VOO vs. SCHD: Which Is the Smarter Buy When Inflation Is Running Hot?

U.S. headline inflation hit 4.2% in May, the highest reading since April 2023, with energy costs up 23.5% year over year.

Even though corporate earnings growth is strong and the labor market is demonstrating resilience, rising inflation changes some of the dynamics of where to put new money to work.

The Vanguard S&P 500 ETF (NYSEMKT: VOO) and the Schwab U.S. Dividend Equity ETF (NYSEMKT: SCHD) perform very differently in bull market rallies. The S&P 500's mega-cap tech concentration tends to do better than more diversified strategies. But the Schwab ETF's focus on high-quality, durable dividend payers has helped it deliver annual dividend growth far above historical inflation rates.

That makes the Schwab U.S. Dividend Equity ETF the smarter buy at the moment.

Image source: Getty Images.

VOO: More tech concentration isn't needed right now

The Vanguard S&P 500 ETF tracks a broad basket of large-cap stocks, but two numbers raise concerns: the 39% allocation to tech, and the 39% concentration in the top 10 holdings. The five largest holdings are:

1. Nvidia: 7.9% of overall portfolio
2. Apple: 7.1%
3. Alphabet: 6.1%
4. Microsoft: 5.1%
5. Amazon: 4.1%

Goldman Sachs (NYSE: GS) recently flagged artificial intelligence (AI) spending as a factor to watch. It noted that "capital expenditures for major cloud operators are projected at roughly $770 billion in 2026, equivalent to approximately 100% of their operating cash flow."

If these companies are maxing out their cash flow spend on capex while margins and returns on equity are about as high as they're going to get, there may be nowhere to go but down for the AI sector. Early indications of a slowdown in development spending, revenue, or earnings could be met with significant selling as momentum slows.

It's not a major risk for the S&P 500 yet, but it limits immediate upside potential.

SCHD: Dividend growth is the right strategy

The Schwab U.S. Dividend Equity ETF screens for companies with at least 10 years of dividend payments, strong cash flows, and consistent earnings growth. Its focus on dividend growth, portfolio quality, and high yield makes it unique in the dividend ETF category. Its top five holdings are:

1. Texas Instruments: 6.1% of overall portfolio
2. Qualcomm: 5.9%
3. UnitedHealth Group: 5.5%
4. Coca-Cola: 4.1%
5. Chevron: 3.8%

Following its portfolio reconstitution, tech exposure jumped from 8% to 11%, but it's still only the fund's fifth-largest sector holding. It's the rest of the fund's exposure that's the bigger story.

Consumer staples, healthcare, and energy each have weights of 17% to 19%, making it a decidedly defensive-tilted portfolio. More importantly, the fund has grown its dividend by about 10% annually over the past decade. Post-reconstitution, the fund's anticipated dividend growth is still north of 9%.

Even if inflation remains above 4% for a while, this fund's near-10% dividend growth rate should help maintain purchasing power. Plus, the portfolio's defensive nature should hold up better if high inflation results in a slowdown in growth.

Overall, the Schwab U.S. Dividend Equity ETF is the better buy. We could be reaching a point of maximum optimism and short-term results in the tech sector. Plus, an extended bout of high inflation should hit that sector particularly hard. The Schwab ETF is simply better built for the environment we're in.

David Dierking has positions in Apple and Schwab U.S. Dividend Equity ETF. The Motley Fool has positions in and recommends Alphabet, Amazon, Apple, Chevron, Goldman Sachs Group, Microsoft, Nvidia, Qualcomm, Texas Instruments, and Vanguard S&P 500 ETF. The Motley Fool recommends UnitedHealth Group. The Motley Fool has a disclosure policy.