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By Jeremy Schwartz, CFA, Director of Research & Tripp Zimmerman, CFA, Research Analyst

Last year, longer-term interest rates in the U.S. rose considerably-mostly driven by the expectation that the Federal Reserve (Fed) would begin tapering its quantitative easing (QE) program. At its December meeting, the Fed began scaling back purchases of both mortgage-backed securities and U.S. Treasury bonds by $10 billion a month and now is on track to end its asset purchase program by the end of 2014-assuming no drop-off in economic performance in the coming months.

The rise in Treasury yields since the beginning of 2013 impacted various income-oriented investment strategies, but not all strategies are the same. When investors think of dividends, they tend to think of mature large-cap companies as the primary source, and as a result, we feel that many investors mistakenly overlook potentially attractive income options. Below we will discuss one segment of the market that often gets overlooked in the hunt for income-producing asset classes-mid- and small-cap dividend payers.

In Search Of Income: Look To Mid- And Small-Caps

We feel many investors mistakenly assume that mid- and small-cap companies are solely focused on growth and therefore reinvest their earnings instead of paying them out in the form of dividends. If you take a look at traditional market cap-weighted indexes for the United States in particular, this assumption seems to be accurate:

+ Going down the size spectrum-from the Russell 1000 (large cap) to the Russell Midcap (mid-cap) and the Russell 2000 (small cap)-in the Russell index family of market cap-weighted indexes illustrated in figure 1, the indexes that focus on larger market capitalization companies have higher trailing 12-month dividend yields.

However, this does not necessarily have to be the case; there are many profitable mid- and small-cap companies that can afford to, and do, pay dividends. 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. When WisdomTree applies its domestic dividend methodology, it includes only dividend-paying companies and then weights these constituents based on their Dividend Streams®. While potentially not as broadly focused as market capitalization-weighted indexes, when combined, these elements tend to produce very different trailing 12-month dividend yields for WisdomTree's LargeCap, MidCap and SmallCap Dividend Indexes.

Small & Mid-Caps for Income: In the current environment, WisdomTree's domestic Dividend Indexes turn this way of thinking on its head-the WisdomTree SmallCap Dividend Index (WTSDI) and the WisdomTree MidCap Dividend Index (WTMDI) had a yield advantage over the WisdomTree LargeCap Dividend Index, the S&P 500 Index and the Russell 1000 Index.

International Mid- And Small-Cap Dividends

While we focused on mid- and small-cap dividend payers in the United States above, we now extend the analysis to developed international markets. We believe the benefits of looking beyond large caps and into mid- and small caps are, in many ways, even stronger in the international markets.

For starters, international markets generally pay more dividends than U.S. markets-which means they represent a bigger investment opportunity set. The Dividend Stream for the WisdomTree Global Dividend Index was over $1 trillion, and while the U.S. market made up 31.1% of the total Dividend Stream, the developed world ex-U.S. accounted for 52.1% of it. The international developed world also tends to have higher trailing 12-month dividend yields than the United States, which is illustrated in the chart below.

International Equities Have Higher Yields: All the MSCI EAFE indexes and WisdomTree International Dividend Indexes shown above have higher trailing 12-month dividend yields than the S&P 500 Index, a proxy for the U.S. markets.

WisdomTree International Dividend Indexes Have Highest Yields: WisdomTree weights companies in its International Dividend Indexes by cash dividends, which tends to increase the yield compared to traditional market cap-weighted benchmarks that do not weight by dividends. Each of these WisdomTree International Indexes has close to twice the trailing 12-month dividend yield of the S&P 500 Index.

WisdomTree International MidCap and SmallCap Dividend Indexes Also Pay: As you move down the size spectrum in the WisdomTree International Dividend family, you do not see a substantial decrease in the trailing 12-month yield that is present in the MSCI EAFE indexes, where the largest-market-capitalization firms have the highest trailing 12-month dividend yields.

Why International Dividends?

Over the past few years, one case in support of dividend-paying stocks highlighted the yield advantage they offered over Treasuries. More recently, that yield advantage has closed and the percentage of equities with a higher dividend yield than the 10-Year U.S. Treasury yield has declined.

