Is the Schwab US Dividend Equity ETF a Safer Bet in a Volatile Market?

Key Points

• The S&P 500 index is near all-time highs, but its gains have largely been driven by a small number of megacap tech stocks.

• The Schwab US Dividend Equity ETF uses a fairly complex screening process to highlight 100 stocks for its portfolio.

• The ETF's lofty yield and below-market valuation make it a safer bet if you expect a volatile market ahead.

• 10 stocks we like better than Schwab U.S. Dividend Equity ETF ›

Sometimes it makes sense to swing for the fences when you are investing, even if your focus is on dividend stocks. But at other times, it makes sense to play it safer. Right now, with the S&P 500 (SNPINDEX: ^GSPC) index trading near its all-time high, a bit of caution is probably in order. Which is why Schwab US Dividend Equity ETF (NYSEMKT: SCHD) is a more prudent bet today.

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What's driving the market?

One of the easiest ways to invest in the stock market is to just buy an exchange-traded fund (ETF) that tracks the S&P 500 -- for example, the Vanguard S&P 500 ETF (NYSEMKT: VOO). There's actually nothing wrong with that approach, per se, but if you are looking to put some money to work in the market today, you ought to keep valuation in mind. The S&P 500's rise to its current lofty levels has been driven mostly by a small number of megacap technology stocks.

That fact might lead some investors to think about focusing specifically on technology stocks, which can be done with an ETF like the Invesco QQQ Trust (NASDAQ: QQQ), which tracks the Nasdaq-100. That index includes only the 100 largest non-financial companies on the Nasdaq exchange. That gives it a heavy bias toward technology stocks -- they make up around 60% of the value of the index, and thus, the QQQ's portfolio. Its top 10 holdings make up roughly 50% of its value, and all of them are technology or technology-related stocks.

But the Invesco QQQ Trust is even worse from a valuation standpoint than an S&P index fund because it doubles down on what are the most expensive stocks in the market. To put some specific numbers on that, the S&P 500 index has an average price-to-earnings ratio of 27.6 right now, while the Nasdaq-100's P/E ratio is a lofty 42. That compares to a P/E of just 17 for the Schwab US Dividend Equity ETF.

What does the Schwab US Dividend Equity ETF do?

The Schwab US Dividend Equity ETF is quite different from the two discussed above. While those two ETFs track well-known indexes, the Schwab US Dividend Equity ETF tracks a bespoke index called the Dow Jones U.S. Dividend 100. It was made specifically for the ETF, so what the index does, the ETF does.

The index's methodology is actually fairly complex. First, it eliminates real estate investment trusts (REITs) from consideration. Next, it reduces its list of potential holdings to only those companies that have increased their dividends for at least 10 consecutive years. Some ETFs would stop there, but the index Schwab US Dividend Equity ETF tracks goes further. It creates a composite score that is based on each company's cash-flow-to-total-debt ratio, return on equity, dividend yield, and five-year dividend growth rate.

These are all data points that a dividend investor would be interested in. The 100 stocks with the highest composite scores get into the index and the ETF, weighted by market cap. And all of that work is provided for a modest expense ratio of 0.06%.

It hasn't been the best-performing ETF you can buy. In fact, the Invesco QQQ Trust has trounced it. But given the currently lofty valuation of Invesco QQQ Trust, more conservative investors should probably err on the side of caution today and go with the portfolio with the more reasonable valuation. That's the Schwab US Dividend Equity ETF. And, notably, it comes with a market-beating dividend yield of 3.8% or so.

Over the longer term, meanwhile, the Schwab US Dividend Equity ETF has provided investors with a generally growing stream of income and capital appreciation. That's a win/win, particularly if you are trying to live off the income your portfolio generates and are hoping to leave something behind for your heirs. All in all, the Schwab US Dividend Equity ETF looks like a good option in what is actually an expensive and volatile market.

Tread with caution in today's investment environment

It is hard to avoid getting caught up in the excitement on Wall Street. Right now, that excitement is centered around technology stocks, which are driving the S&P 500 index and more focused technology funds higher. But if you step back and consider the risks, you might decide that a more nuanced investment approach is a better option. For income investors, the Schwab US Dividend Equity ETF is clearly a good choice. But, given today's valuations, it could also be a good choice for investors who are just worried about the general volatility of the market.

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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard S&P 500 ETF. The Motley Fool recommends Nasdaq. The Motley Fool has a disclosure policy.