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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.

Suitability
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.

Despite the fund’s sector caps, its dividend-seeking approach can create large sector tilts. Its utilities and real estate sector weightings are nearly double the Morningstar Category average’s. These sectors are trading at higher valuations than their historical norms and are sensitive to interest rates, which are key risks. The fund also has greater exposure to the consumer cyclical and consumer defensive sectors than the category average.

In contrast to some of its peers, this strategy does not require a long dividend payment history requirement or screen for dividend sustainability. The fund only considers the most recent (annualized) regular dividend payment to set its weightings. Ignoring sustainable dividend payment increases the risk that some stocks in the fund may cut their dividend, but its broad diversification and sector caps help protect against significant losses from dividend-cutting stocks.

Portfolio Construction
This fund earns a Positive Process Pillar rating because it follows a well-crafted dividend-weighted index that effectively diversifies risk and rebalances into stocks as they become cheaper relative to their dividends. The fund tracks the WisdomTree SmallCap Dividend Index. This index selects stocks representing the smallest 25% of the WisdomTree Dividend Index by market capitalization, after the largest 300 companies are removed. Historically, this diversified fund has held over 500 stocks. Qualifying stocks must have an indicated regular cash dividend, market capitalizations greater than $100 million, and meet trading liquidity requirements. The benchmark weights each constituent by the value of dividends it is expected to pay over the next year, relative to the aggregate value for the portfolio. The portfolio rebalances annually in December. Turnover here has averaged just 33% during the past five years, less than half the level of the small-cap value category average.

Fees
WisdomTree charges 0.38% expense ratio for this fund, which lands in the lowest decile when compared with all small-cap value funds, supporting the Positive Price Pillar rating. While cheaper market-cap-weighted index options are available, the fund’s fee ranks near the average of all index mutual funds and exchange-traded funds in the category. 

Alternatives
There aren’t many small-cap dividend strategies available, but ProShares Russell 2000 Dividend Growers SMDV (0.40% expense ratio) is one of the few. It targets stocks in the Russell 2000 Index that have grown their dividend for at least 10 consecutive years. Even though the fund aims to invest in dividend growers, SMDV’s yield is close to the Russell 2000 Value Index. Not surprisingly, given the dividend growth requirement, SMDV exhibits less of a value tilt and a bias toward more profitable firms than DES. SMDV skews heavily toward the steadier dividend-paying sectors, such as utilities and consumer staples.

PowerShares S&P SmallCap Low Volatility ETF XSLV (0.25% expense ratio) may be a better alternative for more risk-averse investors. It targets the least volatile stocks in the S&P SmallCap 600 Index and weights them by the inverse of their volatility, so that the least-volatile stocks receive the largest weightings. XSLV can have large sector concentrations because it does not impose sector caps like DES.

For investors seeking small-cap value equity exposure without a dividend focus, Vanguard Small-Cap Value ETF VBR (0.08% expense ratio) is tough to top. The fund tracks the market-cap-weighted CRSP US Small Cap Value Index. CRSP defines small-cap stocks as those smaller than the largest 85% of the U.S. stock market by market capitalization and larger than the smallest 2%. It targets the cheaper half of the U.S. small-cap market and weights its holdings by market capitalization. The average market capitalization of VBR’s holdings is about twice that of DES.

  

Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.

 

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

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