Is the Schwab U.S. Dividend Equity ETF a Buy Now?

For years, the Schwab U.S. Dividend Equity ETF (NYSEMKT: SCHD) has been an incredibly popular fund choice. Its combination of strong performance and high yields has made it a source of steady and predictable income for investors.

The last three years, however, have been a different story. The exchange-traded fund has consistently ranked near the bottom of the Morningstar Large Value category, and its performance within the U.S. dividend ETF category over that stretch has been well below average. On a total return basis, it's down by about 3% over the past year, while the S&P 500 is up by around 14%. And over the past three years, the performance gap is much wider.

The question for new investors considering it today is, will the fund return to form, or will its weakness persist? Though it has a lot of positives working in its favor, is it a smart buy right now?

What makes SCHD a good ETF to own

One of the best features of the Schwab U.S. Dividend Equity ETF is that its stock selection criteria include dividend quality, yield, and dividend history.

In order to qualify for inclusion, companies must have at least 10 consecutive years of dividend payments, a minimum $500 million market cap, and an above-average yield. Those that meet those standards are then filtered by evaluating four fundamental ratios: cash flow to debt, return on equity, dividend yield, and 5-year dividend growth rate.

It's one of the most comprehensive selection strategies in the category, and helps the fund managers target the best-of-the-best dividend stocks.

The Schwab U.S. Dividend Equity ETF's five largest sector allocations right now are energy (19.3%), consumer staples (18.5%), healthcare (16.1%), industrials (12.3%), and financials (9.4%). Its top individual holdings include Merck, Amgen, Cisco Systems, and AbbVie.

Overweighted defensive exposure

One of the biggest factors behind the ETF's recent underperformance is that its allocation skews toward defensive stocks and sectors that have fallen out of favor on Wall Street.

Over the past three years, the technology and communication services sectors have been driving most of the growth in the S&P 500. In the broad large-cap index, those two sectors currently combine for a roughly 45% weight. Only about 13% of the Schwab U.S. Dividend Equity ETF's value comes from those sectors.

Because it is overweight on energy, consumer staples, and healthcare, the ETF has been mispositioned to catch the prevailing trends in the market. Its focus on value stocks and lower volatility stocks added to the drag on its performance.

Source: Getty Images.

Strong dividend growth history

Structurally, there's still a lot to like about SCHD even though its selection methodology hasn't been in favor lately.

Its portfolio is full of high-quality companies with healthy balance sheets and strong cash flows. In general, those sorts of stocks make for great long-term holdings in almost any portfolio. And its quality standards also help it pick companies that can sustain their dividend payouts and grow them over time.

Over the past 10 years, the fund has averaged an annual dividend growth rate of 10.4%. That fairly steady growth has allowed shareholders to stay ahead of inflation and rely on their portfolios confidently for income generation.

Still a solid portfolio pick

There's no question that the last three years have been disappointing for investors in this ETF, but it's also important to stay focused on the fund's structural makeup.

Sectors and categories will always go in and out of favor, but I believe that stock selection methodology is what really separates the great dividend ETFs from the average ones.

SCHD targets companies with quality characteristics, strong balance sheets and cash flows, high dividend yields, and track records of reliable payout growth. That makes it a great core portfolio building block, whether your goal is short-term income or long-term capital growth.

The fund's current 3.8% yield is more than triple that of the S&P 500, and its ultra-low 0.06% expense ratio means that you keep more of your money.

Despite its recent weaknesses, the Schwab U.S. Dividend Equity ETF still looks like a solid long-term investment.

David Dierking has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends AbbVie, Amgen, Cisco Systems, and Merck. The Motley Fool has a disclosure policy.