SCHY: Grab 4.50% Yield And Double-Digit Dividend Growth (NYSEARCA:SCHY)

Article Purpose

On Seeking Alpha, I specialize in reviewing U.S Equity ETFs, but today, I’m making an exception and doing a deep dive into the new Schwab International Dividend Equity ETF (SCHY). This 100-stock fund follows a similar methodology to the Schwab U.S. Dividend Equity ETF (SCHD), a personal favorite of mine, and thus, warrants some attention. In this article, my goal is to educate readers on how SCHY selects constituents, the dividend yield they can expect going forward, the fund’s historical performance relative to SCHD and two other international equity ETFs (including backtested results), the fundamentals of its current holdings, and the advantages and disadvantages of investing in foreign equities in general. While I’m only initiating coverage on SCHY and won’t be making a buy rating just yet, I believe SCHY is a high-quality fund most appropriate for conservative dividend growth investors looking for instant diversification. If that sounds like you, then I hope you’ll enjoy this in-depth look at what could turn out to be one of the best international dividend ETFs on the market.

ETF Overview

Strategy and Fund Basics

SCHY’s stated investment objective is to invest in non-U.S. high-dividend-yielding stocks that have paid dividends for at least ten consecutive years, are financially sound, and have low volatility. It tracks the Dow Jones International Dividend 100 Index, which must pass the following screens:

• Minimum ten consecutive years of dividend payments.
• Minimum $500 million market capitalization ($400 for current constituents).
• Median six-month daily traded value of $2 million.
• Minimum universe weight of stock in domiciled country of 0.20% (0.10% for current constituents).
• Indicated dividend yield is greater than the median yield of the existing universe (40th percentile for current constituents).

Similar to SCHD, eligible securities are then ranked equally based on four fundamental metrics:

• Free Cash Flow To Total Debt
• Return on Equity
• Indicated Annual Dividend Yield
• Five-Year Dividend Growth Rate

Three-year price volatility in U.S. dollars is then calculated, and the top 100 qualify. Weightings are based on market capitalizations with no stock accounting for more than 4% of the Index at the time of each quarterly rebalancing or annual reconstitution. Additionally, individual sector exposures are capped at 15%, and emerging markets exposure is also limited to 15% of the portfolio.

Sector Exposures, Geographical Exposures, and Top Holdings

The 15% limit per sector effectively creates a well-diversified Index, considering there are only 11 GICS sectors. The table below compares SCHY’s sector exposures with the SPDR S&P 500 Index ETF (SPY), SCHD, the Vanguard International Dividend Appreciation ETF (VIGI), and the Vanguard International High Dividend Yield ETF (VYMI).

As shown, a few sectors like Consumer Staples, Financials, Health Care, and Communication Services are around the 15% limit, suggesting these are the sectors where the most consistent dividend growth occurs globally. Utilities are high on the list too, but I suspect its exposure isn’t higher primarily because of the free cash flow to total debt screen. This sector is very capital intensive, and debt is crucial in companies’ structures. However, exposure is higher than both VIGI and VYMI, likely due to the low volatility screen.

Geographically, SCHY has more exposure (58.74%) to Greater Europe countries than VIGI and VYMI. Looking at the emerging markets category, SCHY is far underweight compared to the alternatives. VIGI, for example, has 14.36% exposure to emerging companies in Asia, while SCHY has only 1.94% exposure. One potential reason is that VIGI’s Index only requires seven consecutive years of dividend payments and a three-month median daily volume traded amount of $500,000. These less-strict requirements likely lead to a riskier portfolio, and since I am cautious when it comes to international equities, I favor SCHY’s approach in this respect.

Recall how SCHY takes a market-cap-weighted approach that favors the largest companies. Generally speaking, this strategy works well in rising markets and when enthusiasm is high. However, in declining markets, and assuming the top holdings list have higher P/E ratios, it can turn out to be a disadvantage. From my analysis of domestic equities, enthusiasm is decreasing, and assuming that translates to other markets, I’ll be looking for relatively low valuations, low volatility, and a decent level of growth to ensure it can participate in rising markets, too. That part of the analysis is coming soon, but first, here’s a glance at SCHY’s top ten holdings.

As shown, British American Tobacco (BTI) is the fund’s top holding with a 5.07% weighting, followed by BHP Group (BHP) and Sanofi (SNY). My colleague at the Hoya Capital Income Builder, ETF Monkey, recently did an excellent writeup on SCHY and included descriptions of all top ten holdings in his analysis. I won’t duplicate the work, so I encourage all readers to check out his article here since our shared objective is to educate readers on this exciting new offering. Before we look into dividends and performance, below are some additional fund statistics for easy reference.

