A Unique Approach to Target Dividend-Paying Stocks

In an article titled

I recently explored the investment thesis of fundamental indexing and examined the investment merits of strategies that use this weighting approach. This ETF Spotlight takes a closer look at

This exchange-traded fund effectively diversifies risk and rebalances into stocks as they become cheaper relative to their dividends, which should give it an edge over its peers. The fund offers a cost advantage compared with actively managed peers, but there are cheaper index alternatives. It earns a Morningstar Analyst Rating of Bronze.

The fund offers broad exposure to large-cap U.S. dividend-paying stocks and weights them by the value of dividends each stock is expected to pay during the next year. This approach balances firm size (larger companies tend to pay more absolute dividends) against yield. To rebalance back to its target dividend weightings, the fund increases stock holdings that have become cheaper relative to their dividends and their peers, and trims positions that have become more expensive. This contrarian rebalancing discipline injects a modest value tilt. Not surprisingly, the fund’s dividend-weighting skews toward larger and more profitable names such as

This portfolio balances the trade-off between dividend yield and risk. Its broad reach limits its exposure to firm-specific risk and the highest-yielding stocks, which are more likely to cut their dividends than their lower-yielding counterparts. Although the fund doesn’t screen its holdings for dividend sustainability, dividend cuts at a few firms shouldn’t significantly hurt performance. Since its inception in June 2006, this fund has averaged a 20% dividend yield premium over the Russell 1000 Value Index. The fund is well diversified across sectors, although it has greater exposure to consumer staples and telecom stocks than the Russell 1000 Value Index, and less exposure to the financial and energy sectors.

So far, the fund’s approach has paid off. Over the trailing 10 years through June 2017, it bested the large-cap value Morningstar Category average and Russell 1000 Value Index by 1.0 and 0.8 percentage points, respectively, with lower volatility. The fund’s consumer defensive sector overweighting and financial sector underweighting contributed the most to its outperformance.

Fundamental View Modigliani and Miller's dividend irrelevance theorem states that, ignoring taxes, informational asymmetries, and behavioral issues, a firm's dividend payout policy should not affect its stock return. And investors should not care whether stock returns come from dividend income or capital appreciation. But in practice, dividend payments offer tangible benefits. They help investors better forecast income and improve investor behavior, such as offering a cushion to help investors stay invested through the equity market's rough patches. Dividend payments also keep corporate managers in check. Managers are loath to cut dividends, so they may use these payments to signal their confidence in their firm's prospects. Dividend payments encourage managers to exercise greater discipline in capital-allocation decisions, because there is less money on hand to invest in low-return projects, and dividend payments discourage empire-building.

Investors can benefit from owning dividend-paying stocks, but fund construction matters. Simply targeting stocks or funds with the highest dividend yield is a risky proposition. The highest-yielding stocks could be under financial distress and more likely to cut their dividends. This fund’s broad dividend-weighted portfolio helps mitigate some of this risk through diversification. Its approach balances firm size against yield and the fund rebalances opportunistically as stocks become cheaper relative to their dividends. Because this fund does not load up on riskier stocks, its holdings have a higher average market-capitalization and return on invested capital than the constituents of the Russell 1000 Value Index. Comparing the fund’s dividend payout ratio, or the percentage of its earnings that it pays as dividends, to that of its category index also sheds some light on its riskiness. Funds with a dividend payout ratio over 100% cannot sustain those payments without funding them with debt or forgoing capital expenditure investment in its business. As of June 2017, this fund’s dividend payout ratio measured 55% compared with 45% for the Russell 1000 Value Index.

Although the fund has a less-pronounced value tilt than this benchmark, it still lands squarely in large-value territory for three reasons. First, slower-growing firms are more likely to pay dividends. Second, the fund’s dividend-weighting approach overweights stocks trading at low prices compared with their dividends. Finally, the annual rebalance decreases the fund’s exposure to stocks that have become more expensive relative to their dividends and adds to positions that have become cheaper. The value tilt introduces additional risk that does not always pay off. The fund did not experience the same level of drawdowns as the Russell 1000 Value Index during the 2008-09 financial crisis, but it did lag most of its equity income peers.

Unlike some of its peers, this strategy does not apply a dividend history requirement or screen for dividend sustainability. The fund only considers the indicated regular dividend payment to assign its weightings. Ignoring sustainable dividend payment increases the risk that some stocks in the fund may cut their dividend, but its broad diversification helps protect against significant losses from dividend-cutting stocks.

Portfolio Constructions This fund earns a Positive Process Pillar rating because it follows a well-crafted dividend-weighted strategy that effectively diversifies risk and rebalances into stocks as they become cheaper relative to their dividends.

The fund tracks the WisdomTree LargeCap Dividend Index. This index selects the 300 largest companies by market capitalization from the WisdomTree Dividend Index, which includes most U.S.-listed dividend-paying stocks. Qualifying stocks must have an indicated regular cash dividend and market capitalizations greater than $100 million, and must meet trading liquidity requirements. The benchmark weights each constituent by the value of dividends it is expected to pay over the next year, relative to the aggregate value for the portfolio. For example, if Stock A is expected to pay $1 in dividends during the next year and the sum of all U.S. stocks’ dividends are expected to total $10 during the next year, then Stock A is assigned a 10% ($1/$10) weighting in the index. The portfolio rebalances annually in December. Because the fund focuses on dividend payments rather than faster-moving dividend yields, its turnover has averaged just 11% during the past decade. This is about one fourth of the turnover level of the average fund in the category.

Many dividend indexes require a history of dividend payments before a stock can enter the index. WisdomTree's approach includes stocks that only established a dividend payment policy in the past year.

Fees The fund's low fee supports its Positive Price Pillar rating. WisdomTree charges a competitive 0.28% expense ratio for this fund, which lands in the cheapest decile when compared with all large-cap value category funds. While less-expensive index options are available, the fund's fee still scores in the lowest third of index mutual funds and ETFs in the category.

During the past three years, the fund has lagged its underlying index by 31 basis points. This is higher than its average fee of 28 basis points over the same time.

Alternatives

There's no shortage of dividend-oriented ETFs to choose from.

In contrast, Gold-rated

Silver-rated

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