A Deep-Value ETF for Income Seekers

The fund's value exposure has been deeper than most large-value funds, although it has drifted over time. Prior to the financial crisis, the fund had a deep-value tilt and a 54% weighting in financial and real estate stocks compared with just 38% in the typical large-value fund. Many of these stocks were forced to cut their dividends during the crisis. Currently, the fund's value tilt is more modest, and it gives an underweighting to financials relative to the Russell 1000 Value Index. The fund will naturally shift toward the highest-yielding stocks and sectors at rebalance. Currently, telecommunications, utilities, and consumer staples stocks offer the most attractive yields, and this fund has an overweighting in all three sectors.

While it produces high yields, the fund is risky, particularly compared with a blend fund. Since its June 2006 inception, the fund has had a volatility of return of 17.7% compared with 15.7% for the large-value Morningstar Category and 15.4% for the S&P 500. During the financial crisis, the fund suffered a 63% drawdown compared with a 51% drawdown for the S&P 500. Despite the volatility, the fund has had a relatively low return correlation to its large-value peers. For example, the average large-value fund had a 97.5% correlation to the Russell 1000 Value Index and a 97.1% correlation to the S&P 500 during the past five years. This fund had a correlation to those indexes of 85.5% and 84.1%, respectively. This suggests that the fund may offer decent diversification benefits. During the past five years through August 2015, the fund returned 14.0% compared with 14.7% for the Russell 1000 Value.

Fundamental View Dividend-paying stocks have historically outperformed the market. Between 1927 and 2014, stocks that pay a dividend have beaten the total market by about 0.7 percentage points annualized. Stocks in the highest-yielding 30% of the market have done even better, outperforming by about 1.5 percentage points annualized. However, high-yielding stocks can be risky. The highest-yielding stocks have had greater volatility than the broader market because some of these stocks are distressed and may offer an attractive yield as compensation for risk. Dividend yields are quoted on a trailing basis, and a stock that appears to offer an attractive yield may be forced to cut its dividend in the future. Unlike a bond coupon payment, which is a contractual obligation, a stock dividend is paid at the discretion of company management. Companies with high dividend payout ratios may be investing less in the growth of their businesses, and future earnings growth and stock returns might suffer.

Dividend-paying stocks may underperform when interest rates rise, as discussed by my colleague Alex Bryan in a previous article. Interest rates often rise during economic expansions, and dividend-paying stocks typically have less earnings growth to offset the negative impact of rising rates.

In addition to dividends, firms can return capital to shareholders through share buybacks, which have become increasingly popular because they give management greater flexibility. On the other hand, dividends force discipline on company management and encourage prudent use of capital.

The dividend yield on stocks in DHS is 4.45%, gross of the expense ratio, as of mid-September 2015. This compares favorably with the 2.19% dividend yield for stocks in the S&P 500 and the 3.13% yield for the average large-value fund. Dividend funds typically take one of two approaches: They seek out higher-yielding but potentially riskier companies or they target quality companies with a stable, more modest dividend. This fund takes the former approach. This fund has just 37% of its assets in stocks with wide Morningstar Economic Moat Ratings, Morningstar's assessment that a stock enjoys a sustainable competitive advantage. For comparison,

Despite their lower quality, stocks in this portfolio do not appear to be more attractively priced. The fund's 18.1 price/forward earnings ratio is higher than that of the Russell 1000 Value Index (17.3). Morningstar equity analysts cover 135 stocks in DHS, representing 88% of assets. As of this writing, they see the fund trading at a price/fair value of 0.90, which higher than the 0.89 price/fair value for the Russell index.

Portfolio Construction

DHS tracks the WisdomTree High Dividend Index. The starting universe for this index is all dividend-paying U.S. stocks that meet minimum size and liquidity requirements. From this group, the index selects the highest-yielding 30%. Constituents are weighted by their share of total cash dividends that all constituents are projected to pay in the coming year, as measured by their indicated dividend. In 2012, a rule was implemented to cap individual sectors at 25% of assets. Still, the fund makes large sector bets. Relative to the large-value Morningstar Category average, the fund gives an overweighting to the real estate, staples, utilities, and communications sectors and an underweighting to financials, technology, consumer discretionary, and health-care stocks. The fund holds roughly 428 stocks, but 38% of assets are in its top 10 holdings. In fact,

Fees This fund charges a 0.38% expense ratio, which is below average for the large-value category but well above the most competitive dividend-oriented ETFs.

Alternatives

WisdomTree offers several dividend ETFs, including

Vanguard offers two compelling dividend ETFs that each charge 0.10% and use market-cap weighting rather than dividend weighting.

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