An Ideal Time For Small-Cap Compensation

Investors that are tempted by the recent rally in U.S. small-cap stocks but have some reservations about that rally can consider dividend strategies to help smooth some of the volatility associated with smaller stocks.

The WisdomTree U.S. SmallCap Dividend Fund DES is one of the dominant names among small-cap dividend exchange-traded funds. DES, which recently ascended to record highs, is up more than 7 percent over the past month.

While the number of small caps paying dividends has been rising in recent years, the asset class still is not known as income destination. That underscores the advantages of DES for income investors yearning for small-cap exposure. At the end of the third quarter, barely more than half of the S&P SmallCap 600 Index paid dividends, proving the point that traditional small-cap ETFs are not adequate dividend ideas.

Playing Politics

If the White House can get Congress to approve tax reform, U.S. small-caps are expected to benefit.

“Finally, U.S. small-cap stocks tend to pay higher effective corporate taxes than do U.S. large-cap multinationals, which may leave a portion of their earnings outside of the United States to avoid paying taxes,” said WisdomTree.

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"After President Trump’s 2016 election, small-cap stocks went on a massive rally—the Russell 2000 Index was positive 15 days in a row. As the momentum behind corporate tax reform has seemed to wane for most of the year, small caps have underperformed large caps in the U.S.”

DES sports a distribution yield of 4.4 percent, more than triple the dividend yield on the widely followed Russell 2000 Index.

Dividends, Fundamentals Matter

Given that small caps are more volatile than their larger counterparts, investors can be rewarded by focusing on fundamentals and the financial health of smaller companies while making an effort to eschew riskier, cash-strapped firms.

DES tracks the WisdomTree U.S. SmallCap Dividend Index. That benchmark “focuses solely on dividend-paying companies, to the exclusion of any non-dividend payers.” said WisdomTree. “Notably, almost 50% of the Russell 2000 Index market capitalization is in stocks that do not pay dividends, so in U.S. small caps this is an important selection criterion to consider.”

Long-term data suggest investors are not compensated enough for embracing riskier smaller stocks. Over the past three years, DES has slightly outperformed the Russell 2000 while being less volatile and having a significantly lower maximum drawdown.

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