• Current Price: $25.92
• Assets Under Management: $135 million
• Expense Ratio: 0.14%
• Launch Date: April 28, 2021
• Number of Securities: 101
• Assets in Top Ten: 39.83%
• 30-Day Median Bid-Ask Spread: 0.08%
• Tracked Index: Dow Jones International Dividend 100 Index

Historical Performance and Dividends

Analyzing SCHY’s historical performance won’t be very helpful since it launched less than one year ago. However, there are some conclusions we can draw by looking at the Index’s ten-year history, most of which was backtested. Generally, I wouldn’t say I like relying too much on backtested data, but I think it’s reasonably reliable since we are dealing with primarily large-cap stocks where data accuracy probably isn’t an issue. That said, it’s not meant to be a predictor of future results, so always invest in new funds with caution.

The graph above shows that SCHY’s Index returned an annualized 9.61% over the last ten years compared to 14.47% for SCHD’s Index, 8.77% for VIGI’s Index, and 14.65% for the S&P 500. These are total returns, assuming reinvested dividends, highlighting the relative weakness in international investing over the last decade. Investors will need to subtract fund fees to get an idea of what the ETF’s net returns would have been, but thankfully, these fees are negligible.

While not explicitly provided, we can derive estimated ten-year historical dividend yields by comparing the indexes’ total returns and price returns. First, let’s look at the growth of $100 for SCHY and VIGI’s Indexes.

What’s interesting is the large discrepancy between SCHY’s Index Total Returns and Price Returns at the end of ten years, suggesting that dividend growth is a crucial component of the strategy. The 258.81 and 165.30 Total Return and Price Return Index values correspond to an annualized growth of 9.92% and 5.32%, meaning 46% of the ten-year returns were attributed to dividends. In contrast, VIGI’s Total Return and Price Index returns were 9.12% and 6.87%, meaning 25% of the total returns were attributed to dividends. The two are very different in their approach, but it’s clear that reinvesting dividends is the key to success with SCHY. If you opt not to reinvest dividends, you won’t get the same compounding power that’s made SCHD a household name in the dividend ETF world, and you may end up underperforming on the total return side. Based on what you know about your tendencies, please consider that.

To further illustrate, I’ve broken down the calendar year total and price returns for each Index from 2012 until 2021 (2012 excludes January). You can use this as a guide for predicting future dividend payments. However, I caution that since SCHY is a relatively new ETF with only 10.4 million shares outstanding, dividend payments are likely to bounce around as the fund gets more popular. Depending on timing differences between when the ETF collects distributions from underlying holdings and when a large number of new shares are issued, your dividends have the potential to be diluted. The difference will show up in the fund’s NAV, but still, this can be frustrating for dividend investors depending on a consistent and predictable income stream.

As shown, SCHY’s average annual dividend yield is 4.52% compared to 2.28% for VIGI. Presently, VIGI’s trailing yield is 7.58%, but this is misleading due to the $5.18 in capital gains distributions from December. SCHY’s dividends will be much higher, similar to how SCHD compares with the Vanguard Dividend Appreciation ETF (VIG).

Fundamental Analysis

Obtaining information on SCHY’s holdings proved to be a difficult task. Still, I gathered fundamental metrics for nearly 90% of the portfolio, which should be sufficient for these purposes. My goal was to provide further insights into the ETF’s volatility, dividends, growth, and valuation relative to the U.S. market. It’s always important to know what you own, so with that said, here is a summary of SCHY’s top 20 holdings (excluding Kaken Pharmaceuticals) and the summary metrics for the entire fund compared with SCHD.

Right away, the low 0.57 five-year beta (relative to U.S. markets) suggests a defensive portfolio that’s likely to be much less volatile than your U.S. holdings. However, I’m concerned with the low revenue growth rates. Constituents only grew sales by 3.74% over the last five years, and analysts are just slightly more bullish over the next twelve months with an estimate of 5.31%. These numbers are uninspiring, and I think SCHY could significantly lag in bull markets. My preference is for ETFs to be better balanced, though the trailing P/E of 15.87 partially makes up for this flaw.

