Key Points

• SCHD and GCOW focus on higher-yielding dividend stocks.

• The ETFs have different strategies for selecting those stocks.

• They also have different fees and return profiles.

Many exchange-traded funds (ETFs) focus on holding dividend-paying stocks. While that gives income-seeking investors lots of options, it can make it difficult to know which is the best one to buy.

The Schwab U.S. Dividend Equity ETF (NYSEMKT: SCHD) and Pacer Global Cash Cows Dividend ETF (NYSEMKT: GCOW) are two notable dividend ETFs. Here's a look at which is the better one to buy for those seeking to generate passive income.

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Different strategies for selecting high-yielding dividend stocks

The Schwab U.S. Dividend Equity ETF and the Pacer Global Cash Cows Dividend ETF aim to provide their investors with above-average dividend income by holding higher-yielding dividend stocks. The ETFs each hold roughly 100 dividend stocks. However, they use different strategies to select their holdings.

The Schwab U.S. Dividend Equity ETF aims to track the returns of the Dow Jones U.S. Dividend 100 Index. That index screens U.S. dividend stocks based on four quality characteristics:

• Cash flow to debt.
• Return on equity (ROE).
• Indicated dividend yield.
• Five-year dividend growth rate.

The index selects companies that have stronger financial profiles than their peers. That should enable them to deliver sustainable and growing dividends, and the Schwab U.S. Dividend ETF accordingly provides investors with a higher-yielding current dividend that should grow at an above-average rate. At its annual reconstitution, its 100 holdings had an average dividend yield of 3.8% and a five-year dividend growth rate of 8.4%.

The Pacer Global Cash Cows Dividend ETF uses a different strategy for selecting its 100 high-yielding dividend stocks. It starts by screening the 1,000 stocks in the FTSE Developed Large-Cap Index for the 300 companies with the highest free cash flow yield over the past 12 months. It screens those stocks for the 100 highest dividend yields. It then weights those 100 companies in the fund from highest yield to lowest, capping its top holding at 2%. At its last rebalance, which it does twice a year, its 100 holdings had an average free cash flow yield of 6.3% and a dividend yield of 5%.

Here's a look at how the top holdings of these ETFs currently compare:

Data sources: Schwab and Pacer.

Given their different strategies for selecting dividend stocks, the funds have very different holdings. SCHD holds only companies with headquarters in the U.S., while GCOW takes a global approach. U.S. stocks make up less than 25% of its holdings. Meanwhile, SCHD weights its holdings based on their dividend quality, while GCOW weights them based on dividend yield. Given its focus on yield, GCOW offers investors a higher current income yield at 4.2%, compared with 3.9% for SCHD.

Costs and returns

While SCHD and GCOW focus on higher-yielding dividend stocks, their strategies in selecting holdings have a major impact beyond the current dividend income. Because SCHD is a passively managed ETF while GCOW is an actively managed fund, SCHD has a much lower ETF expense ratio than GCOW. SCHD's is just 0.06%, compared with GCOW's 0.6%. Put another way, every $10,000 invested would incur $60 in management fees each year if invested in GCOW, compared with only $6 in SCHD.

GCOW's higher fee really eats into the income the fund generates, which affects its returns over the long term. The fund's current holdings actually have a 4.7% dividend yield, whereas the fund's latest payout had only a 4.2% implied yield.

Data sources: Pacer and Schwab. Note: GCOW's inception date is 2/22/16, while SCHD's is 10/20/11.

GCOW has outperformed SCHD over the past five years. However, SCHD has delivered better performance over the longer term. That's due to its lower costs and focus on companies that grow their dividends, which tend to produce the highest total returns over the long term.

SCHD is a better ETF for passive income

SCHD and GCOW hold higher-yielding dividend stocks, making either ETF ideal for those seeking passive income. However, SCHD stands out as the better one to buy because of its focus on dividend sustainability and growth. It also has a much lower ETF expense ratio. So it should provide investors with an attractive and growing stream of passive dividend income.

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Matt DiLallo has positions in Chevron, Coca-Cola, ConocoPhillips, Gilead Sciences, Schwab U.S. Dividend Equity ETF, and Verizon Communications. The Motley Fool has positions in and recommends Amgen, Chevron, Cisco Systems, Gilead Sciences, and Texas Instruments. The Motley Fool recommends BP, British American Tobacco, Equinor Asa, Lockheed Martin, Nestlé, Philip Morris International, and Verizon Communications and recommends the following options: long January 2026 $40 calls on British American Tobacco and short January 2026 $40 puts on British American Tobacco. The Motley Fool has a disclosure policy.

