WisdomTree SmallCap Dividend ETF (DES): Factors Tell It’s A Hold

The previous time I reviewed the WisdomTree U.S. SmallCap Dividend Fund (NYSEARCA:DES), a smart-beta ETF amalgamating the size and dividend factors was in October 2021 when I wrote a rather skeptical note pointing to its relatively small exposure to the quality factor which posed risks to distributions growth and their durability, a crucial parameter for investors seeking an income-generating vehicle for the long haul. In fact, the precipitous decline in its dividend I flagged in the note had been clearly a direct consequence of that.

Also, I downgraded DES to Hold after its 2021 rally undergirded by the pandemic abating amid widespread vaccination which stimulated capital rotation back to cyclical, small-size companies, which, in turn, allowed the fund’s price to rise meaningfully since my first article on it that was published in October 2020.

Since October 2021 when my forecast became slightly more conservative due to capital appreciation and decline in distributions, the fund has marginally outperformed the market, delivering an almost flat total return.

This year, it has been chugging along, being less sensitive to the bear party on the Street unlike the bellwether funds like the iShares Core S&P 500 ETF (IVV) or its more growth-heavy counterpart the Invesco S&P 500 Pure Growth ETF (RPG) thanks to DES’ natural exposure to modestly valued stocks that have been less afflicted.

However, performance leaves a lot to be desired as some cheap stocks-focused funds like the Invesco S&P 500 Pure Value ETF (RPV) or actively-managed Avantis U.S. Small Cap Value Fund (AVUV) have been doing much better.

Today, I would like to focus on a set of return-driving factors DES is most exposed to at the moment, take a look at the dynamics of its distributions, and explain what is the rationale behind my decision to maintain the Hold rating.

A brief investment strategy recap

To recap, DES’ investment mandate is to track the WisdomTree U.S. SmallCap Dividend index, which is, in essence, consists of the medium- and small-size dividend-paying U.S. companies which are weighted according to their projected cash dividends. This allows eliminating the engrained issues of market-cap-weighted indices, while also somewhat tilting the fund’s portfolio towards the value factor, which is a tailwind during the periods of abating market euphoria followed by a more sober mood, the one we are watching now. The selection universe for the benchmark is the WisdomTree U.S. Dividend index tracked by DTD.

How the factor exposure has changed since September 2021

The fund’s portfolio has been deeply recalibrated since my previous coverage and, as of my analysis, the holdings from its October version have only ~60% weight as of June 1. A few notable deletions were Compass Minerals International (CMP), a materials company with sodium chloride and magnesium chloride amongst key products, and Archrock (AROC), an energy infrastructure player. The fund’s exposure to the range of a few return-driving factors has possibly shifted, and an attentive assessment is necessary.

As of June 1, DES had a portfolio of 670 stocks. Even though the ETF has allocated ~56.4% of its net assets to companies with market values above $2 billion (technically, mid-caps), the median market cap stands at ~$1 billion and a weighted average is ~$2.4 billion, thanks to the smart-beta weighting. Diversification is certainly not an issue for its equity mix given the key ten names account for just 10.6% of the total. In my view, this is completely fine.

Before we actually delve into the discussion of factors, I should briefly remind you that DES has always been overexposed to recession-sensitive, comparatively less generously valued sectors like financials and industrials. We see an ~24% allocation to the former and ~16.8% to the latter in the current iteration. Meanwhile, IT, one of the main victims of the evaporation of the growth premia phenomenon I have been discussing since late 2021, is represented by just a few names with a weight of ~5.3%, with Xerox (XRX), a textbook example of a value stock, being the primary holding from the sector; it should be noted that XRX was not featured in the DES portfolio from October 2021. Overall, a small footprint in IT can be helpful in explaining why DES’ NAV has not declined as steep as IVV’s or RPG’s, which are both tech-heavy.

Now, turning to the Quant factors. Today, I would like to pay special attention to Valuation and Profitability.

First, the fund’s tilt towards value stocks remains generally similar, with only a few percent retreat to ~49.7% from ~53% last year, even though ~40% of the portfolio has been removed since then. I should remind you that such a substantial allocation to stocks with a Quant Valuation grade of B- or better is a direct consequence of mostly the size factor as smaller companies tend to trade with lower multiples compared to their larger counterparts, a phenomenon I discussed a few times in the past.

Unfortunately, DES is far from being perfectly valued, as ~17% of its net assets are allocated to stocks that are dangerously overpriced, including a few F-rated presented below:

Though it is clearly a drawback, I would not say that the share of expensive stocks rose sharply; in fact, it actually reduced from October’s level of ~19% and remains at a relatively modest level.

Now, quality. What we see here is again rather similar to October 2021. Just ~35% of the holdings score nicely against the Quant Profitability grade, with a B- rating at least. That is a decline from the 39% level I mentioned in the previous note. The share of those with worrisome profitability issues (a D+ rating and weaker) remains a bit north of 18%. The takeaway? The fund’s exposure to the quality factor is clearly suboptimal, which I highlight as a risk in the current market environment.

A quick take on distributions

What I highlight as a silver lining is that the fund’s trailing twelve months’ distributions have improved materially since 2021 when they were close to the lowest level since DES’ inception in 2006. More specifically, the LTM figure which includes the most recent distribution made in May (DES pays monthly) stands at $0.86938 and is almost 36% higher compared to the amount as of September 2021. It should be noted that this is also higher compared to the 5-year median annual distribution of $0.77989.

Regardless, though I appreciate the improvement trend depicted on the chart, the quality issue flagged above is a permanent threat hanging over small-cap dividend funds, and higher interest rates will likely exacerbate it going forward.

Final thoughts

Investing in dividend-oriented passive funds to weather a recession assisted by a period of prolonged market softness with minimal losses covered by a consistent income stream is a totally rational step.

But DES, like most of its small-size-focused peers, has a few drawbacks. The reasons for moderate skepticism are as follows:

• Small-cap funds are always exposed to the profitability issue, while it is less of a concern for their large-cap counterparts. That is to say when the markets are pricing in a stagflation risk as a direct consequence of the battle against inflation, small-caps are not a perfect place to be,
• Even though I see a substantial allocation to cheaper cyclical names, I am of the opinion the value factor without a solid exposure to quality is too risky for an economic environment with higher rates and slower growth resulting from both commodity supply/demand imbalances and expansionary monetary policy which is now being urgently adjusted across the globe.
• Also, despite an improvement in the LTM distributions from the 2021 levels, DES’ dividend growth is still inconsistent, while the distribution yield of ~2.8% is too low for my taste.

That being said, I believe DES remains a Hold at the current price.