On the other hand, there’s no denying the dividend yield and growth rates are attractive. I’ve estimated the forward yield of current constituents to be 4.71%, which will be reduced by the fund’s 0.14% fees and potentially more should the fund experience sudden growth. This figure is consistent with the ten-year 4.52% average yield I calculated earlier. Investors will also be pleased with constituents’ 10.25% five-year dividend growth rate. The combination of a high starting yield and high dividend growth is tough to find among U.S. ETFs, so I see SCHY as an excellent tool for supercharging a dividend growth portfolio.

Reasons For Investing Internationally

There are three often-cited advantages of international investing: exposure to new markets, exposure to unique companies, and diversification. Let’s touch on them in a bit more detail.

Exposure To New Markets

Interest in international stocks began around the 1970s with the performance of the Four Asian Tigers (South Korea, Taiwan, Singapore, and Hong Kong). During this period, these countries experienced rapid growth; South Korea and Taiwan became leaders in manufacturing electronic components, while Singapore and Hong Kong became two of the largest financial centers globally, just behind New York and London. The graph below highlights this growth, which is an annualized 8.81% between 1970 and 1990.

However, from 1990 onwards, the average annualized growth rate in real GDP slowed to 4.76%. It’s expected since emerging economies can’t stay emerging forever. Since then, the geographical scope has widened to include former Soviet Union countries, additional Asian and South American countries, China, and Mexico.

Exposure To Unique Companies

Companies in the United States are among the best globally, but not every market is cornered. For example, computer chips manufactured in countries like Taiwan are far more advanced than American companies like Intel produce. Toronto-Dominion Bank (TD) is a member of Canada’s “Big Five” and was recently added to the list of financial institutions that are too big to fail, as published by the Financial Stability Board. Investing internationally allows investors to broaden their horizons, reduce home bias, and target the world’s best-run companies rather than simply the ones they’re most familiar with. It’s a challenging task to find these companies on your own, even for professional investors, so that is where rules-based ETFs like SCHY come in handy.

Increased Diversification

Proponents of Modern Portfolio Theory will argue that increased diversification is a key reason to invest internationally. Theoretically, adding companies that are less correlated to other assets in the portfolio should result in better risk-adjusted returns. However, there is some evidence that international stocks are becoming more correlated with U.S. stocks, diminishing the benefits. In my view, investors would be better off focusing on increased diversification at the industry level instead. Buying high-quality companies is most important regardless of location, and fundamental analysis like the one I presented earlier can assist in that determination.

Investors need to weigh these benefits against the disadvantages of investing internationally. Particularly:

• Higher fees, which compound just like dividends, can add up to a substantial amount over the long run.
• Lower liquidity levels, mainly when dealing with more unique small-cap stocks. High bid-ask spreads tend to be higher for smaller issuers and act as an additional hidden cost.
• Shareholder communications can be worse than what you’re used to, particularly in emerging markets. Information may not be as timely or accurate, and legal rights for shareholders may differ. For example, China has multi-tiered exchanges where shares of the same company are issued with different rights and privileges on different exchanges. However, SCHY’s methodology states that only stocks trading on developed exchanges are eligible, so at least it’s safer from that perspective.
• Sovereign risk exists, as it’s difficult for domestic investors to understand all the factors influencing foreign markets. This risk is impossible to measure, but it’s safe to say it’s greater outside the United States and other well-developed markets.
• Foreign exchange risk can substantially impact returns, both negatively and positively. SCHY is not a hedged product, so drawing conclusions based on past performance may be misleading. It’s possible to hedge this risk on your own using futures, forwards, and options, but most retail investors are uncomfortable doing this.

Investment Recommendation

SCHY is an attractive international ETF unique for its high starting yield, which has averaged 4.52% over the last ten years, and its double-digit five-year dividend growth rate. You’re unlikely to find this combination domestically. To confirm, I did a scan of the 700+ U.S. Equity ETFs I calculate fundamental and technical metrics for, and of the ones with double-digit dividend growth rates at the constituent level, the highest yield was 3.28%. Not surprisingly, this ETF happened to be SCHD. Schwab truly has created a pair of low-cost products investors can use to supercharge their dividend growth portfolios.

International investing comes with additional risks, including foreign exchange risk that you may not feel comfortable hedging. Weakness in foreign currencies will directly impact your returns and may not reflect the quality of the businesses you’re buying. SCHY is also a low-growth ETF, so much like how its Index lagged SCHD’s Index by an annualized 5% over the last ten years, the underperformance in bull markets can be substantial. Nevertheless, I’m looking forward to watching how SCHY performs this year, and should anything change, I’ll be sure to provide an update. Thank you for staying with me through this lengthy post, and I look forward to discussing it further in the comments section below.