Tobacco stocks aren't for everyone. The fact that they deal in vices and sell addictive products is off-putting to some, while others skip over them in favor of faster-growing businesses. British American Tobacco (NYSE: BTI) is one of the industry's most prominent players, boasting a global presence and a diverse portfolio of cigarette brands and smoke-free nicotine products.

The stock's nearly 7% dividend yield offers firm short-term returns, which investors can appreciate when market volatility rises, as it has recently.

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But can you trust British American Tobacco as a long-term holding in your portfolio? There are some risks, but the upside could surprise you.

Emerging from a tumultuous decade

It has been a particularly rough decade for British American Tobacco, also known as BAT. The stock languished for years as the company worked through two primary challenges:

1. The early stages of an industrywide shift away from cigarettes to smoke-free nicotine products.
2. The consequences of overpaying to merge with Reynolds American in 2017, including a $31.5 billion non-cash write-down on its U.S. cigarette brands in late 2023.

Now the dust is settling.

Tobacco companies are transitioning to electronic cigarettes (vapes), heated tobacco, and oral nicotine pouches, and British American Tobacco is competing. Organic, currency-neutral sales for new category products grew by 8.9% in 2024, rising to 17.5% of total revenue. British American Tobacco is trailing Philip Morris International in its smoke-free efforts, but is ahead of Altria Group, which still depends overwhelmingly on Marlboro cigarettes in the U.S.

Combustible cigarette volumes are declining, but BAT is increasing prices to offset the losses -- a classic tactic for tobacco companies.

Continued growth in new category products and stable cigarette revenues could drive modest but steady long-term growth. Management anticipates 3% to 5% annualized currency-neutral revenue growth starting in 2026. That won't light the world on fire, but it's a path forward from a brutal stretch.

Dividend reinvestment is the path to maximizing returns

The beauty of British American Tobacco is that you don't need blazing growth to produce excellent investment returns.

British American Tobacco's dividend yields 7%. If it hits its growth goals and maintains profit margins, the company could generate total annual returns of 10% to 12% over the long term, and that's without factoring in dividend reinvestment. Pump those dividends right back into the stock, and you're going to see some serious compounding over time.

Some investors question the sustainability of the dividend, but I don't see an issue.

British American Tobacco generated 7.9 billion pounds in free cash flow in 2024 and paid out 5.2 billion pounds in dividends. That's a payout ratio of 66%, leaving a substantial amount left over. Additionally, the company owns approximately a quarter of ITC, an Indian conglomerate with a market value of 5.38 trillion rupees, or roughly $63 billion. That's a valuable asset for BAT, and gives the dividend -- a top financial priority for tobacco companies to begin with -- an extra safety net.

Why the stock should perform better over the next decade

Right or wrong, share prices can influence how investors might view a stock. British American Tobacco is up 43% over the past year, but down 25% from a decade ago.

Fortunately, it appears that the stock's recent momentum is the start of a new era. British American Tobacco's price-to-earnings ratio peaked at about 24 at the end of 2017. It slowly unwound for years, a major contributor to the stock's lousy performance.

British American Tobacco hit bottom at under 8 times earnings early last year, following its massive write-off. Now, with a brighter future ahead, the market is buying. The stock's valuation has risen, but it's still under 10 times 2025 earnings estimates. Investors probably shouldn't expect shares to return to 24 times earnings anytime soon, but the current price is reasonable at the very least.

It should enable shareholders to enjoy returns in line with the company's growth and dividends moving forward. That should make long-term investors very happy.

Should you invest $1,000 in British American Tobacco right now?

Before you buy stock in British American Tobacco, consider this:

The Motley Fool Stock Advisor analyst team just identified what they believe are the 10 best stocks for investors to buy now… and British American Tobacco wasn’t one of them. The 10 stocks that made the cut could produce monster returns in the coming years.

Consider when Netflix made this list on December 17, 2004... if you invested $1,000 at the time of our recommendation, you’d have $594,046!* Or when Nvidia made this list on April 15, 2005... if you invested $1,000 at the time of our recommendation, you’d have $680,390!*

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Justin Pope has no position in any of the stocks mentioned. The Motley Fool recommends British American Tobacco P.l.c. and Philip Morris International and recommends the following options: long January 2026 $40 calls on British American Tobacco and short January 2026 $40 puts on British American Tobacco. The Motley Fool has a disclosure policy.