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Our Pick for Emerging-Markets Small-Cap Exposure

This dividend-weighted strategy has resulted in a relatively less volatile fund.

Patricia Oey, 05/28/2013

WisdomTree Emerging Markets Small Cap Dividend DGS has a number of positive attributes. Its small-cap focus provides better diversification benefits relative to large caps, as small companies tend to have more exposure to local economies and customers. Long-term investors may also benefit from the small-cap premium, which has also been observed in emerging markets. This fund employs a dividend-based weighting methodology, which, in the emerging-markets small-cap universe, results in a portfolio with a quality tilt. So even though DGS is a small-cap fund, its volatility has been lower than that of the large-cap benchmark MSCI Emerging Markets Index over the past five years. And since inception, DGS has provided higher absolute and risk-adjusted returns over the MSCI Emerging Markets Index. This outperformance, combined with DGS' relatively lower volatility, suggests that a dividend-focused, small-cap strategy is a viable one in emerging markets.

DGS does not hedge its foreign-currency exposure, so in a risk-off environment, investors can suffer from both falling asset prices and declining currencies. DGS has weathered global volatility better than the MSCI EM Index. DGS' maximum drawdown of 56.0%, which hit its trough in November 2008, was less than the MSCI EM Index's 61.6%, which hit bottom in February 2009. 

The typical arguments in favor of dividend investing also apply in the context of emerging markets. Dividends are a significant contributor to stocks' long-term total return and can also signal effective management and healthy fundamentals. Like many dividend funds, DGS has a value tilt, which may benefit long-term investors, as the value premium has also been observed in emerging markets.

DGS' small-cap, dividend-weighted strategy has resulted in fairly stable country and sector allocations over the past five years. Relative to the MSCI Emerging Markets Index, DGS is heavy in stocks from Taiwan, Thailand, Malaysia, and Turkey, and light in stocks from China, Brazil, India, and Russia. As for sector exposures, this fund has greater exposure to industrial and consumer firms and less exposure to financials and energy firms relative to the MSCI Emerging Markets Index. Also, while cap-weighted, small-cap funds often have high turnover as securities move out of specified market-cap thresholds, DGS' dividend focus has resulted in lower turnover. This is particularly important in the context of a relatively less liquid asset class such as emerging-markets small caps. 

Income-focused investors considering this fund should note the following issues related to dividend investing in foreign equity markets. There can be a significant difference (up to 200 basis points) between the published yield of the benchmark index and the yield of the fund. This is because certain countries impose foreign withholding taxes on dividends. Investors can claim their portion of the withheld taxes as a tax credit, but only if they hold this fund in a taxable account. Qualified dividends also tend to be much lower in foreign equity funds. In 2012, 65% of DGS' dividends were qualified. Finally, dividends are paid to the fund in local currencies, but fund shareholders are paid in U.S. dollars, so currency fluctuations can have an effect on the distributions the fund pays to shareholders.

Our long-term outlook for emerging markets is positive. As the developed world continues to face slow growth in the near term, emerging economies should benefit from a number of long-term growth drivers such as new infrastructure construction and rising domestic consumption. And in the next one or two years, many emerging-markets countries should see improving growth rates following the accommodative monetary and fiscal policies over the past year. In the long run, emerging-markets equities may help hedge against expectations of a weakening dollar. Most emerging-markets countries have healthy budgets, high levels of foreign reserves, and attractive growth outlooks and will likely enjoy investment inflows, all of which will likely support a gradual appreciation of their currencies. 

Portfolio Construction
This fund employs representative sampling to track the WisdomTree Emerging Markets SmallCap Dividend Index, which includes about 600 small-cap companies from 17 countries. This index is a subset (the bottom 10% by market cap) of the WisdomTree Emerging Markets Dividend Index, which uses a number of investability screens and weights holdings based on annual cash dividends paid. This weighting methodology is different from most dividend funds, which weight by dividend yield. The fund is reconstituted annually in June.  

For the 2013 reconstitution, WisdomTree will make a few changes to the index to reduce turnover (through a less stringent security deletion rule) and to improve the tradability of the fund (through a new volume screen). While we think these index methodology changes should improve the fund's ability to more effectively track its index, frequent index changes and their potential effects on the fund's portfolio and future performance should be carefully monitored.

Patricia Oey is an ETF analyst at Morningstar.
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