There is still a healthy part of the broader market that can offer higher yields than U.S. Treasuries, but it is no longer the majority of stocks in the market, so it would be hard to notice by looking only at large-cap indexes weighted by market cap. At WisdomTree we weight eligible companies in our Indexes by their Dividend Stream, which enables us to magnify the effect of dividends. Figure 3, below, illustrates this point by separating the weight each index has in stocks that had a higher dividend yield than the 10-Year Treasury.

International Indexes Have More Weight in High Payers: The international dividend indexes displayed above tend to have higher weights in higher-yielding companies than the S&P 500 Index, allowing them to have a higher percentage weight in stocks with a dividend yield over the U.S. 10-Year Treasury. We find it impressive that the WisdomTree International MidCap Dividend Index (WTIMDI) and WisdomTree International SmallCap Dividend Index (WTISDI) have over three times the weight in stocks with a yield advantage over the U.S. Treasury than does the S&P 500 Index, especially considering many U.S. investors think of domestic large caps first when they think about dividends.

Small & Mid-Caps for Domestic Focus: We find it impressive that WTSDI and WTMDI had more than twice the weight of the S&P 500 in stocks with a dividend yield higher than the 10-Year Treasury. It is even more impressive considering WTSDI and WTMDI had more than three times the weight of the Russell Midcap and Russell 2000 indexes, their market cap-weighted benchmarks.

Possible Diversification Benefits: Mid- And Small-Caps

We feel that investors typically have a large-cap bias when it comes to income as well as in their general portfolio allocation decisions. We believe that mid- and small-cap dividend payers offer a further set of exposures beyond traditional large caps and can potentially lower portfolio risk and enhance returns through these diversification benefits. Moreover, the stocks themselves tend to display different characteristics than large-cap stocks, as illustrated by their sector differentials (figure 4), specifically the exposure to cyclical and defensive sectors.

Cyclical Sector Over-weights: The WisdomTree Dividend Indexes displayed above tend to have more exposure to the cyclical sectors of the markets-compared to popular large-cap market cap-weighted benchmarks such as the S&P 500 and the MSCI EAFE Index. The cyclical sector over-weight is even greater when compared against other dividend-focused indexes, such as the NASDAQ and the Dow Jones indexes.

Defensive Sector Under-weights: Unlike traditional dividend-paying stocks, the WisdomTree Dividend Indexes shown above tend to be under-weight in a number of the traditional dividend-paying sectors. The defensive sector under-weight is even greater when compared against other dividend-focused indexes.

If one believes that the U.S. or the global economy is starting to recover-which is one of the key factors that can support a further increase in interest rates-one might want to supplement traditional large-cap allocations with increased weight in the more cyclical mid- and small-cap segments such as those shown above- whether in the United States or overseas.

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 shareholders and grow them over time-and the WisdomTree Dividend Indexes focus on these firms.

Domestic Mid- and Small Caps Led: Domestically focused indexes outperformed all internationally focused indexes above, and all but one of the domestic small and mid-cap indexes outperformed the S&P 500 Index. Within the United States, mid- cap indexes beat small and large caps, and core segments beat value cuts.

WisdomTree International Indexes Led: Among the developed international indexes, both the WisdomTree International MidCap Dividend Index and the International SmallCap Dividend Index outperformed the other, more traditional large-cap and market cap-weighted international indexes listed above. Most international small-cap indexes led mid- and large caps, but there was no clear divergence between core and value among the market cap indexes.

Performance Divergence Largest among International Markets: WTISDI and WTIMDI were able to outperform the MSCI EAFE Index by over 2.9% and 1.80% per year, respectively, since their inception. The outperformance of domestic small caps was much lower over the same period, with WTSDI and WTMDI outperforming the S&P 500 Index by over 1.1% and .5%, respectively.

Outperformance Against Managers

A common misconception many investors hold is that, especially in more inefficient markets such as mid- and small caps, active management is critical to successful investing. We have looked at the data and do not accept this premise. Index strategies have performed quite well against their active manager peer groups, especially as periods are extended to five years and beyond.

