This Dividend-Weighted Small-Cap ETF Is a Solid Pick for the Long Run

Market-cap-weighted strategies may lead to a portfolio that overweights 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 like WisdomTree US SmallCap Dividend ETF DES strive to circumvent this potential issue by severing the link between a stock's portfolio weighting and its price.

DES is a compelling option for exposure to U.S. small-cap dividend-paying stocks. This strategy weights its holdings by their expected dividend payment, which allows it to target dividend payers without loading up on the riskiest dividend payers. The fund’s low fee adds to its allure in the category and supports its Morningstar Analyst Rating of Bronze.

This portfolio targets dividend payers 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 affect its performance because it is broadly diversified and skews toward larger, more-stable names in the small-value Morningstar Category. 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 April 2019, it had greater exposure to consumer discretionary, real estate, and utility stocks than the Russell 2000 Value Index, and less exposure to the healthcare and information technology sectors.

This strategy weights its holdings by the total value of dividends that each stock is expected to pay during the next year. This fundamental-weighting approach balances firm size (larger companies tend to make higher aggregate dividend payments) against yield. When the fund rebalances back to its target dividend weightings each December, it adds to names that have become cheaper relative to their dividends, and trims positions that have become more expensive. This contrarian rebalancing discipline contributes to the fund’s value tilt.

From its launch in June 2006 through April 2019, the strategy has topped the small-value category average and the Russell 2000 Value Index by 1.2 and 1.0 percentage points annually, respectively, with similar risk. The fund’s favorable stock exposure within the energy and consumer discretionary sectors contributed to most to its outperformance.

Fundamental View Dividend-paying stocks can help investors endure rough patches in the market by offering stable income. This fund pursues dividend-paying stocks without aggressively targeting high yield. Instead, it offers broad exposure to most small-cap U.S. dividend-payers. This gives it less exposure to the highest-yielding names that may not be able to sustain their dividend payments.

While the fund 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) has consistently topped that of its peers and the Russell 2000 Value Index. Profitable stocks are more able to sustain their dividend payments than less profitable names. During the past decade through April 2019, the fund’s average dividend yield topped that of the Russell 2000 Value Index by 60%.

Comparing the fund’s dividend payout ratio (the percentage of earnings that it pays as dividends) to the category index sheds light on its riskiness because funds with a payout ratio over 100% cannot sustain the payments. At the end of April 2019, the fund’s dividend payout ratio measured 62% compared with 33% for the Russell 2000 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 approach add to its value orientation. It overweights stocks trading at low prices compared with their dividends, 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 added sector and stock caps in 2013 to rein in risk. It now caps sector weights to 25% and the cumulative weight of stocks greater than 5% of the portfolio to 50% of the total portfolio. The fund’s financial sector weighting ballooned to over half of its portfolio during the financial crisis in 2008-09. As of this writing, the fund is overweight consumer discretionary, real estate, and utility stocks and has less exposure to stocks in the healthcare and information technology sectors compared with the Russell 2000 Value Index. These bets won’t always work as they have since the fund’s inception in 2006.

The fund’s value and profitability tilts 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 less pronounced value tilt than the Russell 2000 Value Index, which has contributed to its relative outperformance.

Process 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 SmallCap Dividend Index. This index selects the smallest 25% of companies ranked by market capitalization from the WisdomTree Dividend Index after removing the largest 300 firms. Qualifying stocks must have an indicated regular cash dividend, a market capitalization greater than $100 million, and must meet trading liquidity requirements. Stocks do not need a long history of dividend payments to qualify for inclusion. The index weights each constituent by the value of 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% weights is capped at 50% of the total portfolio.

The portfolio rebalances annually in December. Because the fund focuses on dividend payments rather than more-volatile dividend yields, its turnover is low and has averaged a fraction of the average fund in the category during the past decade through 2018.

Fee WisdomTree levies a low 0.38% expense ratio on this fund. This fee is a fraction of the 1.04% median toll that the fund's small-value peers charge and supports its Positive Price Pillar rating.

Over the trailing three years ended April 2019, this fund lagged its underlying index by 34 basis points per year, a bit less than its average annual fee.

Alternatives ProShares Russell 2000 Dividend Growers SMDV (0.40% fee) targets stocks in the Russell 2000 Index that have grown their dividend payment for at least 10 consecutive years. The fund makes larger sector bets than DES that may not always work well. For example, its utility sector weighting represents nearly one third of its portfolio. Not surprisingly, given the dividend growth requirement, SMDV exhibits less of a value tilt and a bias toward more profitable firms than DES.

Bronze-rated Invesco S&P SmallCap Low Volatility ETF XSLV (0.25% fee) may be a better fund for risk-averse investors. It targets the least-volatile 120 names from the S&P SmallCap 600 Index and weights them by the inverse of their volatility. The least-volatile stocks receive the largest weightings in its portfolio. Unlike DES, this fund does not cap its sector weightings, so watch out for larger sector bets here. For example, its real estate and financial sector exposures represent nearly 70% of the fund, more than double that of the S&P SmallCap 600 Index or DES.

Silver-rated DFA US Small Cap Value I DFSVX (0.52% fee) is a great choice for broadly diversified exposure to small-cap U.S. value stocks. Its strategy is riskier than the Russell 2000 Value Index because it has deeper value and small-stock tilts. It ventures further into micro-cap territory than DES. It targets stocks with low valuations while screening out the least-profitable names.

For investors seeking small-cap value equity exposure without a dividend focus, Vanguard Small-Cap Value ETF VBR (0.07% fee) is tough to top. The fund tracks the market-cap-weighted CRSP US Small Cap Value Index. It earns a Morningstar Analyst Rating of Silver.

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