By Alex Bryan
Holdings can say a lot about a fund's investment style, but they
don't always tell you everything. Take WisdomTree SmallCap Dividend
) for example. It invests in dividend-paying small-cap companies
that meet certain liquidity requirements. It then weights them by
the dollar value of dividends they are expected to pay out over the
next year. While its holdings skew toward the small-value side of
the Morningstar Style Box, on average they trade at richer
valuations than the holdings of its peers, which explicitly target
small-value stocks (see the Portfolio Characteristics table below).
Yet, since its inception in July 2006, DES has behaved like a
deeper value fund than nearly all of its peers.
The fund's performance revealed its true colors. Just a few
factors can explain most of the returns on a broad stock portfolio,
including the portfolio's sensitivity to the market, value,
momentum, and small-cap premiums. These are well-documented sources
of return. Value stocks tend to outperform growth stocks, small
caps tend to do better than large caps, and stocks with high
momentum continue to outpace their low-momentum counterparts. By
regressing a fund's returns on each of these factors, we can
evaluate where its returns actually come from. For instance, if a
fund does well when value stocks do well, then it behaves like a
value fund, even if it doesn't own value stocks.
The following table illustrates the results of this analysis for
DES and four of its peers, using data from July 2006 through June
2013. The coefficients from the regression in the table represent
the corresponding fund's sensitivity to each premium. For example,
a value coefficient of 1.0 indicates that the fund tends to
increase in value by 1% when deep-value stocks outperform
high-growth stocks by 1%, holding all other factors constant.
(click to enlarge)
Although DES doesn't specifically target value stocks, it
exhibited the greatest sensitivity to the value premium--nearly
twice that of Vanguard Small Cap Value ETF(
) , which owns the cheaper half of the U.S. small-cap market.
iShares Russell 2000 Value IndexETF (
) offers similar exposure to VBR. It even has a stronger value tilt
than DFA US Small Cap Value Fund(
) and iShares Morningstar Small Value Index ETF(
) , which target the cheapest fourth and third of the small-cap
DES' dividend-weighting approach may offer a partial
explanation. When it rebalances, the fund increases its exposure to
stocks that have become cheaper relative to their dividends and
pares back on those that have become more expensive, regardless of
where these holdings fall in the style box. This dynamic approach
may allow the fund to capture the value premium more effectively
than many of its peers. Some stocks clearly warrant higher
valuations than others, either because they carry less risk,
greater profitability, or faster growth (though the latter is often
overvalued). Consequently, many stocks that trade with low
valuations are fairly priced. The fund's dividend-weighting
approach offers a stronger bet on mean reversion than targeting
stocks trading at low valuations, as many of its peers do. It keeps
some traditional growth and blend stocks in the portfolio but
allows investors to profit when these stocks are temporarily
mispriced. In this way, the fund's rebalancing approach more
closely resembles the way that active managers think about value
than traditional value index funds.
The fund's narrow focus on dividends also enhances its
sensitivity to the value premium. Despite their size, small-cap
dividend-paying stocks also tend to be more mature than their
non-dividend-paying counterparts. For instance, the fund's top
holding, R.R. Donnelley(
) , operates in the declining printing industry and has experienced
flat sales growth and declining profits over the past three years.
Lexmark International(LXK) and cigarette maker Vector Group(VGR) ,
also among the fund's top holdings, face similar low-growth
environments. Many of these holdings may be forced to cut their
dividends during recessions. However, they offer attractive
compensation for this risk and may have a better chance of beating
the market's expectations than their faster-growing peers.
A Steady Stream of Benefits
Dividend investing has a lot to recommend it. Although capital
gains drive short-term performance, dividends increase in
importance with the length of the investment horizon.
