Small Caps, Big Dividend Potential With This ETF

It has been noted several times in this space this year that while small-cap stocks and the corresponding exchange-traded funds have been decent performers, adding dividends to that equation not only reduces volatility but bolsters returns as well.

In Theory, In Practice

The WisdomTree SmallCap Dividend Fund (ETF) DES proves as much. While the widely followed Russell 2000 Index and the S&P SmallCap 600 Index are up an average of 11.5 percent year-to-date, DES is thrashing those returns with a 2016 gain of 17.4 percent. This is old hat for DES, which during the course of its just over 10 years on the market, has made a habit of outperforming its actively managed rivals.

DES has a stablemate, the WisdomTree U.S. SmallCap Quality Dividend Growth Fund (WisdomTree Trust DGRS), that deserves some attention, too. In simple terms, DGRS is the small-cap answer to the popular WisdomTree U.S. Quality Dividend Growth Fund (WisdomTree Trust DGRW).

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DGRS, In Focus

That means DGRS combines the growth and quality factors to use earnings growth, return on assets (ROA) and return on equity (ROE) to identify compelling sources of future dividend growth. Like DES, DGRS is topping the Russell 2000 Index and the S&P SmallCap 600 Index with a gain of nearly 16 percent.

There are some clear reasons why DES and DGRS are outperforming traditional small-cap benchmarks.

“One explanation for this is that in a cap-weighted universe that includes non-dividend payers, there are more companies in 'growth' stages that are using their capital to grow — or even just to break a profit, in many cases, for an index like the Russell 2000,” said WisdomTree Research Director Jeremy Schwartz in a recent note.

DGRS constituents also offer a compelling buyback yield relative to the Russell 2000, indicating companies found in the WisdomTree could be potentially more shareholder friendly than standard small caps.

“While the Index that DGRS is designed to track has a dividend yield of 2.3 percent, still higher than the Russell 2000 and even the S&P 500 Index, it has a net buyback yield of +1.87 percent. This means companies in this Index are reducing shares outstanding, which is one factor that can lead to more positive per share dividend growth in the future,” added Schwartz.

DGRS is benefiting on another front: Exposure to financial services stocks or lack thereof. Small-cap financials are particularly sensitive to interest rates, meaning the group has been hampered by the Fed Reserve's refusal to raise interest rates this year. Financials account for just 10 percent of DGRS, making that the ETF's fifth-largest sector weight.

Additionally, DGRS is significantly underweight healthcare names relative to standard small-cap benchmarks, a plus when smaller healthcare names are struggling against a backdrop of negative political rhetoric.

Disclosure: Todd Shriber owns shares of DGRW.