Today I continue my series of articles on dividend-oriented ETFs with a piece on WisdomTree U.S. High Dividend Fund (DHS). To begin with, I would like to highlight its low expense ratio of 0.38%, low volatility underpinned by a 60-months beta of only 0.88, a substantial standardized yield of 4.6%, and the methodology that factor in a few fundamental scores to separate the wheat from the chaff.
The issue is that despite fundamentals-focused methodology, the fund has still underperformed the S&P 500 in the last 10 years, as its portfolio has some nuances not to be overlooked.
The top line
With assets under management of ~$772.6 million, DHS tracks the WisdomTree U.S. High Dividend Index and has 295 holdings. The WTHYE itself includes stocks with the highest dividend yields from the WisdomTree U.S. Dividend Index. To be included in the WTHYE, a company must have no less than a $200 million market cap and “average daily dollar volumes of at least $200,000 for the prior three months” (page 13).
Eligible stocks are ranked according to their indicated annual dividend yields; those from the top 30% are then included in the WTHYE, and, hence, the DHS portfolio.
Using the dividend weighted methodology, the index is being recalibrated every year “to reflect the proportionate share of the aggregate cash dividends each component company is projected to pay in the coming year” (source).
What I really like about DHS is that the index it tracks is much pickier than, for example, the WTMDI that I discussed earlier, which does not factor in a composite risk score. In the case of the WTHYE, managers not simply rank stocks according to their anticipated annual dividend payouts: instead, the hierarchy of shares in the list is influenced by the CRS that takes into account three parameters: value, quality, and momentum scores. A stock that has a more appealing mix of these three grades will have a higher weight in the index, and vice versa. The approach was discussed in greater depth by Tripp Zimmerman, CFA in the article.
As stated in the rules-based methodology (page 5), the quality factor takes into account such efficiency indicators like Return on Equity, Return on Assets, gross profits over assets, and cash flows over assets. The momentum factor depends on a stock’s risk-adjusted total returns over 6 and 12 months. The value factor is estimated using various ratios from the forward earnings yield to EBITDA/EV (page 22). Importantly, both the QF and VF are calculated within industry groups, which secures an apples-to-apples comparison.
With this composite risk score, WisdomTree attempted to resolve one of the pivotal issues of dividend investing: identification of value traps that investors shun for a reason and that are likely on the cusp of a DPS reduction. The essential problem is that high dividend yield is not indicative of a high-quality business. In many cases, they are antithetical, as appealing yield can point quite to the contrary: a company has fallen out favor with investors, as it is in tatters and its prospects are murky. Its equity value plummeted, and the yield surged as a result. In March this year, we have seen how, for instance, energy players’ yields soared as their market values cratered being dragged down by the oil price war. And then a slew of payout reductions followed. For instance, take a look at the case of OXY.
By analyzing the composite risk score, it is possible to identify chronic laggards and mitigate their impact on the overall portfolio performance.
But I would not say that it is perfect; for example, in the methodology, nothing is said about free cash flows which are at the crux of dividend sustainability. If a company uses mostly debt funds to cover the dividend while its organic cash flow is volatile, it can still be included in the index with solid weight, if its CRS is adequate. Besides, debt-adjusted efficiency indicators like Return on Total Capital are also not used.
The portfolio structure. Diversification. An enigma of underperformance despite exposure to market-darling sectors
In order to secure adequate diversification, the index methodology caps both weights of individual stocks and sectors. On page 8, it is clarified that individual security cannot account for more than 5% of the portfolio; in the case when a sector achieves an equal to or over 25% weight, “weight of companies will be proportionally reduced to 25% as of the annual Screening Date.” But there is one exception: the real estate sector’s weight cannot exceed 5%.
At the moment, the fund’s portfolio is dominated by three sectors: healthcare (a 17.04% weight), technology (15.66%), and consumer staples (12.45%), while its footprint in the embattled financial sector is limited, only…