WisdomTree U.S. Dividend Growth ETF: Fundamentals-Based Strategy Lagging SPY – WisdomTree U.S. Dividend Growth ETF (NASDAQ:DGRW)

WisdomTree U.S. Dividend Growth ETF (NYSE:DGRW) tracks a fundamentally weighted index of dividend-paying companies that are screened for growth metrics and quality factors. Unlike typical market capitalization methodologies, this index is weighted annually based on the proportion of each component company’s projected cash dividend payout for the year ahead. The idea here is that DGRW is built around stocks with the best ability to grow their dividends over time, under the assumption that the compounding potential of dividends could outperform the broader market.

DGRW price chart. Source: FinViz.com

What makes this strategy unique is that instead of focusing on a single metric like “yield,” the fundamentals approach “may provide a more intuitive approach to dividend growth,” according to WisdomTree. Unfortunately, the data shows that since inception, DGRW has slightly underperformed the broader market including the SPDR S&P 500 ETF (NYSE:SPY). Since inception in May of 2013, DGRW is up 100.7% on a total return basis versus 104.6% for SPY. DGRW also lags SPY over the previous 3-year period, 1-year period and YTD 2019 by modest amounts.

DGRW vs. SPY. source: data by YCharts/table author

It’s important to note that while SPY isn’t technically the benchmark for this ETF, the point here is to question the value of this fund that essentially complicates something that should be simple. The data here is also gross of fees. The returns over the various time frames are technically less considering the annual management fee. For SPY the expense ratio is 0.09% while DGRW’s expense ratio is three times as much at 0.28%. Considering the 390bps underperformance in total return since inception plus 19bps in added management fees per year since, investors seeking passive exposure to the market would have been better off tracking the S&P 500.

Data by YCharts

A Bite With No FANG

Considering the focus of DGRW is “quality dividend growth” stocks; it’s actually impressive the returns since inception have only slightly underperformed SPY, since by definition the fund excluded some of the market leaders of recent years. DGRW doesn’t include Facebook Inc. (NASDAQ:FB), Amazon.com Inc. (NASDAQ:AMZN), Netflix Inc. (NASDAQ:NFLX), and Alphabet Inc. (NASDAQ:GOOG) (NASDAQ:GOOGL) collectively known as ‘FANG’.

The absence of these stocks at least in part helps explain why DGRW trailed SPY. The group currently represents an 8.4% weighting in SPY. The characteristic of avoiding non-dividend-paying stocks may be appealing to some investors. Going forward, the lack of exposure to FANG could be a major benefit should trends in the market reverse causing these names to significantly underperform. For this reason, DGRW returns have otherwise been commendable as it demonstrates the methodology has at least kept up with the broad market even by excluding some of the hottest stocks this past decade.

Data by YCharts

DGRW Analysis

Based on the methodology, the annual weighting of stocks in DGRW is based on the individual stock’s dividend annual payout relative to the selection universe of 300 stocks. Apple Inc. (NASDAQ:AAPL) has the largest dividend in the world for example, and represents a payout of $14.2 billion annually. Exxon Mobil Corp. (NYSE:XOM) comes in at a close second at $14.0 billion. Microsoft Corp. (NASDAQ:MSFT) with a payout of $13.5 billion actually has the highest weighting in DGRW primarily since it’s up 37% over the past year.

Once the index is rebalanced, the relative weightings change based on the performance of the stocks that impact their market cap. The other component to the constitution of the ETF are the growth and quality metrics. The index places importance on the three-year average of return on equity and return on assets as the quality factor. According to WisdomTree describing the methodology:

The primary starting screening universe for this index is the constituents of the WisdomTree U.S. Dividend Index with market capitalization of at least $2 billion. The Index is comprised of the 300 companies in the WisdomTree U.S. Dividend Index with the best combined rank of growth and quality factors. The growth factor ranking is based on long-term earnings growth expectations, while the quality factor ranking is based on three year historical averages for return on equity and return on assets. The Index is dividend weighted annually to reflect the proportionate share of the aggregate cash dividends each component company is projected to pay in the coming year, based on the most recently declared dividend per share.

The table below presents the top 25 holdings for DGRW along with the corresponding weight in SPY for each particular stock. Note that the quality and growth metrics below are for reference only, as the underlying index considers averages over periods and uses forecasted growth data within its methodology.

DGRW top 25 holdings

Relative to SPY, which is simply used here as a reference point, DGRW overweights the stocks that have large payouts and includes an adjustment for growth and quality. A notable stock that is absent from the holdings is AT&T Inc. (NYSE:T) that despite its 6.0% dividend and $14 billion annual payout, apparently doesn’t meet the screening criteria for growth and quality. This highlights a concerning weakness in the methodology in that it is backward-looking in terms of the growth and quality screening. AT&T is up 17% in 2019 while Verizon (NYSE:VZ) is up less than 1%. VZ is the fourth largest holding in DGRW with a 4.26% weighting.

Las Vegas Sands Corp. (NYSE:LVS) has a 1.07% weighting and is not a constituent of the S&P 500. Beyond the top 25 holdings, GDRW includes many stocks that are not a part of the S&P 500 down to “mid-caps” with a market capitalization of $2 billion. With 300 holdings, the fund is overall well-diversified, which could actually be a drawback as it becomes so large that the beta properties overwhelm any potential alpha in the strategy. Investors will be attracted to DGRW based on the monthly distribution and yield advantage relative to SPY. DGRW yields 2.35% compared to 1.83% for SPY.

Data by YCharts

Conclusion

I like the concept of the WisdomTree U.S. Dividend Quality Growth ETF but don’t find a reason to be invested in this fund compared to a broad market index ETF alternative. It’s disappointing that the fund has underperformed SPY materially in 2019 and it will likely take a significant shakeup in the market dynamic for DGRW to narrow that return spread. DGRW with only six years in existence likely needs more time through a full market cycle to access if the strategy is effective.

I believe a truly diversified portfolio should consider non-dividend-paying stocks with a focus on a total return basis. Investors will be attracted to DGRW based on the monthly distribution and yield advantage relative to SPY. I will avoid this ETF based on my concern that the fundamentals-weighting methodology has too many subjective components including being backward-looking. Take a look at the fund prospectus for full list of risks and disclaimers.

Disclosure: I am/we are long NFLX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.