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A Worthy Pick for Small-Cap Dividend Exposure

This small-cap dividend-oriented fund's thoughtful index construction sets it apart from its peers.

Adam McCullough, CFA, 12/02/2016

Our team recently published an article evaluating WisdomTree from a Parent Pillar perspective. It is one of the faster-growing exchange-traded fund sponsors and specializes in fundamentally index-weighted funds. Notably its dividend-weighted strategies target yield while balancing risk. There aren’t many dividend-oriented small-cap funds, but WisdomTree SmallCap Dividend ETF ETF DES is one of the better options available to investors.

WisdomTree SmallCap Dividend ETF is one of the few small-cap-focused dividend-weighted strategies. This well-crafted fund effectively diversifies risk and rebalances into stocks as they become cheaper relative to their dividends, which should give it an edge against its peers. It offers a large cost-advantage compared with actively managed peers, but there are cheaper index alternatives. These attributes support its Morningstar Analyst Rating of Bronze.

The fund offers broad exposure to U.S. small-cap dividend-paying stocks and weights them by the value of dividends each stock is expected to pay over the next year. This approach balances firm size (bigger firms tend to pay larger absolute dividends) against yield and injects a contrarian rebalancing discipline. To rebalance back to its target dividend weightings, the fund increases exposure to stocks that have become cheaper relative to their peers based on dividends, and trims positions that have become more expensive. Not surprisingly, the fund exhibits a value tilt, but this tilt is less pronounced than the Russell 2000 Value Index’s. The holdings’ average market capitalization is similar to the index’s, but they tend to be more profitable.

This portfolio effectively balances the trade-off between yield and risk. Its broad reach limits its exposure to both firm-specific risk and the highest-yielding stocks, which are more likely to cut their dividends than their lower-yielding counterparts. Although the fund doesn’t screen for dividend sustainability, dividend cuts at a few firms shouldn’t significantly hurt performance. The fund is well-diversified across sectors, though it has greater exposure to consumer discretionary, industrials, and utilities stocks than the Russell 2000 Value Index, and less exposure to the financial, technology, and healthcare stocks. Despite its broad reach, the fund averages a 60%-plus dividend yield premium over the index.

So far, the fund’s approach has paid off. Over the trailing 10 years through September 2016, it bested the small-cap value category average and Russell 2000 Value Index by 0.8 and 1.5 percentage points annually. More favorable stock exposure in real estate and industrials sectors contributed the most to this outperformance.

Fundamental View
Modigliani and Miller’s dividend irrelevance theorem states that, ignoring taxes, informational asymmetries, and behavioral issues, dividend payout policy should not affect a stock’s returns. And investors should not care whether stock returns come from dividend income or capital appreciation. But in practice, dividends can offer tangible benefits. They can help investors better forecast income and stay invested through the market’s rough patches. Dividend payments can also keep corporate managers in check. Managers are loath to cut dividends, so they may use these payments to signal their confidence in their firm’s prospects. Second, dividend payments should encourage managers to exercise greater discipline in capital allocation decisions, because there is less money on hand to invest in low return projects, and may discourage empire-building.

This is one of only a handful of small-cap dividend funds. Small-cap stocks tend to be riskier and less profitable than mid- and large-cap stocks because they have less established competitive advantages and they’re more affected by poor economic cycles. But small-cap stocks may compensate investors with higher return potential. The fund’s holdings are less volatile than the typical small-cap stock, as they tend to be more mature companies with steadier cash flows. They tend to generate higher average returns on invested capital, a measure of profitability, than that of the category average.

Simply attempting to maximize dividend yield can introduce unintended risks. The highest-yielding stocks could be under financial distress and more likely to cut their dividends. This fund’s broad dividend-weighted portfolio helps mitigate some of this risk. The approach balances firm size against yield and causes the fund to rebalance opportunistically as stocks become cheaper relative to their dividends. But the fund does not load up on riskier stocks. Its holdings average market capitalization is similar to that of the Russell 2000 Value Index, but their average return on invested capital is higher than the index’s.

Adam McCullough, CFA, is an analyst on Morningstar’s manager research team, covering passive strategies.

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