By Michael Rawson

WisdomTree LargeCap Dividend ETF (NYSEARCA:DLN ) provides a handy alternative U.S. equity core holding for investors who want a value tilt and extra income. This fund targets high-dividend-paying companies and forgoes the standard market-capitalization weighting scheme traditional market indexes, such as the S&P 500, use. Instead, WisdomTree has an annual rebalancing in December when it assesses how much each company plans to pay in dividends over the next year and then weights each company’s common stock by its percentage of the total planned dividend payout of all companies in the portfolio. This means that the top companies in DLN’s portfolio are still the mega-caps, such as Exxon Mobil (NYSE:XOM ) and Procter & Gamble (NYSE:PG ). But it provides a more distinct value flavor by excluding non-dividend-paying companies and larger stakes in high-yielding but volatile smaller-cap companies.

Historically, a large portion of the returns from investing in stocks has come from dividends. However, stocks that pay unsustainably high dividends are often distressed and are likely to see their dividends and share prices fall in the future. By weighting stocks by total dollar payout, rather than by dividend yield, this fund attempts to avoid overweighting stocks that are likely to cut their dividends. Still, there is also no guarantee that firms that have paid or increased dividends in the past will continue to do so. The portfolio shies away from higher-growth, lower-yielding sectors, such as technology, business, and consumer services, while loading up on the traditional dividend-heavy industries, such as utilities. This does not lead to a lower-quality portfolio, just one in which more of the profits are distributed to shareholders rather than reinvested in the business.

To see how the fund’s unique approach to dividend investing works, consider a portfolio of the following three stocks. The first two are large-cap companies that pay a large dollar amount of dividends, but with relatively small yields. The third is a risky small-cap company with a high yield. By weighting the stocks by dollar amount of dividends, the risky company gets a small weighting. On the other hand, a portfolio that weights based on dividend yield would put its largest weighting in the volatile small-cap company. Because larger companies tend to pay out more in absolute dollars, the fund’s dividend weighting approach balances yield against market capitalization. As a result, the portfolio isn’t dominated by either low-yielding mega-cap stocks or very high-yielding, risky names (as might result from a naive dividend-yield approach).

On average, dividend-paying stocks have outperformed nonpayers going back to 1926. However, there can be greater risk from either high-yielding and low-quality value traps or from economic cycles that favor growth companies. In the current low-interest-rate environment, investors have shown an unusual preference for the dividend-paying stocks. This is likely due to bond investors taking more equity exposure in search for greater yield and due to equity investors preferring the safety of dividend payers in this low-growth environment. As a consequence, dividend-paying stocks look expensive relative to the historical record and it is far from guaranteed that they will outperform their non-dividend-paying brethren.

This fund tracks the WisdomTree LargeCap Dividend Index, which compiles stocks that have paid regular cash dividends in the 12 months prior to index reconstitution and selects the 300 largest such companies by dividends paid. Rather than market-cap-weighting, the benchmark weights constituents based on projected cash dividends to be paid over the next year. The company projected to pay the most cash to its shareholders over the coming year receives the largest weighting.

Investors have a number of excellent options when searching for a dividend orientated ETF. Schwab US Dividend Equity ETF (NYSEARCA:SCHD ) is the cheapest in the category at just 0.07%. SCHD’s constituents must pass a variety of screens, including paying dividends for the past 10 consecutive years. SCHD has one of the highest-quality portfolios among dividend ETFs.

Vanguard offers a pair of dividend ETFs. Vanguard High Dividend Yield ETF (NYSEARCA:VYM ) (0.10% expense ratio) sorts U.S. stocks by their forecast annual dividend yield and weights them by their market cap. VYM has a value tilt compared with Vanguard Dividend Appreciation ETF (NYSEARCA:VIG ) and yields slightly more. Like VIG, VYM is a relatively conservative dividend strategy and is appropriate as a core holding for most investors. VIG also charges 0.10% and targets companies that have raised their dividends in each of the past 10 years.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

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