SCHD's Top Sector Bet Is Healthcare at 20.7%. I'm Not Sure What's More Surprising: What It Doesn't Hold, or What It Does.

The Schwab U.S. Dividend Equity ETF (NYSEMKT:SCHD) holds 100 of the highest-quality, high-yielding dividend stocks. The ETF currently has a 20.7% allocation to healthcare stocks, its top sector weighting. What's surprising is that two of the seemingly highest quality healthcare dividend stocks -- Johnson & Johnson (NYSE:JNJ) and Medtronic (NYSE:MDT) -- aren't among its holdings at all. Instead, its two largest healthcare stock holdings -- Merck (NYSE:MRK) and UnitedHealth (NYSE:UNH) -- are facing notable headwinds.

Here's why my surprise isn't making me concerned about the fund's ability to continue paying dividends.

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What SCHD holds (and what's surprisingly missing)

The Schwab U.S. Dividend Equity ETF tracks the Dow Jones U.S. Dividend 100 Index, which screens companies for dividend quality. Its screens include a couple of financial metrics, dividend yield, and five-year dividend growth rate. The index reconstitutes its holdings each year. At its last annual reconstitution, it deleted 22 existing stocks (including AbbVie) and added 25 new holdings (including UnitedHealth and Abbott Labs). Meanwhile, healthcare rose to its second-largest sector weighting at the time to 18.9% (from 15.4%). It's currently the largest sector weighting at 20.7%.

Those new holdings joined holdovers Merck, Amgen, and Bristol Myers Squibb. Surprisingly missing from this list are Johnson & Johnson and Medtronic. The former has increased its dividend for 64 straight years, qualifying it as a Dividend King (a company with 50 or more years of annual dividend increases). Meanwhile, Medtronic is one year shy of joining it in that elite group. Johnson & Johnson has a pristine AAA credit rating and currently has a 2% dividend yield. Meanwhile, Medtronic has a strong balance sheet (A/A3 ratings) and an attractive 3.2% yield.

Quality questions

Instead of holding those healthcare dividend stalwarts, SCHD's top healthcare holding (and fifth-largest overall) is Merck at 4.1%, while UnitedHealth is two spots behind it at 3.9%. While they both currently have higher yields than JNJ (MRK's is 2.3% and UNH's is 2.4%), they're facing some notable headwinds.

Merck is currently facing the loss of its biggest revenue driver, Keytruda, which could lose U.S. patent exclusivity in 2028. The one product contributed over 50% of its sales during the second quarter ($8.4 billion of its $16.6 billion in total sales). On a positive note, Merck has invested heavily in R&D and acquisitions to get past this patent cliff. It has several potential blockbuster products in the pipeline, which it hopes to launch over the next several years to more than offset the impact of patent expirations.

Meanwhile, UnitedHealth has faced several headwinds over the past few years, including issues with its Medicare Advantage Program and higher-than-expected costs. The company's revenue has struggled to grow, while its earnings have been lumpy. While the company has begun to turn things around, it still faces questions about its role in the country's high healthcare costs.

Why I'm not concerned

Even though I have some quality concerns about Merck and UnitedHealth, they still passed the stringent screens required for inclusion in the index SCHD tracks. Further, their high ranking in the fund means they scored very highly on the quality metrics it screens for. If their quality declines, the fund will simply replace them with even higher-quality holdings. That's why I have no issues with them being part of SCHD right now.

Matt DiLallo has positions in Bristol Myers Squibb, Johnson & Johnson, Medtronic, and Schwab U.S. Dividend Equity ETF. The Motley Fool has positions in and recommends AbbVie, Abbott Laboratories, Amgen, Bristol Myers Squibb, Medtronic, and Merck. The Motley Fool recommends Johnson & Johnson and UnitedHealth Group. The Motley Fool has a disclosure policy.