Today I continue my series of articles on dividend-focused ETFs with a piece on the WisdomTree U.S. SmallCap Dividend ETF (DES).

In my opinion, DES might be an ETF of choice for many investors given its comfortable expense ratio of 0.38%, 4.2% standardized yield, and quarterly distributions. Another advantage of the fund is that the index it was designed to track has a 17.6x Price/Earnings, which is lower than 23.5x of the iShares Core S&P 500 ETF (IVV), and thus it offers some margin of safety in the case the market experiences valuation reset triggered by an unforeseen and seriously detrimental event like a pandemic. Besides, the fund has a weighty portfolio of 638 stocks, which helps to mitigate undesirable single-stock volatility.

On the other hand, anecdotal evidence suggests that DES has a higher risk if compared to the other WisdomTree ETFs designed to track the dividend indexes focused on the upper- and mid-echelon stocks, as for small-cap players, it is much tougher to navigate the recession. Anyway, I reckon its significant exposure to industrials is supportive of short-term price gains.

What the fund is focused on

The WisdomTree U.S. SmallCap Dividend ETF, a member of the ETF triumvirate focused on the U.S. dividend-paying companies, has a few similarities and apparent differences with the WisdomTree U.S. LargeCap Dividend ETF (DLN), the fund that is focused on the upper echelon of the U.S. market, and the WisdomTree U.S. MidCap Dividend ETF (DON), which was designed to track the index that reflects the performance of dividend-paying equities from the middle segment.

Precisely like the two other WisdomTree ETFs that I have covered recently, DES tracks an index that represents a fraction of the WisdomTree Dividend Index, which has 1256 constituents. The WisdomTree U.S. SmallCap Dividend Index (abbreviated as the WTSDI) includes the bottom 25% of stocks from the DI and is reconstituted annually.

The essential matter worth understanding about DES is that it does not invest in micro-cap or nano-cap stocks, or, put another way, those companies with a market capitalization of lower than $100 million, as they are not eligible for the inclusion in the domestic dividend indexes of WisdomTree (page 5).

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An Achilles heel of the WTSDI is that it does not factor in any financial metrics beyond cash dividends to be paid and market capitalization. These two parameters cannot reveal structural weaknesses or even signs of systematic value destruction (for example, continuous borrowings to cover the dividend, with zero or sub-zero FCF, and margin compression). Thus, a small-cap player incorporated and listed in the U.S. that has declared the DPS before the reconstitution date of the DI can easily qualify for the inclusion and find its place among DES’ holdings. And if such a company uses a highly destructive capital allocation paradigm, there is a material risk that its payout will be trimmed if the redirection of borrowed funds to shareholder rewards is no longer viable (for example, in the case of looming debt repayment). So, as being dividend-paying, it will still qualify for the inclusion in the index, but the distributions of the ETF, and, hence, total returns, will be afflicted. And if investors realize the stock’s previously hidden flaws at some point in the future, its market value will crater.

Certainly, DON and DLN have precisely the same risk, as their methodologies are akin. By contrast, the index that is being followed by the WisdomTree U.S. High Dividend ETF (DHS) is being regularly recalibrated with the composite risk score taken into account. Again, I would not say the score has an ideal combination of quality factors, but it still helps to identify and get rid of obvious short candidates in many cases.

A deeper look at holdings

With 638 holdings, DES is much more diversified than DLN and DON, which have 279 and 332 holdings, respectively. Only seven stocks have a weight greater than 1%. Combined, the ten largest holdings account for only 13.6% of the overall portfolio.

DES 10 largest holdings

Created by the author using the total holdings dataset

Shares of Antero Midstream Corporation (AM) is the ETF’s most significant asset with a ~2.46% weight, while GAMCO Investors (GBL) is at the very bottom of the list with a microscopic 0.0014% weight. The explanation is simple: precisely like in the case of the large-cap and mid-cap oriented WisdomTree dividend indexes, the hierarchy of constituents depends on the volume of their annual payout. For example, in 2019, AM paid $496.2 million in dividends, while GBL’s payout was only $2.8 million.

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On a side note, among the DES’ top-ten holdings there are a few companies that I cover, like Chemours (CC), Olin (OLN), and Vector Group (VGR).

Unfavorable sector mix weighed on returns

A few of my dear readers who have been closely following the U.S. stock market trajectory in recent years likely know that the most depressed sectors that have been under strain given unfavorable macro are financials and energy.

ChartData by YCharts

So, the issue with DES is that its sector mix is anything but recession-immune. For example, financials account for almost 28% of the portfolio, while industrials are in second place with 16.5% weight. At the same time, the fund has almost no exposure to the market-darling IT sector, which accounts for only 3.7% of the portfolio. So, investors who would like to own a more tech-heavy ETF should take a look at DLN, which has a 2.37% distribution yield and over 22% of total assets allocated to the IT.

But it would be incorrect to suggest that all the financial names in the portfolio have been in decline this year. Surprisingly, among the top 5 financial holdings of DES, three players have delivered double-digit price returns.

ChartData by YCharts

Energy stocks that have been battered by the oil supply-demand imbalance have only a 5.4% share of the overall portfolio. Most importantly, it has only marginal exposure to the oilfield services industry (e.g., Patterson-UTI Energy (PTEN), a drilling company, has a 0.06% weight), which has been bearing the brunt of the repercussions of the plummeting commodity prices, as upstream players cut capex to the bone.

ChartData by YCharts

As I said above, the fund is underweight in IT, but an essential remark worth making when discussing the superb returns of the overheat tech stocks is that not all IT companies have bumper growth profiles, and, hence, have been enjoying lofty valuations. I have pointed that out in my recent piece on DLN, which despite its massive exposure to the IT sector, has still lagged behind the U.S. market benchmark because it has limited exposure to the FAANGM cohort.

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The chart below represents the price returns of DES’s top five tech holdings. As you can see, while some have been leading the benchmark higher, others have delivered subpar performance.

ChartData by YCharts

Total returns are barely comparable with the S&P 500

The S&P 500 has easily trounced the fund, delivering a 10-year total return of 257.7%, while DES went up only ~108%. DLN and DON have also been much stronger.

Source: Seeking AlphaSource: Seeking Alpha

Source: Seeking AlphaThe one-year figure is even more disappointing, as the fund has not fully recovered from the March stock market slump yet, and is trading almost 16% below the level seen in October 2019.

Final thoughts

To sum up, given exposure to the small-cap segment, the ETF is riskier than its mid- and large-cap-focused peers. On the positive side, its 4.2% SEC 30-day yield is definitely appealing.

By and large, DES’ YTD total returns are heavily influenced by the softness in the financial sector precipitated by the dovish stance of the Fed, and also by the slow recovery in the stock prices of industrial companies. However, given the tech rally is largely overdone, I am more bullish on the industrial names now given appealing sector valuation (e.g., 12.8x median EV/EBITDA vs. 17.6x in the case of the IT) and overall economic recovery prospects. So, I would like to give the ETF a short-term bullish rating.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.