DGRS: Comes Up Short On Size, Quality And Growth

The WisdomTree U.S. SmallCap Quality Dividend Growth Fund (NASDAQ:DGRS) has the objective of tracking the results of dividend-paying small-cap companies with growth and quality characteristics in the U.S. equity market.

What type of investor would DGRS be suitable for?

If you want exposure to small-cap stocks, then DGRS might be able to lower the risk of buying junk.

• Most small-cap investors would like to see their tiny stocks grow into very big stocks. The growth factor may help with that.
• Dividends may possibly find you fundamentally sound stocks. It is unlikely that a small company that relies on share dilution for growth will be paying out dividends.
• Finally, the quality factors could isolate a group of stocks where you can trust the earnings… where they are not being juiced or manipulated. High quality earnings for a small-cap company could potentially reduce the risk of untrustworthy earnings.

It all sounds very good. Let’s open the hood and look at how this fund is designed.

Is it a Small-Cap Fund?

First up, I want to determine whether this is actually a small-cap fund. My definition, which is the most common one you will find, is that small-caps are between $300mm to $2B of market capitalization.

Herein lies the problem. Fund managers want to amass a pile of assets as more money in the fund means more total fees. But small-cap stocks cannot handle massive piles of cash funneled into them on a single day. The solution many funds take? Stretch the definition of small-caps to include larger stocks.

To analyze DGRS I first downloaded a list of all holdings from their website. I then looked up the market-caps for each holding. The spreadsheet of holdings also has the weighting for each position. This is what I found.

• The top 57 stocks by weight make up 50% of the fund
• The remaining 230+ stocks make up the other 50% of the fund
• Of the top 57 stocks, the average market-cap is $2.5B

On the website, ETF.com, they state that the weighted average market-cap of this fund is $2.51B.

Keep in mind that this is an average. Some stocks are bigger and some are smaller. I would prefer to see the average at $1B or even $1.5B for a small-cap fund. I consider this to be a very small mid-cap fund. If you are investing in this solely for the size factor, there are better options out there.

Quality or Efficiency?

WisdomTree throws around the term ‘quality’ quite a lot. But what exactly is quality? How do they define it?

• They define quality as profitability.

To be fair, the quality factor is one of the more ambiguous ones. It isn’t as clearly defined as value, momentum, sentiment or growth. There may be some crossover between profitability and quality, but I wouldn’t call them the same thing.

Profitability is an efficiency ratio. It tells you how much money is being made off a certain amount of assets. All things being equal, you want an efficient company who can make loads of profit without intensive capital expenditures. But this may also have you finding companies that are service-based, which don’t require loads of assets.

The term quality, however, is usually in reference to the quality of earnings. Below is an example of why the quality of earnings is important.

You have 2 companies. They have the same market-cap. They have the same revenue. They have the same profit. The companies appear equal. But are the earnings truly the same? Not necessarily.

• Compare the amount of cash coming in with the booked profit. Is much of the profit in the form of accruals but not actual cash flow?
• Are the earnings based on regular operations or are some one-time events boosting it?
• Is the company carrying loads of debt so that the profit is being made on leverage?

Quality should give you an indication of how much you trust the earnings and whether you think it is being manipulated to look better than it actually is.

There is some crossover between profitability and quality, but I don’t feel that they are the same thing. In the DGRS prospectus, they define quality as return on equity and return on assets.

I feel that this comes up short for quality factors.

Growth Factor

DGRS finds growth stocks by looking at the long-term earnings growth expectations. I don’t have any specific issue with this as it will indeed screen stocks which are expected to have high growth. I give it a pass on this factor.

However, on a different note, I would encourage investors to be wary of investing in growth stocks without any consideration to value. This is why…

Analysts have been known to be overly optimistic as to future growth prospects. There is a lot of literature written on the subject, and here is just one paper discussing analyst optimism. Firms that are harder to forecast will often have more optimism from analysts. What this means is that firms with very high expected future growth prospects are more prone to miss the mark.

Now, this wouldn’t be a problem if the average investor was pricing this in. Perhaps the growth is expected to be 30%, but the investor realizes that it is probably closer to 15 or 20% at best. Thus, the share price will reflect a more reasonable forecast. But if the unrealistic forecast is already baked into the price, you will typically have price underperformance when the high earnings forecast is not realized.

There are ratios such as the PEG (price to earnings divided by growth) that tries to combine buying growth at a reasonable price. The idea is that growth and the PE ratio should be roughly equal or less for a reasonable buy. 30 percent future growth at a PE of 30 is one example.

Again, I don’t fault the fund on how they use the growth factor. But I merely mention this as a caution to investors since I personally believe that investing in growth should be done through the perspective of value. High growth, even if you are correct, may be a bad investment if the current price isn’t right.

Rebalancing

It is in a fund’s best interest to keep turnover down as much as possible. This will reduce cost to the end investor. High turnover in small-caps leads to high slippage, which in turn erodes performance. DGRS rebalances and reconstitutes once per year.

I am all for keeping costs down. You definitely do not want to overtrade small stocks, and particularly when you have a lot of AUM. But I don’t think that annual rebalancing is the most efficient way to go about this.

The problem with annual rebalancing is that it is not timely or responsive to a change. What happens if analysts downgrade a stock’s earnings prospect one month after the rebalance date? You hold it for the next 11 months, even though it doesn’t belong in the fund. You also introduce timing risk. What makes one specific date better than another? Due to bad luck, you could rebalance at the wrong time.

A better approach would be to have the rebalance or reconstitution points more frequently. To keep turnover down, you also want to add a buffer. For example, suppose you invest in the top 100 stocks with the highest growth prospects out of a potential 1,000 stocks. Every month you examine the holdings, and you replace a stock only if it drops to the 200th place or worse. Thus, you have added in a ranking buffer. This allows you to replace a stock if it no longer fits your definition of a good holding, but it also keeps turnover down.

Performance

When it comes to performance, I find very little difference between this and the Russell 2000 index. You get slightly more dividend yield with DGRS. But as for real-world performance since inception, they look so similar to me that I doubt the diversification benefits of DGRS over IWM. As IWM has a lower expense ratio of 0.19% versus 0.38%, it is hard for me to see what additional benefit DGRS is providing.

Final Thoughts

My main concern with DGRS is that I don’t see the additional benefits of how it is designed over and above a simple cap-weighted Russell 2000 ETF at a lower cost.

• DGRS is too big in my opinion to be a true small-cap allocation.
• My preference is to focus on dividends or growth but not both. A fast-growing company shouldn’t be paying dividends, and a dividend-paying company likely isn’t at the top of its growth cycle.
• I question what they call quality factors as they seem to be efficiency factors.
• I prefer to invest in growth when combined with some sort of value.
• Finally, I find annual rebalancing to be too infrequent. There are ways to make it more responsive and timelier without increasing turnover.

For me, DGRS is a pass. There may be a slight advantage to dividend stocks in that there might be a small value tilt. This may provide a bit of downside protection in bad markets. Maybe. Recently, dividend companies have outperformed. But I don’t believe that the benefit is enough for me to recommend this above a broad Russell 2000 fund.