I recently wrote an article talking about the PowerShares S&P 500 High Dividend Low Volatility ETF (SPHD) and its prospects for the upcoming year. The comment thread got pretty active with several readers sharing how they used SPHD in conjunction with other dividend ETFs in their portfolios. One fund that kept coming up several times in that discussion was the Schwab U.S. Dividend Equity ETF (SCHD). Some said that they preferred SCHD over SPHD. Some said they owned both of them together. Others wondered if the two funds were a good fit.
What almost everybody agreed on is that SPHD and SCHD are both great funds. They’ve got 5-star ratings from Morningstar, and have long histories of delivering superior risk-adjusted returns and above average dividend yields. But throwing a bunch of highly rated funds together does not a portfolio make! There are the matters of risk balancing, correlation, overlap and style to consider. SPHD and SCHD are great, but are they great together? The answer is yes, and here's why.
SPHD: Targeting Conservative High Yields
SPHD tracks the S&P 500 Low Volatility High Dividend Index, which starts by identifying, from the S&P 500, the 75 securities with the highest dividend yields over the past 12 months, with no one sector within the S&P 500 allowed to contribute more than 10 securities. From those securities, the index selects the 50 securities with the lowest volatility over the past 12 months. The index weights each of the constituent securities by its dividend yield, with the highest dividend-yielding securities receiving the highest weights.
This fund has a stellar 5-star rating from Morningstar, but has really struggled over the past year or so. After doubling the S&P 500's performance during the 2015-2016 time frame, SPHD struggled mightily in 2017 as investors turned to growth stocks in the persistent low volatility environment, trailing the S&P 500 by 10%.
The fund's top 10 holdings are filled with higher yielding REITs and utilities.
SCHD: Focusing On Long-Term Dividend Payers
SCHD tracks the Dow Jones U.S. Dividend 100 Index, which is designed to measure the performance of high dividend yielding stocks issued by U.S. companies that have a record of consistently paying dividends, excluding real estate investment trusts (REITs), master limited partnerships (MLPs), preferred stocks and convertibles. All index eligible stocks must have sustained at least 10 consecutive years of dividend payments. The index components are then selected by evaluating the highest dividend yielding stocks based on four fundamentals-based characteristics — cash flow to total debt, return on equity, dividend yield and 5-year dividend growth rate. Stocks in the index are weighted based on a modified market capitalization approach. No single stock can represent more than 4.5% of the index and no single sector can represent more than 25% of the index.
Dividend ETFs have broken into two groups in 2017 - those focused on high yielders, which have struggled, and those focused on dividend growers, which have fared well. SCHD has spent the past three years closely following the S&P 500, and has managed to outperform the index with less variability compared to SPHD.
SCHD's top 10 holdings are much more heavily skewed towards mega-cap names, as is the portfolio in general.
Optimizing a Combination of SPHD and SCHD
First, let's take a look at the composition of these products side-by-side, and then we'll take a bit of a deeper dive into portfolio theory.
Like many high yield equity portfolios, SPHD leans a lot on utilities and REITs. With interest rates rising, it's easy to see why SPHD has struggled lately. Underweights to tech and financials haven't helped either. SCHD, on the other hand, has been better diversified, and, while it's lagged the S&P 500 as growth continues to dominate, it's focus on financially healthy, cash-rich dividend growth names has paid off.
A quick look at the disparate allocations of the two funds would seem to suggest that they'd fit well together. SPHD and SCHD currently have a correlation factor of around 0.90, but that number has fluctuated significantly over the past several months.
Back around November, the 60-day rolling correlation dipped all the way down to 0.50, an unusually low number for two dividend ETFs. It's since returned to historical average, but even that number isn't extraordinarily high. According to ETFScreen.com, SPHD is more closely correlated with more than a dozen other dividend ETFs.
One of the websites I like to use for portfolio analysis and optimization is Portfolio Visualizer. I've used it many times to determine asset correlations, do asset mix analysis and even run Monte Carlo simulations on various retirement planning scenarios. This is the site that I'll be using for this exercise as well.
