By Jeremy Schwartz, Executive Vice President, Global Head of Research, WisdomTree

Increasing portfolio quality is a theme many investors flock to during recessions.

You might worry that rotation and flows to quality strategies push up valuations to premium prices, hurting the prospects of forward-looking returns. But WisdomTree has a potential solution. We have a family of quality dividend growth strategies that combine elements of screening for profitability (high return on equity (ROE) and return on assets (ROA)) and strong earnings growth expectations.

Because of the profitability focus and the dividend requirement, one of the interesting parts of our U.S. Quality Dividend Growth Fund (DGRW) is that it is trading at price-to-earnings (P/E) multiples that resemble the characteristics of “value” sides of the market, but with significantly higher quality ratios.

While the S&P 500 Value Index has a return on equity of 9.4%—below the S&P 500 level of 13.1%—DGRW has an ROE of more than 24%.

Refreshing Valuations 1

Please click here for standardized and the most recent month-end performance.

For definitions of terms in the table, please visit our glossary.

Let’s look at some of the nuance of this strategy.

Dividends Under Pressure

The broad universe of value strategies and dividend-paying stocks has come under pressure in 2020 as many companies were forced to scale back or cut their dividends.

Less Likely to Cut Dividends: Whereas 272 companies, or 13%, of the 1,471 dividend payers in the WisdomTree U.S. Dividend Index either cut or suspended dividends in 2020, less than 8% of the 300 companies in the WisdomTree Quality Dividend Growth Index cut or suspended dividends in 2020.

Quality More Likely to Grow Dividends: Quality companies also tend to be able to grow dividends faster over time, and they were stress-tested during this pandemic. Whereas 54% of the broad universe of 1,471

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.

(Source: finviz.com)

DLN Background

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