Forget Factor / Smart-Beta ETFs: Dividend ETFs Can Be Just as Effective

What is factor investing?

Factor investing, in simple terms, is a strategy that focuses on specific characteristics or "factors" that have historically been associated with higher expected returns. Think of it as systematically selecting stocks based on certain attributes that research suggests can boost performance.

At the core of factor investing is the idea of the equity risk premium—the extra return you get from owning stocks over safer bets like bonds. This premium compensates you for the additional risks of being in the stock market.

In finance terms, this is often captured by the formula Rm−Rf, where Rm​ represents the return on the market and Rf is the risk-free rate, typically the return on Treasury bills.

But here's where it gets more interesting. In the early 90s, researchers Eugene Fama and Kenneth French identified several factors beyond just market risk that seemed to influence stock returns. These include:

• Size (SMB, "Small Minus Big"): This factor suggests that, over time, small-cap stocks tend to outperform large-cap stocks.
• Value (HML, "High Minus Low"): This factor indicates that stocks with lower price-to-book ratios (seen as "value" stocks) tend to outperform those with higher ratios.
• Profitability (RMW, "Robust Minus Weak"): Here, companies with strong profitability outperform those with weaker earnings.
• Investment (CMA, "Conservative Minus Aggressive"): This factor shows that firms with conservative investment policies outperform those with more aggressive growth strategies.

Today, many smart-beta ETFs aim to harness these factors, either individually or in combination (known as multi-factor ETFs). For instance, a quality-focused ETF might target the profitability and investment factors, while a small-cap value ETF might focus on the size and value factors.

Why dividend ETFs?

Interestingly, certain dividend ETFs that use fundamental weighting strategies can capture various investment factors surprisingly well. This is because they allocate their holdings based on financial metrics rather than market cap alone.

For example, the WisdomTree U.S. LargeCap Dividend Fund

and the WisdomTree U.S. Total Dividend Fund

DTD

-0.64%

focus on U.S. listed stocks that not only pay dividends but also meet liquidity and market cap requirements. Their holdings, however, are weighted annually based on the aggregate cash dividends each company is projected to pay in the coming year.

Despite their differences—DTD includes large, mid, and small caps, while DLN focuses on 300 large caps—as per the ETF Central comparison tool, their top holdings and sector allocations are similar.

Between March 2018 and June 2024, both ETFs have shown statistically significant alignments with the value, profitability, and investment factors, according to research. This means that their portfolios favor stocks that align with these recognized factors of historical excess returns.

This factor alignment in DLN and DTD is actually competitive with that of the Vanguard US Multifactor ETF

, a well-known multi-factor ETF.

It's interesting to consider why these fundamentally indexed dividend ETFs might offer similar factor exposures: their focus on dividend-paying companies that also meet certain financial criteria helps mimic a factor-based strategy, providing an exposure to value and profitability that you wouldn't necessarily get from a market cap-weighted ETF like the SPDR S&P 500 ETF

, which mainly offers market beta.

Finally, both DLN and DTD offer the additional benefit of monthly distributions, with 30-day SEC yields of 2.03% and 2.10% respectively. Investors can expect a 0.28% expense ratio.

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.