A Smart Approach to Dividend ETFs

Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Dividend investors typically focus their attention on big and stable companies with a solid reputation, usually in low-growth sectors like consumer staples, telecom or utilities. There is nothing wrong with this traditional approach to dividend investing, but some innovative ETFs may offer a more convenient strategy for superior long-term returns. The case for small-capitalization dividend-weighted ETFs.

There is wisdom in wisdom tree

WisdomTree (NASDAQ: WETF) is arguably the most innovative ETF provider out there. The company has developed several alternative indexes that are not only supported by a strong theoretical framework, but according to the company´s research, they also generate better back-tested returns than the typical broad indexes.  

Investors seem to be quite happy with the products offered by WisdomTree, at least judging by their reaction when it comes to capital allocation. WisdomTree went from being the eighth ETF sponsor in terms of assets under management in 2010 to occupying the fifth position in the first quarter of 2013.

<img alt="" height="456" src="http://g.fool.com/editorial/images/40340/ranking_large_large.jpg" width="659" />

Source: WisdonTree earnings presentation

The company has managed to outgrow the competition while still charging higher than average management fees, which is a strong reflection about the quality and differentiation of its ETFs.

A different indexing methodology

Most market indexes are market-cap weighted, meaning that bigger companies have a higher weight in the index. WisdomTree, on the other hand, has developed several fundamentally weighted indexes that give more representation to those companies with desirable characteristics like dividends or earnings.

WisdomTree’s index methodology for its U.S. dividend family is notably different than a market-capitalization weighted approach: the company includes only dividend-paying companies in its universe, and weights these constituents based on their indicated dividend streams.

This approach has some important implications when compared the traditional indexes like the Russell family. To begin with, WisdomTree's domestic dividend indexes are more concentrated than the Russell Indexes since they include only dividend-paying stocks, hence a smaller universe. Secondly, their dividend-centric approach to weighting means they also pay higher dividend yields on an average basis.

And there is a third particularity that deserves close attention from investors -- when it comes to WisdomTree indexes, the smaller the market capitalization, the higher the dividend yield. The WisdomTree SmallCap Dividend Index pays a higher yield WisdomTree MidCap Dividend Index, and the WisdomTree MidCap Dividend Index has a yield advantage over the WisdomTree LargeCap Dividend Index.

<img alt="" height="315" src="http://g.fool.com/editorial/images/40340/dividends_large.jpg" width="694" />

Source: WisdomTree research

This is in contrast to what is usually observed in other kinds of indexes -- big and mature companies usually pay higher dividend yields than their smaller counterparts, but the construction methodology of the WisdomTree indexes means that investors get a bigger yield when focusing on smaller companies.

Smaller companies are usually more risky and volatile than bigger ones, but they also have more growth potential; that´s why higher returns can be expected on a long-term basis from small corporations. When it comes to WisdomTree MidCap dividend and WisdomTree SmallCap Dividend indexes, they have materially outperformed other indexes over the last five years.

<img alt="" height="306" src="http://g.fool.com/editorial/images/40340/returns_large.jpg" width="718" />

Source: WisdomTree research

Investment vehicles

WisdomTree SmallCap Dividend Fund (NYSEMKT: DES) is the ETF that tracks the  WisdomTree SmallCap Dividend Index. The index is comprised of the companies that make the bottom 25% of the market capitalization of the WisdomTree Dividend Index after the 300 largest companies have been removed. The ETF has a 0.38% annual expense ratio and it pays a 3.7% dividend yield; it holds a portfolio of more than 640 companies.

<img alt="" src="http://g.fool.com/editorial/images/40340/des_sector_large.png" />

For investors preferring exposure to the mid-cap sector, WisdomTree MidCap Dividend Fund (NYSEMKT: DON) tracks the WisdomTree MidCap Dividend Index, which is comprised of the companies that make the top 75% of the market capitalization of the WisdomTree Dividend Index after the 300 largest companies have been removed. The ETF pays a 3.2% dividend yield, it charges a 0.38% in annual expenses and provides access to a basket of more than 360 mid-cap dividend stocks.

<img alt="" src="http://g.fool.com/editorial/images/40340/donsector_large.png" />

When compared to other more traditional big cap dividends ETFs like iShares Dow Jones Select Dividend (NYSEMKT: DVY) these ETFs look well positioned for long-term outperformance. DVY has a similar dividend yield of 3.3%, and an expense ratio in the same area around 0.4% annually. However, its portfolio is more exposed to sectors like utilities and consumer defensive, which most likely means slower growth for this instrument versus its WisdomTree competitors.

<img alt="" src="http://g.fool.com/editorial/images/40340/dvy_sector_large.png" />

If recent history is any valid guide, the WisdomTree vehicles should do better in terms of total returns than the iShares product over the next years.

<img alt="" src="http://g.fool.com/editorial/images/40340/price_large.png" />

Bottom line

In the world of dividend investing, most people usually think about big companies in conservative sectors, and most dividend ETFs typically go in that direction. But it sometimes pays to be creative, and dividend-weighted ETFs with a focus on smaller companies could be a better alternative in terms of generating superior returns in the long term.

If you're an investor who prefers returns to rhetoric, you'll want to read The Motley Fool's new free report, "5 Dividend Myths ... Busted!" In it, you'll learn which stocks provide premium growth and whether bigger dividends are better. Click here to keep reading. 

Andrés Cardenal has no position in any stocks mentioned. The Motley Fool recommends WisdomTree Investments. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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