The 1 Costly Mistake Income Investors Make When They Buy SCHD

Investing in an exchange-traded fund (ETF) is one of the simplest ways to diversify a portfolio. However, not all ETFs provide the diversification investors expect.

Consider the Schwab U.S. Dividend Equity ETF (NYSEMKT:SCHD). While it holds roughly 100 stocks, its 10 largest positions account for more than 40% of its assets. That concentration creates a potential pitfall for income investors who already own some of those same companies.

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Why SCHD attracts income investors

The Schwab U.S. Dividend Equity ETF is one of the most popular dividend ETFs. It's the largest dividend-focused fund by assets under management, at over $118.5 billion. So many income-focused investors (including me) entrust SCHD with their capital because it offers a high-yielding, steadily rising dividend and has historically delivered strong total returns.

The fund tracks the Dow Jones U.S. Dividend 100 Index, which screens dividend-paying companies based on dividend history and fundamental quality. It currently has about 100 top U.S. high-yielding dividend stocks, including Procter & Gamble (NYSE:PG), Home Depot, Chevron, Coca-Cola, and other well-known dividend payers. They have grown their dividends by more than 9% annually on average over the last five years. Investors gain access to this high-quality income stock portfolio for a very reasonable cost (0.06% expense ratio).

Make no mistake: SCHD is one of the highest-quality dividend-focused ETFs around. However, investors can err by failing to understand how the fund changes the risk profile of their existing investments.

The costly mistake: Overlooking portfolio overlap

It can be easy to assume that because SCHD holds 100 top-notch dividend stocks, it would instantly diversify your individual stock portfolio. However, that's not necessarily the case. It weights its holdings using a float-adjusted market capitalization approach, meaning the largest companies have a higher weight in the fund. Its 10 largest holdings currently comprise nearly 42% of the fund's value.

For example, consumer household products giant Procter & Gamble is currently in the top 10 at a 4.3% weighting. Like many income investors, I hold shares of P&G in my portfolio. It's as durable a dividend stock as there is. The company has increased its dividend for 70 straight years, one of the longest streaks in the U.S. stock market. It more than qualifies it as a Dividend King, a company with 50 or more years of annual dividend growth.

I want to build my P&G position. However, I need to be careful not to over-allocate my portfolio to the consumer products giant as I also build my SCHD position. Likewise, I own shares of Coca-Cola, Chevron, and Home Depot, which are also among SCHD's 10 largest holdings.

The other thing investors need to consider is sector weighting. While SCHD is broadly diversified by sector, it has a higher weighting to consumer staples (20%), healthcare (19.2%), and energy (15.4%). I need to keep that in mind, especially the energy concentration. In addition to holding Chevron stock, I also own several other energy companies. I need to make sure I don't allocate too much to that volatile sector when I'm building my SCHD position.

How to avoid the mistake

You can easily avoid this potentially costly mistake. Here are three practical steps to follow before buying SCHD or adding to your existing position:

1. Review the ETF's largest holdings. SCHD publishes its complete holdings on its website, making it easy to identify overlap with your existing investments.
2. Compare sector weights. Check whether the fund adds exposure to industries that already dominate your portfolio.
3. Evaluate the combined allocation. Decide whether SCHD meaningfully improves your diversification or merely increases the size of your existing bets.

Here's a simple way to evaluate how much SCHD could impact your portfolio's diversification. Let's say you're considering investing $10,000 in SCHD but already have a sizable interest in Procter & Gamble. At 4.3% of the fund, you'd be adding $430 of additional indirect exposure to the consumer products giant. Likewise, that same investment would add $1,538 of additional exposure to the energy market at its current 15.3% weighting. If that additional exposure would increase your allocation above your comfort level, you might not want to make this purchase or consider reducing those individual positions.

Consider the complete fit before buying

The biggest mistake investors can make with SCHD isn't necessarily paying too much or chasing its dividend yield. It's assuming that owning an ETF automatically means they're adequately diversified. SCHD's holdings include many excellent companies, but investors who already own several of them could end up taking more concentrated risks than they intended. Understanding what you own -- and how it all fits together -- is essential to building a resilient income portfolio.

Matt DiLallo has positions in Chevron, Coca-Cola, Home Depot, Procter & Gamble, and Schwab U.S. Dividend Equity ETF. The Motley Fool has positions in and recommends Chevron and Home Depot. The Motley Fool has a disclosure policy.