Dividend ETFs are all the rage. However, strategies that focus on emerging markets rather than U.S. stocks are often overlooked in this fast-growing segment of the business.

That may soon change as one ETF, WisdomTree Emerging Markets Equity Income Fund (NYSEArca: DEM), continues to put up stellar performance versus the competition.

DEM has a three-year annualized return of 14.5%, compared with 9% for iShares MSCI Emerging Markets (NYSEArca: EEM) and 10.1% for Vanguard MSCI Emerging Markets (NYSEArca: VWO), according to Morningstar.

WisdomTree Emerging Markets Equity Income Fund has seen net inflows of about $220 million since the beginning of June.

DEM combines two powerful investment themes in today’s markets: dividends and emerging markets.

Most of the world’s population lives in emerging markets and many countries are showing better economic growth than developed markets. Of course, long-term investors in emerging markets need to be ready for a bumpy ride in this notoriously volatile asset class.

Meanwhile, dividend ETFs have been very popular with risk-averse investors who want to keep at least some money in stocks. Dividends historically have been an important component of total return and can help cushion the blow in down markets.

Dividend approach

DEM resides in the loosely-defined category of ETFs that weight stocks by fundamental factors such as valuation, or in this case, dividends.

DEM manager WisdomTree takes a different approach than ETFs that weight individual companies by market cap, such as EEM and VWO.

WisdomTree director of research Jeremy Schwartz in a telephone interview said part of the outperformance of DEM is driven by it holding up better in down markets, and also the annual rebalance forces the ETF to buy low and sell high.

DEM screens stocks based on dividend yield, while stocks eligible for the index are weighted by their dividend stream. There are 235 stocks in the portfolio. For comparison, EEM has 839 holdings.

WisdomTree says the dividend strategy focuses on healthy companies and provides better downside protection in bear markets.

“It helped in the down markets of 2008 and 2011 in emerging markets, which earned some of the relative performance advantage,” Schwartz said.

Secret weapon: June rebalance

DEM underwent the annual rebalance last month.

Schwartz said the ETF sells stocks that have appreciated and buys stocks that have fallen. The reshuffle also acts to lower the average price-to-earnings ratio (P/E) of the portfolio holdings.

In terms of individual countries, the June rebalance resulted in DEM boosting its allocation to China and Russia, two beaten-down markets. The fund currently has 21.2% in Taiwan, 14.2% in Brazil, 14.2% in China and 13.8% in Russia.

In sectors, the ETF bought materials and energy stocks in the rebalance, which hunts for cheap sectors.

DEM does not hedge its exposure to emerging market currencies, which weighed on performance the past year as the dollar strengthened.

The ETF will shortly release five-year performance data as it launched in July 2007. It holds $3.8 billion in assets.

The fund’s tracking index has been less volatile than market-cap weighted emerging market benchmarks over the past five years. The WidsomTree Emerging Markets Equity Income Index has a five-year beta of 0.8 versus the MSCI Emerging Market Index.

Other emerging market dividend ETFs include SPDR S&P Emerging Markets Dividend (NYSEArca: EDIV), EGShares Low Volatility Emerging Markets Dividend ETF (NYSEArca: HILO) and iShares Emerging Markets Dividend (NYSEArca: DVYE).

iShares MSCI Emerging Markets

The opinions and forecasts expressed herein are solely those of John Spence, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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