Investors who are looking for a value-oriented income opportunity may look to a fundamentally weighted dividend-focused exchange traded fund strategy that diversifies risk and rebalances towards those that have become cheaper relative to their dividends.
The WisdomTree LargeCap Dividend Fund (NYSEArca: DLN) 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. Or to put it in layman’s terms, DLN eschews weighting by dividend increase or yield, the latter of which can lead investors toward stocks vulnerable to dividend cuts.
“This approach balances firm size (larger companies tend to pay more absolute dividends) against yield,” Adam McCullough, an analyst on Morningstar’s manager research team, said in a research note. “To rebalance back to its target dividend weightings, the fund increases stock holdings that have become cheaper relative to their dividends and their peers, and trims positions that have become more expensive. This contrarian rebalancing discipline injects a modest value tilt.”
Consequently, due to its dividend-weighting methodology, the ETF leans toward larger and more profitable companies, like Apple (NasdaqGS: AAPL), Microsoft (NasdaqGS: MSFT) and Exxon Mobil (NYSE: XOM).
The resulting portfolio provides investors with a balanced trade-off between dividend yield and risk. The fund limits its exposure to firm-specific risk and the highest-yielding stocks, which are more apt to cut dividends. While this may be a cause for concern, the strategy has helped the dividend ETF stand out. Since its inception, DLN has averaged a 20% dividend yield premium over the Russel 1000 Value Index, and the ETF has outperformed the large-cap value Morningstar category average and the Russel 1000 Value Index by 1.0 and 0.8 percentage points, respectively.
Related: 2017 Mid-Year Outlook and ETF Strategy Review
The dividend-paying strategy also helps investors target a higher quality of companies that try to reign in reckless business management for more steady returns that in turn end up with a loyal investor.
“They help investors better forecast income and improve investor behavior, such as offering a cushion to help investors stay invested through the equity market’s rough patches,” McCullough said. “Dividend payments also keep corporate managers in check. Managers are loath to cut dividends, so they may use these payments to signal their confidence in their firm’s prospects. Dividend payments encourage managers to exercise greater discipline in capital-allocation decisions, because there is less money on hand to invest in low-return projects, and dividend payments discourage empire-building.”
For more information on yield-paying stocks, visit our dividend ETFs category.