Dividend-paying stocks have historically generated superior returns
than non-dividend-paying stocks in most markets and time periods
studied, with less risk. This may be partially because dividends
impose greater discipline on managers by reducing their capacity to
engage in value-destructive empire-building. Growth can be
tantalizing. Manager compensation is often positively correlated
with firm size. Armed with a large pile of cash, managers may be
tempted to expand the business through investments in risky
projects and acquisitions, even when doing so is not in
shareholders' best interests. Dividend payments reduce firms'
access to easy capital and create a higher hurdle to undertake new
projects, which can benefit shareholders.
Managers can also use dividends to signal their confidence in
their firms' future business prospects, particularly when they
raise these payments. In a study published in 2006, Ping Zhou and
William Ruland found that stocks with higher dividend payouts also
experienced faster earnings growth. While this study only covered
dividend-paying stocks, it is consistent with a signaling story.
Investors tend to severely punish companies that cut their
dividends. Consequently, managers are reluctant to commit to
dividend payments unless they are confident they will be able to
honor them over the full business cycle. Because of this
constraint, dividend paying stocks tend to be more profitable and
generate more-stable cash flows than non-dividend-paying firms. For
instance, the average return on invested capital of the fund's
holdings (6.1%) dwarfs the corresponding figure on the Russell 2000
Value Index (1.2%).
Therefore, it shouldn't be surprising that the fund exhibited a
lower downside capture ratio than both its peer group and the
Russell 2000 Value Index over the past five years. It was also
slightly less volatile than the small-value category average during
that time. Dividends help dampen the fund's volatility because
investors immediately benefit from these payments, while there is
more uncertainty about the value of future growth. Although some
firms may cut their dividends during recessions, dividends tend to
be more stable than earnings. Investors in this fund will be paid
to wait out the bad times.
While large-cap dividend-paying stocks tend to be more stable
and have greater capacity to weather recessions than their
small-cap counterparts, the fund has two things going for it.
First, it offers a more attractive dividend yield than WisdomTree
LargeCap Dividend(DLN) . But more importantly, the value premium
has historically been larger among small-cap stocks. Wall Street
analysts do not cover many of these firms, so there is a greater
potential for mispricing. However, that also exposes investors to
Although chasing yield can skew a portfolio toward low-quality
holdings, the fund's dividend-weighting approach helps limit this
risk because it allows both firm size and yield to influence each
holding's weighting in the portfolio. This hybrid approach reduces
the weighting of distressed companies in the portfolio relative to
a more naive yield-weighting formula.
Nuts and Bolts
The fund tracks the WisdomTree SmallCap Dividend Index, which
represents the smallest 25% of the broad WisdomTree Dividend Index
by market cap, after the largest 300 companies have been removed.
This broad reach sweeps in more than 600 small-cap dividend-paying
stocks. WisdomTree weights each holding according to the dollar
value of dividends it is expected to pay out over the next year
relative to aggregate value of all the companies in the index,
based on the most recent dividend. For example, a stock that pays
out $2 million in dividends will receive twice the weight as a firm
that pays out $1 million. The index is rebalanced annually.
Relative to the Russell 2000 Value Index, the fund overweights
industrials, consumer defensive, and utilities stocks, and
significantly underweights financials.
Investors who find this approach appealing will have to put up
with a 0.38% expense ratio. That's not bad, considering the fund's
high sensitivity to the value premium. However, investors looking
for a more-moderate value tilt can find cheaper alternatives, such
as Vanguard SmallCap Value (0.10% expense ratio).
WisdomTree International SmallCap Dividend ETF(DLS) (0.58% expense
ratio) and WisdomTree Emerging Markets SmallCap Dividend ETF(DGS)
(0.68% expense ratio) offer the same approach as DES in developed
and emerging markets, respectively.
PowerShares FTSE RAFI US 1500 Small-Mid ETF(PRFZ) (0.39% expense
ratio) offers an alternative fundamental weighting approach. It
weights its holdings based on historical dividends, sales, book
value, and earnings. This gives PRFZ a broader portfolio with a
lower dividend yield. It is also less sensitive to the value
premium than DES.
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