Dividend-paying stocks are compelling to investors for many reasons. They tend to be less volatile as a group. They provide a real cash return right away. And they can also reflect management's long-range visibility on profits and show its commitment to partnering with shareholders.
Back in 2006, WisdomTree Investments began weighting some of its equity exchange-traded funds not by each company's market value (as was the traditional indexing approach, popularized by Vanguard), but rather by total dividends paid. WisdomTree's rationale made some sense -- at least in theory.
Indeed, the group supported this theory by backtesting the strategy from 1964 to 2005. It found that not only did the portfolios exhibit lower volatility, but also that "four of the six WisdomTree Domestic Dividend Indexes generated greater price appreciation than the S&P 500 Index, even without the reinvestment of dividends."
Unfortunately, this dividend-weighted theory rested on one enormous assumption: The dividend-paying environment would continue to behave roughly the same way it had for that 41-year testing period.
As we're all now well aware, the dividend landscape dramatically changed as the financial crisis began in 2008. The past two years have been the worst stretch for dividend investors in modern history. According to Standard & Poor's, there were 804 dividend cuts in 2009 alone, including those from Discover Financial Services (NYSE: DFS ) , Newell Rubbermaid (NYSE: NWL ) , and CBS (NYSE: CBS ) , costing investors a total of $58 billion in income.
Needless to say, these massive dividend cuts did some damage to WisdomTree's dividend-weighted strategy. As of Dec. 31, none of the six domestic dividend exchange-traded funds had outperformed their respective benchmarks since inception.
In fact, the worst-performing WisdomTree domestic dividend ETF has been the High-Yielding Equity Fund (DHS) -- or, as it was curiously but unsurprisingly renamed last March, the Equity Income Index. Whatever name it goes by, this dividend-weighted ETF is down 20% since its inception in 2006, much worse than the 3% lost by the S&P over the same period.
The wide underperformance of the ETF largely results from its dividend-weighted design, which aims 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." In other words, if Company A is expected to pay $500 in cash dividends next year, it should have a larger weight in the index than Company B, which is expected to pay $250.
Under normal circumstances, that sounds like a nice way to generate extra dividend income and stack your bets behind strong companies. This year, though, has been anything but normal. The higher-yielding stocks have faced the greatest pressure on their dividends.
To illustrate this problem, as of Dec. 31, 2008, the Equity Income Index's top five holdings were General Electric, Bank of America, AT&T, Pfizer, and JPMorgan Chase, which together made up about 35% of the ETF's assets at the time. Only one of those companies -- AT&T -- didn't cut its dividend in 2009.
Adding insult to injury, the ETF only rebalances once annually, rendering it effectively helpless in a rapidly changing dividend environment. As dividend-dependent investors flocked out of stocks with dramatically lower payouts, this ETF had to sit and grind it out, hoping to benefit from other holdings like Duke Energy (NYSE: DUK ) and Southern Company (NYSE: SO ) .
In fact, only recently was the ETF able to rebalance with stocks still paying substantial dividends. Fortunately, there are some stronger names among this year's top 10 holdings, including Chevron (NYSE: CVX ) and McDonald's (NYSE: MCD ) . However, some 35% of the ETF's overall assets now reside in consumer-based stocks, which may have their own problems in coming years if consumer spending doesn't recover.
A better way
For investors seeking to benefit from the advantages of dividend-paying stocks, the WisdomTree Equity Income ETF is one investment to avoid. Because no company ever guarantees dividends, selectivity is essential, leaving mechanical strategies like this one at a major disadvantage. Among other things, savvy dividend investors will want to look for companies with solid balance sheets, a history of increasing dividend payouts, and plenty of free cash flow to cover the payments.
One company that fits this bill is PepsiCo -- which our Motley Fool Income Investor team has classified as a "Buy First" stock. At present, Income Investor picks yield 4.1% on average.
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This article was originally published March 5, 2009. It has been updated.
Fool analyst Todd Wenning warns you that when in Paris, it is illegal to stare at the mayor. He does not own shares of any company mentioned. Pfizer and Discover Financial Services are Motley Fool Inside Value picks. PepsiCo, Duke Energy, and Southern Company are Income Investor choices. The Fool's disclosure policy tells it like it is.