriented sectors. There has been a natural draw towards SCHD due to recent outperformance, but that is more likely a typical investor bias, chasing recent outperformance, rather than a true expectation of continued outperformance.
For further details see:
DGRO Vs. SCHD: A Deep Dive Comparison