The WisdomTree MidCap Dividend Index was able to outperform the Russell Midcap Value Index, its performance benchmark, by approximately 0.50% on an average annual basis since inception. The Index also outperformed over 73% of active managers and ETFs in the Morningstar Mid-Cap Value peer group since inception, and over 69% over the most recent three- and five-year periods.

TheWisdomTreeSmallCapDividendIndex was able to out perform the Russell 2000 Value Index, its performance benchmark, by 1.19% on an average annual basis since inception. The Index also outperformed over 54% of active managers and ETFs in the Morningstar Small Value peer group since inception, and over 70% over the most recent three-year period.

The WisdomTree International MidCap Dividend Index was able to outperform the MSCI EAFE Mid Cap Index, its performance benchmark, by 1.72% on an average annual basis since inception. The Index also outperformed over 74% of managers in the Morningstar Foreign Small & Mid-Cap Value peer group.

The WisdomTree International SmallCap Dividend Index was able to outperform the MSCI EAFE Small Cap Index, its performance benchmark, by 1.48% on an average annual basis since inception. The Index also outperformed over 85% of managers in the Morningstar Foreign Small & Mid-Cap Value peer group.

Conclusion

We believe one of the supporting points for equities during the last few years was the income advantage they provided compared to the traditionally low yields available in fixed income securities. There is still a healthy part of the broader market that can offer higher yields than U.S. Treasuries, but it is no longer the majority of stocks in the market, and investors shouldn't look to just large-cap equities.

In our opinion, if investors want to focus on equities for their income potential, mid- and small-cap companies are important tools for providing diversification benefits and increased potential return. Specifically, we think that both domestic and international mid- and small-cap dividend-paying companies deserve a larger share than they're currently being allocated.

Important Risks Related to this Report

Diversification does not eliminate the risk of experiencing investment losses. Dividends are not guaranteed, and a company's future ability to pay dividends may be limited. A company paying dividends may cease paying dividends at any time. Investments focusing on certain sectors and/or smaller companies increase their vulnerability to any single economic or regulatory development. This may result in greater share price volatility. Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. The Dow Jones U.S. Select Dividend Index is calculated, distributed and marketed by Dow Jones Indexes, a licensed trademark of CME Group Index Services LLC, and has been licensed for use.

Investors should carefully consider the investment objectives, risks, charges and expenses of the Funds before investing. To obtain a prospectus containing this and other important information, call 866.909.WISE (9473) or visit wisdomtree.com. Read the prospectus carefully before you invest.

