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Hidden Value in Small-Cap Dividends

While it doesn't take a traditional approach, this small-cap dividend ETF offers one of the best ways to unlock the value premium.   

Alex Bryan, 08/30/2013

Holdings can say a lot about a fund's investment style, but they don't always tell you everything. Take WisdomTree SmallCap Dividend DES for example. It invests in dividend-paying small-cap companies that meet certain liquidity requirements. It then weights them by the dollar value of dividends they are expected to pay out over the next year. While its holdings skew toward the small-value side of the Morningstar Style Box, on average they trade at richer valuations than the holdings of its peers, which explicitly target small-value stocks (see the Portfolio Characteristics table below). Yet, since its inception in July 2006, DES has behaved like a deeper value fund than nearly all of its peers.

The fund's performance revealed its true colors. Just a few factors can explain most of the returns on a broad stock portfolio, including the portfolio's sensitivity to the market, value, momentum, and small-cap premiums. These are well-documented sources of return. Value stocks tend to outperform growth stocks, small caps tend to do better than large caps, and stocks with high momentum continue to outpace their low-momentum counterparts. By regressing a fund's returns on each of these factors, we can evaluate where its returns actually come from. For instance, if a fund does well when value stocks do well, then it behaves like a value fund, even if it doesn't own value stocks.

The following table illustrates the results of this analysis for DES and four of its peers, using data from July 2006 through June 2013. The coefficients from the regression in the table represent the corresponding fund's sensitivity to each premium. For example, a value coefficient of 1.0 indicates that the fund tends to increase in value by 1% when deep-value stocks outperform high-growth stocks by 1%, holding all other factors constant.

Although DES doesn't specifically target value stocks, it exhibited the greatest sensitivity to the value premium--nearly twice that of Vanguard Small Cap Value VBR, which owns the cheaper half of the U.S. small-cap market. IShares Russell 2000 Value Index IWN offers similar exposure to VBR. It even has a stronger value tilt than DFA US Small Cap Value DFSVX and iShares Morningstar Small Value Index JKL, which target the cheapest fourth and third of the small-cap market, respectively.

DES' dividend-weighting approach may offer a partial explanation. When it rebalances, the fund increases its exposure to stocks that have become cheaper relative to their dividends and pares back on those that have become more expensive, regardless of where these holdings fall in the style box. This dynamic approach may allow the fund to capture the value premium more effectively than many of its peers. Some stocks clearly warrant higher valuations than others, either because they carry less risk, greater profitability, or faster growth (though the latter is often overvalued). Consequently, many stocks that trade with low valuations are fairly priced. The fund's dividend-weighting approach offers a stronger bet on mean reversion than targeting stocks trading at low valuations, as many of its peers do. It keeps some traditional growth and blend stocks in the portfolio but allows investors to profit when these stocks are temporarily mispriced. In this way, the fund's rebalancing approach more closely resembles the way that active managers think about value than traditional value index funds.

The fund's narrow focus on dividends also enhances its sensitivity to the value premium. Despite their size, small-cap dividend-paying stocks also tend to be more mature than their non-dividend-paying counterparts. For instance, the fund's top holding, R.R. Donnelley RRD, operates in the declining printing industry and has experienced flat sales growth and declining profits over the past three years. Lexmark International LXK and cigarette maker Vector Group VGR, also among the fund's top holdings, face similar low-growth environments. Many of these holdings may be forced to cut their dividends during recessions. However, they offer attractive compensation for this risk and may have a better chance of beating the market's expectations than their faster-growing peers.

Alex Bryan is an ETF analyst with Morningstar.

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