Dividend-based ETFs: simple ways to place bets on smart ideas

A new range of dividend-based ETFs offer tantalising new prospects for smart-beta' investors.

Funds are like buses: you wait an age for a good idea and then suddenly a whole bunch of them come along at once. And so it is with smart beta' funds, which I mentioned a couple of weeks back.

At the time, I focused on a clutch of new iShares exchange-traded funds (ETFs). Hot on the heel of these comes another gaggle of interesting funds from WisdomTree, one of the leading US innovators in this area, which is finally launching here in the UK.

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To recap quickly, the idea behind smart-beta investing is to identify traits (also known as factors) that seem to be associated with outperforming stocks, compile indices of stocks selected on the basis of those traits, and track those indices.

In essence, it lies halfway between active management and passively tracking a broad market index, such as the FTSE 100 or S&P 500. WisdomTree has been pounding away at the smart-beta subject for nearly a decade stateside, and is now the fifth largest ETF provider in America, with about $33.5bn in assets.

The importance of dividends

WisdomTree's funds have an important twist or two compared to rival smart-beta products. The firm believes that dividends are hugely important. So it screens its target stockmarkets for decently valued stocks that also pay a robust dividend income.

In other words, with WisdomTree ETFs you're buying into a relatively cheap, mechanical, equity-income strategy,

This is attractive, as dividends have mattered hugely in the past. Academic studies show that between 30% and 90% of long-term equity returns (depending on which decade you pick) are due to receiving and reinvesting dividends.

Of course, you could simply buy a traditional actively managed equity-income fund as a mainstream alternative. There are some with very strong records, but you take two obvious risks.

The first is that you pay more in fees at least 40 to 50 basis points more per year. The second is the risk that the active fund manager takes a big bet on the wrong stock.

For instance, they might have heavily overweighted Tesco because they thought it offered great value, only to be caught out by recent events. This is known as idiosyncratic risk, or stock-specific risk. By contrast, smart-beta funds are designed to invest in a diverse portfolio of stocks, reducing the impact that a single underpeformer can have on returns.

With that in mind, lets take a look at WisdomTree's new launches and what makes them interesting. So far, the firm has listed four ETFs in London: Europe Equity Income (LSE: EEI) and US Equity Income (LSE: DHS), both of which have a total expense ratio (TER) of 0.29%, and Europe Small Cap Dividend (LSE: DFE) and US Small Cap Dividend (LSE: DESE), carrying TERs of 0.38%. Hopefully more should be on the way, including its range of emerging-markets funds.

Unlike most ETF providers, the indices tracked by WisdomTree's ETFs are developed by WisdomTree itself and use a different way of mixing and matching individual stocks.

After first screening stocks on some basic criteria intended to ensure they are suitable for inclusion in an ETF such as the size of the company and the liquidity of its shares the weight of each stock in the portfolio is determined by its share of the total regular dividends paid by all companies in the index.

This stands in contrast to most indices, which are typically weighted by market capitalisation, and is intended to "magnify the effect fundamentals have on risk and return characteristics", as WisdomTree puts it.

Lower-risk returns

So how well has this alternative approach worked in practice? From its inception in June 2006 through to 30 June 2014, the Total Dividend Fund (US: DTD), WisdomTree's core US equity fund, has returned an average 7.8% per annum. That compares to 8% p/a for the comprehensive Russell 3000 index.

That may not look very promising at first: the WisdomTree fund has clearly underperformed the overall market.But that very broad index has manymore volatile growth stocks in it.

The WisdomTree ETFs are in effect cheap ways of buying value stocks and the better comparison is with the Russell 3000 Value index, which has returned just 6.8% p/a. Crucially, the WisdomTree ETF has also been less volatile and thus less risky (in statistical terms at least).

WisdomTree has also been running international variants of this methodology over the same period. Here, the numbers are much more immediately compelling.

The DEFA Fund (US: DWM), which tracks stocks from developed markets in Europe, the Far East and Australasia, has returned 4.6% p/a since June 2006 versus 3.87% p/a for the MSCI EAFE index and 3.27% p/a for MSCI EAFE Value index.

In practical terms, the WisdomTree US Equity Income ETF offers another important first: you can now use a London-listed fund to track the broad US market in a tax-efficient structure.

Previously, you could have bought the US ETF issued by WisdomTree, but you'd have to have paid withholding tax on those dividends. And due to UK tax rules on non-UK funds, you would potentially have been liable to pay tax on any capital gains at income-tax rates, rather than capital-gains rates.

A welcome choice

As it happens, WisdomTree's ETFs aren't the first to focus on dividends here in Europe: iShares has long offered the UK Dividend ETF (LSE: IUKD). This tracks what I think is an unattractive benchmark called the FTSE UK Dividend+ index.

State Street has the Euro Dividend Aristocrats ETF (LSE: EUDV), which tracks an index of companies that have been progressively increasing the dividend payout for some time.

In recent months we've also had Hinde Capital's Active Dividend ETN (LSE: HALF), issued via Socit Gnrale. This focuses on stocks in the FTSE 350, weights them by dividend payout and tries to introduces some protection against market volatility by hedging 50% of its exposure through short positions on the FTSE 100 and FTSE 250.

However, the arrival of WisdomTree's funds mean that investors now have more flexibility to customise a smart-beta portfolio to their needs. If you want core UK access, my guess is that the Hinde ETN is probably the most interesting option.

At the global level tracked by the MSCI World index I'd probably stick with the iShares factor ETFsI mentioned in my last article.

However, I think the new US Equity Income ETF could be a core purchase for a long-term investor. And the European Small Cap Income fund is a fascinating bet.

Numerous studies have shown that the greatest potential for dividend growth is with smaller companies, and this fund offers easy access to a diverse pool of stocks.