Very often, dividend investors focus on dividend yield as a key selection metric. To some extent that makes sense, but it can miss important company-specific issues that might lead you to avoid a stock. That’s exactly why dividend investors looking for an exchange-traded fund (ETF) need to examine Schwab U.S. Dividend Equity ETF (NYSEMKT: SCHD). Here’s what you need to know.

All in on high yields

Stocks with high yields often have high yields for a reason. Either the sectors from which they hail are known for high yields, like utilities and real estate investment trusts (REITs), or the companies have temporarily fallen on hard times, which is normal in cyclical industries like energy or can be company-specific. The point is that buying stocks based solely on yield will often result in a portfolio that’s concentrated in a small number of sectors and often will leave you with at least a few troubled stocks.

Image source: Getty Images.

This isn’t inherently bad, since yield is the focus. And out-of-favor stocks often have a value flare to them, if you like buying stocks when they’re cheap. There are a number of exchange-traded funds that you can choose from in this regard, like SPDR Portfolio S&P 500 High Dividend ETF (NYSEMKT: SPYD). This ETF is composed of the 80 highest-yielding stocks in the S&P 500 Index.

While the S&P 500 is itself made up of a hand-picked group of large, economically important companies, culling out the 80 highest yielders from the list is not exactly rocket science-level portfolio management. Real estate is the largest segment of the portfolio at 26% of assets, followed by financials at about 21% and utilities at 18% or so. Together these three sectors account for nearly two-thirds of the portfolio.

Compared with what SPDR Portfolio S&P 500 High Dividend ETF is doing, Schwab U.S. Dividend Equity ETF takes dividend investing to the next level.

Schwab U.S. Dividend Equity ETF is about yield and quality

For starters, Schwab U.S. Dividend Equity ETF excludes REITs, pulling out stocks that would, by the nature of their corporate structure, tend to have among the highest yields. It also required stocks to have at least 10 years of annual dividend increases behind them, focusing both on consistent dividend payers and companies that provide shareholders with a growing income stream over time. There are also some liquidity and market cap rules, but those are basically fairly easy hurdles. To be honest, there’s nothing all that special going on so far.

What comes next is unique. Schwab creates a composite score based on a number of key variables that attempt to highlight company quality. Some of the key metrics in the composite score include cash flow to total debt, return on equity, the dividend yield, and the five-year dividend growth rate. The ETF then ranks stocks from best to worst on its composite score, selecting the top 100 names, weighted by market cap, for inclusion in Schwab U.S. Dividend Equity ETF.

This approach mixes yield with quality and leads to a slightly different portfolio makeup. For starters, real estate is absent from the portfolio by design, but utilities are also a very small issue, at less than 1% of assets. The top sectors are financials, healthcare, consumer staples, industrials, energy, and consumer discretionary. While these sectors account for a bit over 80% of the total portfolio, the largest of them, financials, is only about 17% or so of the portfolio. That’s smaller than the third largest sector in SPDR Portfolio S&P 500 High Dividend ETF.

SPYD Total Return Price data by YCharts

To be fair, SPDR Portfolio S&P 500 High Dividend ETF offers a yield of 4.4% while Schwab U.S. Dividend Equity ETF’s yield is lower at 3.3%. However, Schwab U.S. Dividend Equity ETF is more diversified, and the stocks it owns are likely to be of higher quality because of the screening techniques employed. For most dividend-focused investors trying to find a single ETF to buy, giving up a little yield here will probably make a great deal of sense. And as the preceding chart shows, total return results, which assumes dividend reinvestment, clearly favor Schwab U.S. Dividend Equity ETF’s approach.

All dividend ETFs are not created equally

The big message here is that you can’t judge a dividend ETF by its yield alone — which is, of course, true of stocks, too. You need to dig in and understand how the portfolio is created. There are material drawbacks when it comes to ETFs that consider yield only when building a portfolio, while ETFs like Schwab U.S. Dividend Equity ETF tries to create a more compelling portfolio by combining yield with other fundamental data to pick good companies that also have high yields. That’ll probably sound like a better long-term proposition for many investors.

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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.