Why Quality Matters with Small Caps | ETF Trends

Factor leadership is constantly changing, but one of the great things about the quality factor is that it’s usually sturdy and practically never out of style.

Those are points worth remembering with smaller stocks, and it’s easy to put that into practice thanks to the WisdomTree U.S. SmallCap Dividend Growth Fund (NasdaqGM: DGRS).

Home to nearly $200 million in assets under management, DGRS recently turned eight years and tracked the WisdomTree U.S. SmallCap Quality Dividend Growth Index. That dividend-weighted benchmark employs both growth and quality scoring.

“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,” according to WisdomTree.

In DGRS, Quality Matters

Typically, investors prize small-cap stocks for growth prospects and forsake quality and value along the way. While the strategy can be rewarding, it’s far from risk-free. In fact, doing that can be a way of embracing a lot of low-quality companies.

As WisdomTree Head of Equity Strategy Jeff Weniger points out, 33.9% of the members of the small-cap Russell 2000 are unprofitable companies. That’s more than double the percentage of money losers in the Russell Mid-Cap Index. The percentage of unprofitable companies in the large-cap Russell 1000 Index is just 7.5%.

That’s potentially problematic for quality investors seeking small-cap exposure because the Russell 2000 is widely followed. So are its growth and value offshoots, meaning investors can encounter plenty of unprofitable smaller companies when embracing any number of small-cap index funds and exchange traded funds.

Fortunately, that scenario is easily rectified, thanks to DGRS. Just 10.3% of the members of the Russell 2000 reside in the WisdomTree ETF, and the overlap by weight between that benchmark and DGRS is just 10%, according to ETF Research Center data.

Predictably, some of the DGRS quality advantage is derived from sector attribution. For as high-quality as they are in the large-cap realm, small-cap healthcare and tech companies often focus on growth, not profitability. Those sectors combine for just 6.6% of the DGRS roster.

Conversely, DGRS allocates over half its weight to industrial and financial services stocks, the latter of which levers the ETF to rising Treasury yields.

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The opinions and forecasts expressed herein are solely those of Tom Lydon, 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.