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When investors think of dividends, they tend to think of mature large-cap companies as the primary source. Many investors assume that mid and small-cap companies can't afford to pay dividends because their main focus is on growth and they need to reinvest their earnings to support that growth. If you take a look at traditional market cap-weighted indexes, this assumption seems to be accurate. Within this piece, we will illustrate certain characteristics of different market capitalization equity size segments through the use of a series of Russell Indexes, each selected for the broadness of its exposure to that particular set of stocks. For full rationale behind choosing these indexes for the comparison, please read our research here.

Going down the size spectrum in the Russell index family of market cap-weighted indexes illustrated in figure 1, from Russell 1000 (Large) to Russell Midcap and Russell 2000 (Small Cap), the indexes focused on larger-market-capitalization companies have higher trailing 12-month dividend yields. The "value" sides of each size-based index holds a mixed story-the Russell 1000 Value Index has a higher trailing yield than the Russell Midcap Value Index but comes up slightly short against the Russell 2000 Value Index.

Interestingly, the reverse is true for WisdomTree's Dividend Indexes: smaller-cap indexes display higher income levels. While it's important to note that dividend income is not the objective of the Russell indexes, differences in methodology can help explain why this occurs.

First, WisdomTree only includes dividend-paying companies. Second, WisdomTree weights its constituents by their indicated dividend streams. Combined, these elements can cause very different trailing 12-month dividend yields for WisdomTree's large, mid, and small-cap Dividend Indexes. Weighting eligible companies in our indexes by their indicated dividend streams enables us to magnify the effect dividends have on performance. Market capitalization-weighted indexes provide the benefit of as broad an exposure as possible to a given universe of stocks, but they do not directly focus on dividends or dividend-payers. While market cap-weighting may be broader in scope, dividend weighting may increase dividend yields.

Figure 1: Market Cap-Weighting vs. Dividend Stream Weighting

(click to enlarge)

For definitions of the indexes, please visit our glossary.

  • In the current environment, WisdomTree's domestic Dividend Indexes turn this way of thinking on its head-the WisdomTree SmallCap Dividend Index had a yield advantage over the WisdomTree MidCap Dividend Index, and the WisdomTree MidCap Dividend Index had a yield advantage over the WisdomTree LargeCap Dividend Index.
  • The WisdomTree SmallCap Dividend Index had a trailing 12-month dividend yield advantage of more than 1.8% over its market cap-weighted index peers, the Russell 2000 Value and the Russell 2000 indexes.
  • The WisdomTree MidCap Dividend Index had a trailing 12-month dividend yield advantage of more than 1.4% over its market cap-weighted index peers, the Russell Midcap Value and the Russell Midcap indexes.

A Closer Look at Mid and Small Caps

Mid and small-cap stocks have traditionally outperformed large-cap stocks over long periods. This outperformance is typically a result of the higher growth potential of mid- and small-cap companies, but it also is usually associated with greater risks due to the volatility in earnings and uncertainty about new or unproven business models. We feel this view incorrectly stereotypes all mid and small-cap companies, and we do not think all mid- and small-cap companies are created equal. There are many mid- and small-cap companies that have proven business models with relatively stable earnings streams. We believe these companies have the ability to pay out dividends to shareholder and grow them over time. The WisdomTree MidCap Dividend and SmallCap Dividend Indexes focus on these firms.

Figure 2: WisdomTree Index Returns vs. Popular Market-Cap Weighted Benchmark Indexes

(click to enlarge)

Large-cap dividend-paying stocks have been the primary focus for income investors. Yet within the spectrum of dividend-paying indexes, the Russell large value has lagged the WisdomTree MidCap and SmallCap Dividend Indexes. Overall, all large-cap indexes above have lagged the mid- and small-cap segments of the market over the last five years.

  • Mid-Cap and Small-Cap Lead: All the mid and small-cap indexes displayed above outperformed their respective large-cap peers on an annualized basis over the most recent five-year period. The WisdomTree MidCap Dividend Index outperformed all other indexes over the period.
  • Mid-Caps Were Best Performers: The WisdomTree MidCap Dividend Index outperformed the Russell Midcap Value Index and the Russell Midcap Index by almost 2% annualized over the most recent five-year period. Notably, the WisdomTree MidCap Dividend Index outperformed the WisdomTree LargeCap Dividend Index and the Russell Large Value Index by over 4% a year over the period-showing one drawback of only focusing on the large-cap segment of the market.
  • The WisdomTree SmallCap Dividend Index outperformed the Russell Small Index by 1.3% per year and the Russell Small Value Index by almost 2.0% per year over the most recent five-year period. The WisdomTree SmallCap Dividend Index outperformed the WisdomTree Large Cap Dividend Index and the Russell Large Value Index by over 3.5% per year for this five-year period.

Weighting by Fundamentals: The Dividend Difference

We believe dividends provide an objective measure of company profitability and have theoretical and empirical importance in determining stock values. Weighting eligible companies in our Indexes by their indicated dividend streams enables us to magnify the effect dividends have on performance. Each stock eligible for inclusion in an Index is weighted by its share of the dividend stream (which is the sum of regular cash dividends paid by all the companies in the Index). In a recent market insight, we evaluated how various indexes allocate weights to companies in different dividend yield buckets. We concluded here:

  • Higher Weights in Highest-Dividend Stocks: For stocks with dividend yields greater than 4%, both WisdomTree MidCap and SmallCap Indexes have more than twice the weight, 25% and 32%, respectively, of their market cap-weighted value peers. The Russell Midcap Value and the Russell 2000 Value indexes have 20% and 40%, respectively, weight in companies with no indicated dividend yields.
  • Non-Payers Allocations: All Russell indexes are market capitalization weighted and, as such, place the largest weights on firms with the largest market capitalizations. This means they will all have weight in non-dividend paying stocks (20% for the Russell Midcap value and 40% for the Russell 2000 Value), which, of course, are ineligible for the WisdomTree Dividend Indexes.

Conclusion

In our opinion, mid and small-cap companies are important tools for providing diversification benefits and increased potential return. Specifically, we think that mid and small-cap dividend-paying companies deserve a larger share than they're currently being allocated by market cap-weighted indexes. Allocation to mid and small-cap dividend-paying companies can increase trailing 12-month dividend yield.

At WisdomTree, we do things differently. We build our Indexes and the ETFs designed to track them with proprietary methodologies, smart structures and/or uncommon access to provide investors with the potential for income, performance, diversification and more. In the mid- and small-cap market, we believe our approach can help investors more successfully capture a higher level of income from smaller companies.

Important Risks Related To This Article:

You cannot invest directly in an index.

Investors should carefully consider the investment objectives, risks, charges, and expenses of the Funds before investing. Read the prospectus carefully before you invest. Past performance does not guarantee future results.

There are risks involved with investing, including possible loss of principal. Foreign investing involves currency, political and economic risk. Funds focusing on a single country, sector and/or funds that emphasize investments in smaller companies may experience greater price volatility. Investments in emerging markets, currency, fixed income and alternative investments include additional risks. Please see prospectus for discussion of risks.

Dividends are not guaranteed and a company's future abilities to pay dividends may be limited. A company currently paying dividends may cease paying dividends at any time.

Source: In Search Of Income: Consider Mid And Small Caps