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ETF Specialist

This Dividend-Weighted Mid-Cap ETF Is a Strong Pick for the Long Haul

It provides broad exposure to mid-cap dividend-paying stocks while keeping risk in check.

A knock against market-cap weighting is that it may lead a portfolio to overweight the most expensive areas of the market. This is because a stock's weighting in a market-cap-weighted portfolio moves with its share price, and its weighting increases (and decreases) with its price. Fundamental index funds attempt to circumvent this potential issue by severing the link between a stock's portfolio weighting and its price.

 WisdomTree U.S. MidCap Dividend ETF (DON) employs a fundamental weighting approach and is a strong candidate for exposure to dividend-paying U.S. mid-cap stocks. This fund weights its holdings by their expected dividend payment, which effectively diversifies risk, and rebalances into stocks as they become cheaper relative to their dividends. The fund's cost advantage gives it a leg up over its peers and supports its Morningstar Analyst Rating of Bronze.

Many dividend-oriented funds land in the mid-value Morningstar Category because they weight large-cap stocks by dividend yield or equally, which knocks down their portfolio's weighted average market cap. This fund offers broad exposure to mid-cap U.S. dividend-paying stocks and weights them by the total value of dividends that each stock is expected to pay during the next year. This approach balances firm size (larger companies tend to make higher aggregate dividend payments) against yield. When it rebalances back to its target dividend weightings each December, the fund adds to stocks that have become cheaper relative to their dividends and trims positions that have become more expensive.

This portfolio effectively targets dividend yield without incurring too much risk. Although the fund doesn't screen its holdings for profitability or dividend sustainability, a few dividend cuts across its portfolio shouldn't significantly impact its performance because it is broadly diversified and skews toward larger, more-stable names. 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. At the end of May 2018, it had greater exposure to consumer discretionary, real estate, and utilities stocks than the average fund in the category, and less exposure to the financials and technology sectors.

Over the past decade through May 2018, the fund topped the mid-value category average and Russell Midcap Value Index by 3.0 and 1.9 percentage points, respectively, with lower risk. The fund's favorable stock exposure within the energy and consumer discretionary sectors contributed the most to its outperformance.

Fundamental View
Dividend-paying stocks can offer stable income, which can help investors weather turbulent markets. This fund targets dividend-paying stocks without aggressively chasing yield. Instead, it offers broad exposure to most mid-cap dividend payers. This gives it less exposure to the highest-yielding names that may not be able to sustain their dividend payments.

While DON does not apply a dividend history requirement or screen for dividend sustainability, its broad diversification keeps risk in check. It weights its holdings by the proportion of dividend payments that each firm is expected to make among all dividend-paying stocks. For example, if Firm Z is expected to pay $1 in dividends, and the total expected amount of dividends across the fund's positions is $20, then the fund assigns Firm Z a 5% weighting ($1 Firm Z dividends/$20 portfolio dividends).

This approach skews its portfolio toward profitable stocks. The fund's average return on invested capital (a profitability metric) of its holdings has consistently topped that of its peers and the Russell Midcap Value Index. Profitable stocks are more able to sustain their dividend payments than less-profitable names. During the past decade through May 2018, the fund's average dividend yield topped the Russell index's by 45%.

Comparing the fund's dividend payout ratio (the percentage of earnings that it pays as dividends) with that of its category index sheds light on its riskiness because funds with a payout ratio over 100% cannot sustain those payments. At the end of May 2018, the fund's dividend payout ratio measured 56% compared with 37% for the Russell Midcap Value Index based on calculations from earnings and dividend forecasts presented in Morningstar Direct.

Like most dividend-oriented strategies, this fund has a value tilt. Mature, slow-growing firms tend to trade at lower valuations and pay out more of their earnings as dividends than faster-growing stocks, which invest to expand. The fund's dividend-weighting and rebalancing approaches add to its value orientation. It overweights stocks trading at low prices compared with their dividends and decreases the fund's exposure to stocks that have become more expensive relative to their dividends and adds to positions that have become cheaper at its annual rebalance.

WisdomTree caps stock and sector weightings to reduce risk. The fund hasn't bumped up against these caps, but it still makes persistent sector bets. As of this writing, the fund is overweight consumer discretionary, real estate, and utilities stocks and has less exposure to the financials and technology sectors compared with the Russell Midcap Value Index. These bets have paid off since the fund's inception in 2006, but that won't always be the case.

The fund's value and profitability tilts should continue to impact performance. Both characteristics have been associated with higher returns over the long term, but they don't always pay off. In the United States, value stocks have lagged growth stocks over the fund's life. The fund has a more pronounced value tilt than the Russell Midcap Value Index, and this has detracted from its performance. But its stronger profitability tilt helped.

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 U.S. MidCap Dividend Index. This index selects the top 75% of companies ranked by market cap from the WisdomTree U.S. Dividend Index after removing the largest 300 firms. Qualifying stocks must have an indicated regular cash dividend and a market cap greater than $100 million and meet trading liquidity requirements. The index weights each constituent by the value of the dividends it expects to pay over the next year, relative to the aggregate value for the portfolio.

WisdomTree caps sector weightings to 25% of the portfolio and limits the weighting of its largest holdings. The cumulative weighting of the fund's stocks with greater than 5% weightings is capped at 50% of the total portfolio.

The portfolio rebalances annually in December. Because the fund focuses on dividend payments rather than faster-moving dividend yields, its turnover is low and has averaged just 28% during the past decade through 2017. This is about one third of the turnover level for the average fund in the category. Many dividend indexes require a long record 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.

The fund's low fee supports its Positive Price Pillar rating. WisdomTree charges a competitive 0.38% expense ratio, which lands near the cheapest decile when compared with all mid-value category funds. While less-expensive index options are available, the fund's fee still scores in the lower half of index mutual funds and exchange-traded funds in the category.

During the past three years through May 2018, the fund lagged its underlying index by 43 basis points. This was higher than its average fee of 38 basis points over the same time frame.

 IShares Select Dividend ETF (DVY) (0.39% fee) targets dividend-paying stocks but courts more risk than DON because it targets 100 high-yielding stocks that meet dividend coverage criteria and weights them by their dividend yields. Unlike DON, this fund's holdings range from small- to large-cap stocks. It lands in the mid-value category because it weights its names by their dividend yield. DVY's riskier portfolio limits its Analyst Rating to Neutral.

Similar to DVY,  Invesco High Yield Equity Dividend Achievers ETF (PEY) (0.54% fee) targets high-yielding names of all sizes and weights them by their dividend yield. PEY requires its holdings to have increased dividend payments for at least 10 consecutive years and selects the top 50 stocks ranked by dividend yield that meet its dividend-growth screen. This creates high dividend yield at the expense of having a highly concentrated and riskier portfolio. PEY's riskier approach limits it to a Neutral rating.  

ProShares S&P MidCap 400 Dividend Aristocrats (REGL) (0.40% fee) follows a similar dividend-growth screen as PEY but focuses only on stocks in the S&P MidCap 400 Index. Its average market cap is lower than DON's. A more stringent dividend-growth screen creates a higher-quality portfolio, but the portfolio's yield is also lower. REGL only holds 40-50 stocks, leaving it far less diversified than DON.

For investors seeking mid-cap value equity exposure without a dividend focus, Silver-rated  Vanguard Mid-Cap Value ETF (VOE) (0.07% fee) is tough to beat. The fund targets the cheaper half of the U.S. mid-cap market and weights its holdings by market cap.



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Adam McCullough has a position in the following securities mentioned above: VOE. Find out about Morningstar’s editorial policies.