You Can Do Better Than the S&P 500. Buy This ETF Instead

Investing isn’t a one-size-fits-all situation, which is why there are so many different investment approaches you can follow. And yet the common reference point for most investors is the S&P 500 (^GSPC 0.12%) index. Here’s one big problem for a retired investor in need of income who just defaults to the S&P 500: The index’s dividend yield is a scant 1.3% today. It would be hard for a dividend investor to live off of that, which is why a better option would be Schwab U.S. Dividend Equity ETF (SCHD 0.10%), which has a yield of nearly 3.5%.

There’s nothing wrong with the S&P 500 Index

As far as indexes go, the S&P 500 Index is fairly well constructed. For starters, it owns a large number of stocks, providing diversification. The stocks are selected based on their size and importance to the U.S. economy, so they are notable companies, not obscure businesses. The stocks in the index are weighted based on market cap, so the largest stocks have the most influence on the index’s performance. That’s pretty representative of the real world, and it ensures that anyone who owns the index is putting more money into the best-performing stocks (which are usually, though not always, the largest ones).

Image source: Getty Images.

But just because an index is well constructed doesn’t mean it is the right index for every investor to own. As noted, the yield on the S&P 500 Index is a slim 1.3%. That’s a very small number, and it would require a huge investment to generate a meaningful level of dividend income if you just owned an S&P 500-tracking exchange-traded fund (ETF) like SPDR S&P 500 ETF Trust (SPY 0.14%). A better bet would be to buy an ETF that is focused on generating dividend income. A good option is Schwab U.S. Dividend Equity ETF, which offers a yield that’s nearly three times the size of what you’d collect from an S&P 500 tracking ETF.

What does Schwab U.S. Dividend Equity ETF do?

Before you buy Schwab U.S. Dividend Equity ETF, or any ETF for that matter, you need to dig into the investment methodology. In this case, the ETF is trying to create a balance between quality and dividend yield. That’s notably different from an ETF like SPDR Portfolio S&P 500 High Dividend ETF (SPYD 0.10%), which simply buys the 80 highest-yielding stocks in the S&P 500 index.

To get its final list of about 100 stocks, Schwab U.S. Dividend Equity ETF first removes real estate investment trusts (REITs). It then screens for companies that have increased their dividends annually for 10 consecutive years. This is the base list of investment candidates. For each of these potential investments, it creates a composite score using cash-flow-to-total debt, return on equity, dividend yield, and the five-year dividend-growth rate. The scores for each company are ranked from best to worst, and the top 100 are the ones that get into Schwab U.S. Dividend Equity ETF.

The end result isn’t an income-focused ETF, per se, but an ETF that tries to ensure that investors own good companies with growing businesses and attractive yields. All in all, based on the investment approach, Schwab U.S. Dividend Equity ETF sounds like it would be a pretty good option for most dividend investors who want a simple way to invest in dividend stocks. Pair that with a broad-based bond fund, perhaps like Vanguard Total Bond Market Index ETF (BND -0.25%), and you have a fairly solid foundation for a balanced portfolio. Notably, Vanguard Total Bond Market Index ETF has a yield that’s a bit over 3.3%. You could probably do better than that if you were willing to take on more fixed-income risk.

Investing isn’t one-size fits all

The S&P 500 index is great, but it isn’t the right investment option for every investor. For example, the S&P’s goal is just to represent the broader economy, which is not going to serve dividend investors very well. If you are looking for income, an ETF like Schwab U.S. Dividend Equity ETF will probably be a better choice. It is specifically designed to meet the needs of dividend investors looking to own high-quality growing businesses that pay attractive dividends.