WisdomTree LargeCap Dividend Index: A fundamentally weighted index that measures the performance of the large-capitalization segment of the U.S. dividend- paying market. The Index comprises the 300 largest companies ranked by market capitalization from the WisdomTree Dividend Index. WisdomTree MidCap Dividend Index: A fundamentally weighted index that measures the performance of the mid-capitalization segment of the U.S. dividend-paying market. The Index comprises the companies that constitute the top 75% of the market capitalization of the WisdomTree Dividend Index after the 300 largest companies have been removed. The Index is dividend weighted annually to reflect the proportionate share of the aggregate cash dividends each component company is projected to pay in the coming year, based on the most recently declared dividend per share. WisdomTree SmallCap Dividend Index: A fundamentally weighted index that measures the performance of the small-capitalization segment of the U.S. dividend-paying market. The Index comprises the companies that constitute the bottom 25% of the market capitalization of the WisdomTree Dividend Index after the 300 largest companies have been removed. The Index is dividend weighted annually to reflect the proportionate share of the aggregate cash dividends each component company is projected to pay in the coming year, based on the most recently declared dividend per share. Russell 1000 Index: A measure of the performance of the 1,000 largest companies by market capitalization in the Russell 3000 Index. Russell Midcap Index: Measures the performance of the mid-cap segment of the U.S. equity universe. The Russell Midcap is a subset of the Russell 1000 Index. It includes approximately 800 of the smallest securities based on a combination of their market cap and current index membership. Russell Midcap Value Index: Measures the performance of the mid-cap value segment of the U.S. equity universe. It includes those Russell Midcap Index companies with lower price-to- book ratios and lower forecasted growth values. Russell 2000 Index: A market capitalization-weighted index that measures the performance of the 2,000 smallest securities in the Russell 3000 Index. Russell 2000 Value Index: Measures the performance of the small-cap value segment of the U.S. equity universe. It includes those Russell 2000 Index companies with lower price-to-book ratios and lower forecasted growth values. WisdomTree Global Dividend Index: WisdomTree's broadest measure of dividend-paying stocks, including firms incorporated in emerging markets, developed international markets and the United States, weighted by cash dividends. WisdomTree International LargeCap Dividend Index: A fundamentally weighted index that measures the performance of the large-capitalization segment of the dividend-paying market in the industrialized world outside the U.S. and Canada. The Index comprises the 300 largest companies ranked by market capitalization from the WisdomTree DEFA Index. Companies are weighted in the Index based on annual cash dividends paid. WisdomTree International MidCap Dividend Index: A fundamentally weighted index that measures the performance of the mid-capitalization segment of the dividend-paying market in the industrialized world outside the U.S. and Canada. The Index comprises the companies that compose the top 75% of the market capitalization of the WisdomTree DEFA Index after the 300 largest companies have been removed. Companies are weighted in the Index based on annual cash dividends paid. WisdomTree International SmallCap Dividend Index: A fundamentally weighted index that measures the performance of the small-capitalization segment of the dividend-paying market in the industrialized world outside the U.S. and Canada. The Index comprises the companies that compose the bottom 25% of the market capitalization of the WisdomTree DEFA Index after the 300 largest companies have been removed. Companies are weighted in the Index based on annual cash dividends paid. MSCI EAFE Index (Europe, Australasia, Far East): A market cap-weighted index composed of companies representative of the developed market structure of 22 developed countries in Europe, Australasia and Japan. MSCI EAFE Mid Cap Index: A free float-adjusted market capitalization equity index that captures mid-cap representation across developed markets countries around the world, excluding the U.S. and Canada. MSCI EAFE Mid Cap Value Index: A free float-adjusted market capitalization equity index that captures mid-cap securities exhibiting overall value style characteristics across developed market countries around the world, excluding the U.S. and Canada. MSCI EAFE Small Cap Index: A free float-adjusted market capitalization equity index that captures small-cap representation across developed markets countries around the world, excluding the U.S. and Canada. MSCI EAFE Small Cap Value Index: A free float-adjusted market capitalization equity index that captures small-cap securities exhibiting overall value style characteristics across developed market countries around the world, excluding the U.S. and Canada. S&P 500 Index: A market capitalization-weighted benchmark of 500 stocks selected by the Standard & Poor's Index Committee, designed to represent the performance of the leading industries in the United States economy. NASDAQ International Dividend Achievers Index: Designed to measure the performance of companies in developed international markets that have increased their dividends for the past five consecutive years. Weighting is by dividend yield. NASDAQ US Dividend Achievers Select Index: Designed to track the performance of dividend-paying companies in the U.S. that have increased their annual dividend payments for the last 10 or more consecutive years. Dow Jones EPAC Select Dividend Index: Designed to measure the performance of relatively higher-yielding companies in developed market countries outside the United States that meet certain dividend criteria defined by Dow Jones. Weighting is by dividend yield. Dow Jones U.S. Select Dividend Index: A modified market capitalization approach that weights by dividend yield. Stocks are selected for fundamental strength relative to their peers, subject to various screens such as dividend quality and liquidity.

WisdomTree Funds are distributed by ALPS Distributors, Inc.
Jeremy Schwartz and Tripp Zimmerman are registered representatives of ALPS Distributors, Inc.
© 2014 WisdomTree Investments, Inc. "WisdomTree" is a registered mark of WisdomTree Investments, Inc.

Jeremy Schwartz, Director of Research

As WisdomTree's Director of Research, Jeremy Schwartz offers timely ideas and timeless wisdom on a bi-monthly basis. Prior to joining WisdomTree, Jeremy was Professor Jeremy Siegel's head research assistant and helped with the research and writing of Stocks for the Long Run and The Future for Investors. He is also the co-author of the Financial Analysts Journal paper "What Happened to the Original Stocks in the S&P 500?" and the Wall Street Journal article "The Great American Bond Bubble."

Source: The Forgotten Dividend Payers: Mid- And Small-Cap Equities