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By Alex Bryan | 01-23-2015 02:00 PM

A Small-Cap Dividend ETF With a Value Tilt

WisdomTree SmallCap Dividend ETF's approach offers value investors an interesting way to play small caps.

Alex Bryan: WisdomTree SmallCap Dividend ETF (DES) may not be marketed as a value fund, but it offers a strong value tilt. It targets U.S. small-cap dividend-paying companies and weights these holdings based on the dollar value of dividends that they are expected to pay out over the next year. This introduces a value tilt in two ways. First, dividend-paying stocks tend to be slower growing and trade out lower valuations than non-dividend-paying firms.

Secondly, the fund's dividend-weighting approach causes it to increase its exposure to stocks as they become cheaper relative to their dividends and trim back on positions that become more expensive when it rebalances. This allows investors to profit from mean reversions in valuations.

Small-cap companies tend to be less widely followed than their larger-cap counterparts. So, they may be more likely to become mispriced, and that can help value-oriented investors in the small-cap space.

However, these stocks are also a little bit riskier. Dividend-paying stocks have historically outperformed their non-dividend-paying counterparts over long time horizons with less risk. While this may be partially due to these companies' lower valuations, dividend payments may also help improve performance by making it harder for managers to pursue unprofitable growth.

Managers who have access to a lot of cash in their balance sheet may be tempted to undertake risky projects in order to expand their business even when doing so is not in investors' best interest. Dividend payments reduce firms' access to easy capital, making it more difficult for them to undertake these types of projects. And that can help benefit investors in the long term.

Managers may also use dividend payments in order to signal their confidence about their firm's future business prospects, and that's particularly true when they raise these dividend payments.

Investors tend to punish companies that cut their dividends, so managers are reluctant to commit to them unless they are confident they'll be able to honor these payments over the full business cycle.

As a result of this constraint, dividend-paying companies tend to be more profitable and generate more stable cash flows than non-dividend-paying firms.

Investors looking for exposure to these types of stocks should consider WisdomTree SmallCap Dividend ETF, which offers comprehensive exposure to small-cap dividend payers for a low 38-basis-point expense ratio. 

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