4 Reasons This Dividend ETF May Outperform Schwab's ETF for Income Investors

When asked to choose one dividend exchange-traded fund (ETF) above all others, the Schwab U.S. Dividend Equity ETF (NYSEMKT: SCHD) is probably the most popular answer. It's a great answer, too, because the fund's comprehensive selection strategy does a really good job of picking the best dividend stocks.

That doesn't always mean it's going to be an outperformer, though. Shareholders found that out the hard way in 2023-2025 when it was actually one of the worst-performing dividend ETFs.

There are times when other dividend ETFs are going to beat it. I think the iShares Core Dividend Growth ETF (NYSEMKT: DGRO) is a good candidate to do just that during the next few years. A hawkish Federal Reserve, an elevated inflation rate, and higher Treasury yields could be a combination that hurts stocks that aren't increasing their dividends.

Although both of these ETFs incorporate dividend history into their selection strategy, here's why I think the iShares' portfolio might be able to hold up better in this market.

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Payout ratio screen gives the IShares fund an edge

For all that the Schwab ETF does to screen for quality, one of the things it doesn't look at is a company's payout ratio. This is essentially a measure of how much of its earnings are being paid out in dividends.

The iShares ETF does. It only selects stocks of companies that pay out no more than 75% of their earnings as dividends. This screen helps ensure that companies have earnings in reserve to keep paying and raising their dividends in case the economy starts to stumble or margins get squeezed.

With borrowing costs likely to remain elevated for the foreseeable future, that could prove to be an important distinction.

The iShare fund comes with less concentration

The Schwab ETF's portfolio consists of just 100 stocks. The top 10 holdings alone account for roughly 40% of the portfolio. That number isn't as high as some of the big tech and growth ETFs out there, but it is higher than that of the S&P 500 (SNPINDEX: ^GSPC).

The iShares ETF sits at just 27% and it gives an allocation of 10% or more to five different industry sectors. Diversification of holdings alone isn't necessarily going to improve returns, but it could mitigate some volatility and idiosyncratic risk.

Concentration has been a problem within U.S. equities for years. And it's a bit of a problem for the Schwab ETF as well.

SCHD index mechanics can trigger major portfolio shifts

The Schwab ETF just went through one of its biggest annual reconstitutions in years. Roughly two dozen positions were swapped, accounting for just over 31% of the portfolio overall. Energy, the largest sector holding before the adjustment, fell from a 23% weighting down to about 16%.

This type of broad portfolio change can make an investor feel like they suddenly own an entirely new portfolio. If you like the fund's sector composition or top holdings, don't be surprised if they're suddenly gone or significantly changed.

The iShares ETF typically has a lower turnover rate, and it doesn't drop like a hammer on just one day of the year.

The iShare fund topped Schwab's counterpart during the past decade

Although these funds are designed to simply track their respective indexes, we shouldn't discount their past performance altogether.

The Schwab ETF is beating the iShares ETF by about nine percentage points year to date. But during the past decade, it's the latter that's outperforming by roughly 1% per year. And it's been able to deliver that performance with slightly less volatility.

Overall, if you need income and cash flow now, the Schwab U.S. Dividend Equity ETF is probably still the better choice -- its 3.3% yield easily beats the 2% yield of the iShares Core Dividend Growth ETF.

On a total-return basis, however, there's a strong case that favors the iShare ETF over Schwab's.

David Dierking has positions in Schwab U.S. Dividend Equity ETF. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.