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The WisdomTree LargeCap Dividend ETF (NYSE:DLN) is meant to track the performance of the largest U.S. dividend-paying stocks. The allure here is that companies able to regularly distribute payouts to shareholders generally present stronger fundamentals with lower risk and potentially higher total returns. Indeed, the fund has a value-tilt while offering a 2.7% yield which is attractive relative to the broader equity market. While the fund benefits from a portfolio built around high-quality stocks, DLN suffers from what we view are structural weaknesses in dividend weighted index tracking methodology. The combination of disappointing performance history and poor risk profile, despite similar exposure to broad index funds, limits DLN’s value in the context of a diversified portfolio. We recommend investors avoid this strategy and look for alternative dividend-focused ETFs.
DLN is designed to track the ‘WisdomTree U.S. LargeCap Dividend Index’ comprised of the 300 largest companies ranked by market capitalization. An important aspect of the tracking index methodology is that holdings are dividend-weighted, which reflects the proportionate share of the projected aggregate year-ahead cash payout for each underlying company based on the most recent distribution.
The result is that Apple Inc. (AAPL) which only yields 0.7%, but distributes over $14 billion in total annual dividends, and Microsoft Corp. (MSFT) paying out $15.1 billion in dividends are the two largest current holdings of the fund. Separately, a high-yield stalwart like AT&T Inc. (T) with a 7.25% yield is among the top holdings as the company’s annual cash distribution of $14.9 billion over the past year is also among the largest in the market.
(Source: data by YCharts/ table by author)
WisdomTree explains that this methodology has the effect of tilting the total return profile of the fund towards dividends and a value equity factor by favoring companies with the largest cash dividends on a nominal basis.
As the index is rebalanced only on an annual basis, each underlying stock will tend to gain or lose importance to its relative weighting based on its share price performance. An example here is Exxon Mobil (NYSE:XOM) which distributed over $14.9 billion in dividends over the past year, making it one of the largest payers in the market. On the other hand, the stock is down by 49% year to date, and thus XOM is currently only the 11th largest holding in the fund. Unless Exxon Mobil announces a dividend cut before the next index rebalancing scheduled for October 15, 2020, the stock is set to reclaim its spot as one of the largest holdings in the fund based on the index methodology.
The other point we highlight here is the large overlap in holdings among the top positions in the fund S&P 500 (SPY). Within the top 25 holdings of DLN, 11 stocks are also within the top 25 constituents of the S&P 500. DLN essentially overweights the dividend payers of the S&P 500 across its 280 current holdings. Our criticism here is that for investors already allocated to a broad market index fund, or invested in shares of AAPL and MSFT, DLN offers little in terms of diversification.
Year to date, DLN is down 5% on a total return basis pressured by the overall challenging market environment amid the COVID-19 pandemic. DLN’s decline this year represents a significant underperformance compared to a 7.1% gain in the S&P 500 year to date.
One explanation for DLN’s lagging returns to the broader market is the fund’s lack of exposure to some key market-leading stocks that are not dividend payers. One of the market trends this year has been the relative strength of high-growth technology sector companies, which have been more resilient to the economic disruptions. In particular, strong gains from Amazon.com, Inc. (AMZN), up 67% year to date, and Facebook, Inc. (FB) up 26%, both of which are among top constituents of the S&P 500 have dragged the relative results for DLN.
The longer-term performance history of DLN also leaves a lot to be desired. Since the fund’s inception in June of 2006, DLN has underperformed the S&P 500 over the entire period, along with a 10-year, 5-year, 3-year, and 1-year time frame. While recognizing that DLN is not meant to compete or necessarily outperform the S&P 500, the data here is evidence that the strategy hasn’t worked and may represent a structural disadvantage. One positive to note is DLN’s larger yield at 2.7% compared to 1.7% for the SPY.
(Source: data by YCharts/ table by author)
In the context of a diversified portfolio, a weak performance can be overlooked if the security offers significantly uncorrelated returns or lower risk. That’s not the case with DLN. The period of extreme market volatility earlier this year in Q1 offered a good stress scenario for how DLN performs in a down market. Compared to a max drawdown of 33.7% at the lows in March for SPY, the WisdomTree LargeCap Dividend ETF faced a deeper 35.8% selloff. In this regard, the “large-cap dividend approach” has not limited the fund’s risk. Over the past 5 years, a Sharpe ratio for DLN at 0.65 compared to 0.84 for SPY suggests the fund has delivered weaker risk-adjusted returns.
Analysis and Forward-Looking Commentary
One of the criticisms we have towards DLN beyond its poor performance history and disappointing risk profile is what we view as a structural weakness in the underlying index weighting methodology. By dividend weighting the stocks, the result is an otherwise arbitrary ranking that is only loosely based on the market capitalization of each stock.
We argue that the performance of Apple being up 60% this year is unrelated to its dividend income profile as it only yields 0.7%. While Apple may be a fine stock on its own, it shares little in common with a dividend payer like Philip Morris International Inc. (PM) which yields 6.7%, for example. The equity factors and market trends driving Apple or Microsoft are too distinct from typical “dividend stocks.” Investors that can appreciate this type of diversification should just stick with an S&P 500 ETF.
Other methodologies utilized by alternative “dividend funds” make more sense in our opinion and can better isolate the dividend equity factor. We highlight the SPDR Portfolio S&P 500 High Dividend ETF (SPYD) which invests in the 80 highest yielding stocks in the S&P 500 through an equal-weighted methodology. While SPYD has faced its own challenges this year down by 25% year to date, the fund remains distinctly uncorrelated to the SPY while yielding an aggressive 5.4%.
There is also the Schwab U.S. Dividend Equity ETF (SCHD) which tracks the performance of the 100 highest yielding U.S. stocks with a market-cap weighted methodology. Separately, SCHD also includes fundamental filters like limiting companies with a 10-year history of paying dividends and several financial metrics to build a higher quality portfolio. We particularly like SCHD as the portfolio represents a unique exposure and yields 3.4%.
Investors can also consider more focused dividend investment strategy funds like the iShares Core Dividend Growth ETF (DGRO) which invests in companies with a history of increasing their payouts for at least 5 years. Going a step further, the ProShares S&P 500 Dividend Aristocrats ETF (NOBL) requires companies to have a consecutive 25-year history of increasing their payouts. Except for SPYD, which is the high-yield option in the group, DLN up 56.5% over the past 5 years has underperformed SCHD, DGRO and NOBL over the period.
While we’re not suggesting one fund is necessarily always better than another, we believe DLN has the least to offer in terms of adding value in the context of a diversified portfolio. It’s possible that DLN or any other dividend-focused fund can outperform the market over a particular timeframe going forward although we believe this is unlikely to be sustainable over the long run. The lack of exposure to non-dividend payers, while systematically underweighting growth stocks limit the total return potential of the fund. Similarly, companies that may have recently cut or suspended their payouts resulting in exclusion from the fund could turn out to be big winners in the next time period.
In the current market environment that continues to face uncertainties regarding the strength of the U.S. recovery, we expect volatility to continue. The market is likely to reward companies that can offer present strong growth and increasing earnings regardless of their dividend profile. We expect DLN to continue underperforming the broader market through 2021.
Investors have many options when selecting equity funds to build a portfolio with core holdings. While DLN represents a particular strategy and performs according to its tracking index methodology, the quirkiness of the dividend-weighted methodology may not be the most effective approach. Considering a consistent record of disappointing returns and poor risk profile, investors must question if DLN’s ~100 basis point yield advantage over an S&P 500 index fund can compensate for its other weaknesses. We believe alternative dividend funds with a more focused strategy can be a better option.
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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.