A Distinct Approach to Investing in Dividend-Paying Mid-Caps

By weighting mid-cap stocks by the dollar amount of dividends paid, the fund provides a less aggressive approach to dividend investing compared with funds that concentrate in the highest-yielding stocks. The fund takes small positions in several hundred stocks that pay a dividend and have a market capitalization below that of the 300th-largest dividend payer. It could serve as a suitable satellite holding for investors seeking mid-cap exposure who believe in the fund's dividend-weighting approach.

From inception through February 2016, the fund has returned 7.8% compared with 6.6% for the Russell Mid Cap Value Index. Risk was nearly identical to the index but higher than that of the S&P 500. There is solid historical evidence for investing in mid-value stocks. Based on data from the French Data Library, mid-value stocks have outperformed the market by about 3 percentage points per year since 1927. These higher returns may be fair compensation for bearing risk. Historically, mid-value stocks have exhibited greater volatility than the broad market. However, even after adjusting returns for volatility, mid-value stocks have historically offered better performance, which is why some suggest it may be due to mispricing. If more investors attempt to profit from these potential mispricings, mid-value stocks' return advantage may not persist.

Fundamental View

While many large-cap companies pay a dividend, fewer mid-cap companies do. Dividend payers tend to be more mature and slower growing, but they can also be distressed or moribund. The risk of picking a distressed stock is even greater when targeting high-yielding mid-cap stocks, where volatility is higher and companies are less well-diversified. The fund’s largest holding as of this writing is

Smaller-cap stocks are less likely to have competitive advantages and tend to be more sensitive to the business cycle than their large-cap counterparts. While the stocks in this fund have a higher dividend yield than the S&P 500 (3.9% versus 2.4%), they are also of lower quality. Just 8% of assets are invested in companies with a wide Morningstar Economic Moat Rating, compared with 52% for the S&P 500. They are also less profitable, earning a return on invested capital of 9.6% versus 12.7% for the S&P 500 during the year through February 2016. In addition, stocks in the fund have more debt than the mid-value Morningstar Category average.

Income-seeking investors have shown a renewed preference for dividend-paying stocks in the current economic environment, which is characterized by low bond yields. This preference has caused dividend-paying stocks to trade at a premium. When interest rates rise, the preference for dividend-paying stocks may reverse and this fund may suffer. Dividend-paying stocks tend to underperform during periods of rising rates because they tend to be slower growing, and their earnings may not grow fast enough to offset the effects of rising interest rates relative to their faster-growing peers.

Unlike market-cap-weighted index funds, this fund weights securities based on the dollar amount of dividends paid. Because stock prices tend to be more volatile than dividends, this weighting approach causes the fund to trade against the market. The fund will sell stocks that have risen faster than their share of total dividends paid and increase its exposure to stocks that have become cheaper relative to their dividends. This helps give the fund a significant value orientation. It effectively sells recent winners and buys recent losers. This causes the fund to bet against momentum, which could detract from the benefit of its value tilt.

With roughly 400 holdings, the fund is not overly concentrated in any one stock. Sector exposures can vary from the typical index fund in that category. After the financial crisis, the index changed its methodology to include a 25% cap on each sector. It currently has greater exposure to the consumer cyclical and industrial sectors and less exposure to financials, healthcare, and technology than the mid-value category average.

Portfolio Construction The fund tracks the WisdomTree MidCap Dividend Index. The index starts with U.S. stocks that pay a dividend and meet minimum size requirements and then ranks them by market capitalization. Of these, the fund includes 75% of the aggregate market value of all stocks after the 300 largest, typically 300-450 companies. The average market cap of the fund's holdings is currently $5.5 billion, and its top 10 holdings account for 11% of the portfolio, meaning that the fund has a slightly smaller market-cap orientation and is less concentrated than the average fund in the category. Rather than market-cap weighting, the fund weights each constituent by its share of the aggregate dividends estimated to be paid during the next year. The fund holds REITs but excludes business-development corporations and master limited partnerships. It is rebalanced and reconstituted annually in December. Turnover averaged 25% between 2007 and 2015, well below the category average. The portfolio is subadvised by Mellon Capital.

Fees At 0.38%, the fund is less expensive than the average mutual fund and competitive with dividend-oriented mid-cap ETFs, although there are cheaper market-cap-weighted alternatives.

Alternatives

Most dividend-themed ETFs fall in the large-value category, so there are fewer choices for investors looking for dividend-themed mid-cap value funds. One of the largest is

Three other interesting mid-cap value funds incorporate fundamental information in addition to dividends in their stock-selection methodology. Cambria Shareholder Yield ETF SYLD (0.59%) tracks 100 companies that have high shareholder yield, which includes dividend payments as well as share repurchases and debt repayment.

Those looking for a market-cap-weighted approach to mid-cap value should consider

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