First, let's take a look at the two funds individually. These figures use five years of history, or basically the entire life of SPHD, for direct comparison purposes.
Over the past five years, SPHD has underperformed by about 1% per year, but has done so with slightly less risk. Given the objectives of the two funds, this isn't really a surprising result. Sharpe ratios, a measure of risk-adjusted rates of return, are pretty similar.
Now, let's plug these two funds into the portfolio optimizer tool. My optimization goal for this exercise will to maximize the Sharpe ratio for SCHD and SPHD together. The tool also allows you to model for minimum drawdowns or minimum volatility, but I'm choosing to try to maximize risk-adjusted returns. Here's the result I get...
The ideal combination is 57% in SCHD and 43% in SPHD. Again, it's not a surprising result given that SCHD has delivered a slightly higher Sharpe ratio, but the slightly lower risk of SPHD and the correlation between the two funds also adds value to SPHD in this equation.
The efficient frontier for the two-fund combination is especially interesting. This graphic demonstrates risk/return data for all possible asset allocations between the two funds.
The maximum Sharpe ratio exists at the 57/43 mix detailed above. SCHD alone delivers a Sharpe ratio of 1.794, while SPHD offers a ratio of 1.730. The optimized allocation of SPHD and SCHD together provide a Sharpe ratio of 1.872. Historically, the average annual return would be reduced slightly compared to if you invested in SCHD alone, but overall risk would be reduced by 7%. The 57-43 mix of SCHD and SPHD would also be about 9% less risky than the S&P 500, but only reduce return by about 2.6%.
The next step I wanted to do is plug the 57-43 mix into Morningstar's Instant X-Ray tool to see what the combination would look like in practice.
SPHD and SCHD only have 20% overlap of assets, so the combo passes the first diversification test. The pair's 80-20 mix of large- and mid-caps is a nice combination of conservative long-term growth mixed in with a splash of smaller names for added growth potential. Not surprisingly, the combo skews heavily towards Morningstar's large value style box.
Thanks to SPHD, the fund pair is still strongly overweight in real estate and utilities, but it's not quite as egregious as SPHD alone would be (for the record, SCHD avoids real estate by rule, and has almost nothing invested in utilities). This portfolio overall would be overweight in traditionally defensive areas, such as consumer staples and industrials, while being underweight in tech, healthcare and financials. This allocation might be less than ideal in the current economic environment, but it's right where investors would want to be if they had a need for low volatility and above average dividend yields.
There is nary a sniff of potentially volatile investments in this portfolio. Aggressive growth, speculative growth and distressed assets combine for just 1% of the portfolio. The riskiest part of the combo is probably the interest rate sensitive REIT and utility allocations.
SCHD is one of the cheapest dividend ETFs in the marketplace with an expense ratio of just 0.07%. SPHD's relatively high expense ratio of 0.30% puts the pair in more of an average position fee-wise. With about a half dozen highly rated dividend ETFs, SCHD included, charging less than 0.10% in expenses, cost savings isn't necessarily going to be an advantage with the SCHD-SPHD pair.
Like each of the funds individually, the pair produces a low growth, value-tilted high yield portfolio. A dividend yield more than 1% higher than the S&P 500 will no doubt please income, while the lower P/E ratio should provide a degree of downside protection in volatile markets (in the most recent correction, SPHD and other low volatility ETFs did, in fact, drop less than the S&P 500).
Conclusion
Do SCHD and SPHD fit well together as a single pair? I think the answer is a clear yes. The two funds are clearly dissimilar to each whether you look at sector allocations or asset overlap. The heavy allocation to rate sensitive REITs and utilities is offset by the absence of the securities in SCHD. Better yet, an optimized combination of the two funds is still able to maintain the core characteristics of lower beta and higher yield, while reducing portfolio risk further through diversification.
The downside is that the pair together is still somewhat susceptible to rising interest rates, and we don't really have a good sense for how the funds will do in a prolonged down market, the current correction not withstanding. But there's five years of evidence to suggest that SCHD and SPHD are a really good fit together. Investors should have relatively little to worry about holding these two ETFs together.
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