Credit: Shutterstock photoSmall cap stocks are traditionally known as centers of growth in the global capital markets. These companies often demonstrate greater risk due to their diminished market footprint. However, they also offer compelling performance and diversification dynamics for investors with a higher risk tolerance.
Most exchange-traded funds that track this segment are focused on broad swaths of the small cap category. They typically own hundreds, if not thousands, of individual stocks with market capitalizations of less than $2-$3 billion.
The largest examples are the iShares Core S&P Small Cap ETF (IJR) and the iShares Russell 2000 ETF (IWM). These two funds make excellent core holdings for those who want to expand their portfolios beyond the traditional large-cap dominated benchmarks.
There is also a segment of the small cap market with compelling benefits for more conservative income investors as well. This is the target demographic for the newly released O’Shares FTSE Russell Small Cap Quality DividendETF (OUSM). O’Shares is known for its smart beta dividend portfolios and outspoken Chairman, Kevin O’Leary, of Shark Tank fame.
The index strategy behind OUSM is based on enhanced criteria that screens for three key factors: high quality, low volatility, and high dividend payout rates. The end result is a basket of more than 300 publicly traded stocks plucked from the thousands in the small cap universe with the highest overall scores in those three categories. The stocks with the highest scores are given the greatest weightings within the portfolio as well.
The largest sector allocations within OUSM include: real estate, consumer discretionary, and financial stocks. Furthermore, there is a maximum cap of 3% for any single security to prevent overexposure to a solitary stock.
At present, OUSM carries a 30-day SEC yield of 3.29% and dividends are paid monthly to shareholders. This monthly dividend stream is an attractive feature for income-focused investors that prefer steadier payments rather than the quarterly lump sums offered by many equity funds.
If history is any guide, there is certainly a great deal of potential for this type of ETF to thrive. O’Shares biggest competitor in this space is the WisdomTree SmallCap Dividend Fund (DES), which has over $2 billion in assets and has been in existence since 2006. DES is really the standard by which all other small cap dividend funds will be matched against.
For comparison purposes, DES owns nearly 700 stocks from a broad range of dividend paying companies and weights its constituents according to their payout ratios. This gives the largest share of assets to the stocks that pay the highest yields. The fund offers a similar 30-day SEC yield of 3.33% and dividends are paid monthly as well.
Side by side, it’s easy to note the more concentrated group of stocks in OUSM is due to the additional screening factors that must be satisfied for inclusion in the portfolio. Profitability and trailing volatility scores are not considered when constructing the DES portfolio.
This creates a point of differentiation for investors to evaluate in their search for an appropriate small cap dividend ETF. More factors do not necessarily mean the fund is better. It simply means there are going to be differing holdings selected and weighted over time that will change the risk and performance of the portfolio over varying market cycles.
It’s also worth noting that OUSM has a slightly higher expense ratio of 0.48% versus 0.38% in DES. This may not seem like a meaningful difference, but both funds carry large premiums to a benchmark-type index such as IJR that charges just 0.07% annually. This is common practice among smart-beta funds that offer a unique portfolio construction methodology.
The Bottom Line
As more trading history develops, it will be interesting to note the differences in performance between OUSM and DES. I’m particularly curious if the volatility screens in OUSM will minimize peaks and valleys in this fund relative to other small cap benchmarks. We will only know for sure with time and real-world trading experience.
Both funds offer compelling index methodologies and reasonable expenses for equity-income investors to consider.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
