Schwab U.S. Dividend Equity ETF (SCHD 0.67%) has a unique approach to stock selection, and in some ways, it feels like it is more than just a simple index fund. That, however, is not the case, since it basically tracks the Dow Jones U.S. Dividend 100 Index. Understand that index, and you'll understand why the Schwab U.S. Dividend Equity ETF is such an attractive source of passive income. Here's what you need to know.

What does the Dow Jones U.S. Dividend 100 Index (SCHD) do?

As an index-tracking exchange traded fund (ETF), the single most important thing for investors to know about the Schwab U.S. Dividend Equity ETF is really to understand what the Dow Jones Dividend 100 Index does. The goal of the index is simple: to provide investors a reliable income stream backed by financially strong companies, but the methodology is fairly complex.

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The first step for this index is to create a pond from which to fish. That pond only includes companies that have increased their dividends each and every year for a decade or more. Real estate investment trusts (REITs) are eliminated from consideration, which makes logical sense because they are designed to generate income and would likely end up overtaking the index if they were included.

That first step, which is fairly easy to understand, sets a solid foundation. Only relatively strong companies are likely to have the wherewithal to increase their dividends year in and year out for more than 10 years. The next step is the complex part, involving the creation of a composite score that examines four distinct variables: cash flow to total debt, return on equity, dividend yield, and the five-year dividend growth rate.

What do each of these factors measure? Cash flow to total debt is a way to examine financial strength. Return on equity is a way to evaluate the strength of the business. Dividend yield is pretty clearly a measure of the income investors are receiving. And the five-year dividend growth rate kind of provides a combination view of financial strength and business strength. A faster-growing dividend, on average, is likely to be backed by a company that is doing fairly well.

Once this composite score has been created, the pool of potential investments are lined up from the best score to the worst. The 100 best-scoring companies are included in the Dow Jones Dividend 100 Index and, thus, within this Schwab ETF. The holdings in the ETF are market cap weighted, so the largest companies have the greatest impact on performance. And the holding list is rebalanced annually, which helps ensure that the most attractive investment candidates are in the ETF at all times.

The cost for all of this? A very modest 0.06% expense ratio. Add in a nearly 3.6% dividend yield, and you can see why the Schwab U.S. Dividend Equity ETF has over $68 billion in assets. That fact, meanwhile, is another plus, because it means the ETF isn't likely to be shut down by the sponsor anytime soon.

SCHD data by YCharts.

Why you should buy Schwab U.S. Dividend Equity ETF (SCHD) and hold it forever

Simply put, this Schwab ETF is doing what most dividend investors are trying to do with their portfolios. Only, if you buy is dividend equity ETF, you don't actually have to do all of the work. One simple investment with a very modest expense ratio, and you're done. There is an argument to be made that the yield isn't exactly huge. However, given that the S&P 500 index (^GSPC -0.47%) is offering a yield of just under 1.2%, it is still very generous.

But here's the really exciting part of the story: You don't have to just buy this one investment. You can use the Schwab U.S. Dividend Equity ETF as a core holding or, if you prefer, a foundational investment. Then you can layer in other stocks, perhaps with higher yields, on top of it. REITs would be a great starting place for further research, but this Schwab ETF is a bit light on utility stocks as well.

And so if you are looking for a more hands-on approach to dividend investing, REITS and utilities have historically offered high yields and have unique characteristics that you can focus on more deeply if you are outsourcing the rest of your portfolio to the Schwab ETF.

SCHD Dividend Yield data by YCharts.

You could also focus your attention on turnaround stocks, which probably won't be big holdings in the ETF. Or you could scan the ETF's portfolio for companies you really like and buy shares of the few individual holdings you want to own more of. The key is to use the ETF as a way to simplify your investment life in the way that works best for you.

One and done or more

The Schwab U.S. Dividend Equity ETF isn't a simple index fund. Yes, all it does is track the Dow Jones U.S. Dividend 100 Index, but that index's construction is fairly complex. But it does what most dividend investors try to do when building a portfolio. That could make it a great option for investors who want to buy just one investment or for investors who want to use it as the foundation for a broader portfolio. And given that the portfolio is updated regularly, you can buy it and comfortably hold it forever.