DGRS Looks Like Great Diversification At First, But Poor Liquidity Is More Likely

By | January 7, 2015

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  Summary I’m taking a look at DGRS as a candidate for inclusion in my ETF portfolio. The ETF tracks small dividend paying stocks, but the yield isn’t too great. The correlation to SPY is low, but the statistics are unreliable because of poor liquidity. Diversification within the portfolio isn’t bad, but it isn’t amazing either. I’m not assessing any tax impacts. Investors should check their own situation for tax exposure. Investors should be seeking to improve their risk adjusted returns. I’m a big fan of using ETFs to achieve the risk adjusted returns relative to the portfolios that a normal investor can generate for themselves after trading costs. I’m working on building a new portfolio and I’m going to be analyzing several of the ETFs that I am considering for my personal portfolio. One of the funds that I’m considering is the WisdomTree U.S. SmallCap Dividend Growth Fund (NASDAQ: DGRS ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification to reduce my risk level. What does DGRS do? DGRS attempts to track the total return (before fees and expenses) of the WisdomTree U.S. SmallCap Dividend Growth Index. At least 90% of the assets are invested in funds included in this index. DGRS falls under the category of “Small Blend”. Does DGRS provide diversification benefits to a portfolio? Each investor may hold a different portfolio, but I use (NYSEARCA: SPY ) as the basis for my analysis. I believe SPY, or another large cap U.S. fund with similar properties, represents the reasonable first step for many investors designing an ETF portfolio. Therefore, I start my diversification analysis by seeing how it works with SPY. I start with an ANOVA table: (click to enlarge) The correlation is excellent at 74.6%. I want to see low correlations on my investments. Extremely low levels of correlation are wonderful for establishing a more stable portfolio. I consider anything under 50% to be extremely low. However, for equity securities an extremely low correlation is frequently only found when there are substantial issues with trading volumes that may distort the statistics. Standard deviation of daily returns (dividend adjusted, measured since August 2013) The standard deviation is great. For DGRS it is .8929%. For SPY, it is 0.6717% for the same period. SPY usually beats other ETFs in this regard. However, many ETFs won’t lose this badly to SPY, but it is worth noting that the standard deviation is pretty high. The best way to counteract the high standard deviation for an ETF with low correlation is to simply use it as a fairly small part of the portfolio. Liquidity is awful Average trading volume is absolutely terrible. The average volume for the last 10 days is only 3,181 shares. It’s possible to buy and sell in an ETF with terrible liquidity, but it is a very unattractive feature for the casual investor seeking diversification. I checked the change in closing values looking for the 0.00% change in dividend adjusted close that could indicate a day in which 0 shares changed hands. In the time period I used, from August 2013 through the middle of December 2014, there were 11 days where there was no change. It is possible that this is simply a coincidence, but investors should be aware that the presence of these days represents a challenge to the validity of the correlation and standard deviation that were calculated. The real values may be lower or higher, though I think higher is more likely than lower. Mixing it with SPY I also run comparisons on the standard deviation of daily returns for the portfolio assuming that the portfolio is combined with the S&P 500. For research, I assume daily rebalancing because it dramatically simplifies the math. With a 50/50 weighting in a portfolio holding only SPY and DGRS, the standard deviation of daily returns across the entire portfolio is 0.7321%. With 80% in SPY and 20% in DGRS, the standard deviation of the portfolio would have been .6811%. If an investor wanted to use DGRS as a supplement to their portfolio, the standard deviation across the portfolio with 95% in SPY and 5% in DGRS would have been .6721%. Why I use standard deviation of daily returns I don’t believe historical returns have predictive power for future returns, but I do believe historical values for standard deviations of returns relative to other ETFs have some predictive power on future risks and correlations. Yield & Taxes The distribution yield is 1.85%. This is a little low for retirees hoping to use the yield for income, but I’d be even more concerned about the poor liquidity if the investor had any liquidity needs. I wouldn’t consider an illiquid investment with only a moderate distribution yield if I were a retiring investor. I’m not a CPA or CFP, so I’m not assessing any tax impacts. Expense Ratio The ETF is posting .38% for both the gross and net expense ratios. I want diversification, I want stability, and I don’t want to pay for them. The expense ratio on this fund is higher than I want to pay for equity securities, but not high enough to make me eliminate it from consideration. I view expense ratios as a very important part of the long term return picture because I want to hold the ETF for a time period measured in decades. Market to NAV The ETF is at a .09% premium to NAV currently. Premiums or discounts to NAV can change very quickly so investors should check prior to putting in an order. The premium isn’t enough to be concerned about, but the liquidity issues could still result in a large bid-ask spread. If an investor was determined to invest in DGRS, I would hope they would use limit orders and be wary of crossing the spread. Largest Holdings The diversification within the ETF isn’t too bad. Unfortunately, it isn’t too good either. The top ten positions are all in the 2% to 1% range. (click to enlarge) Conclusion I’m currently screening a large volume of ETFs for my own portfolio. The portfolio I’m building is through Schwab, so I’m able to trade DGRS with no commissions. I have a strong preference for researching ETFs that are free to trade in my account, so most of my research will be on ETFs that fall under the “ETF OneSource” program. While I like the low correlation, I’m concerned that if liquidity were higher the correlation would also be higher. If the ETF had a substantial increase in volume without a significant increase in correlation, I’d be contemplating it. As it stands currently, I don’t see enough value to make it worth the headache of the low liquidity. I’ll be knocking it off my list of ETFs to consider for my long term portfolio. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis. The analyst holds a diversified portfolio including mutual funds or index funds which may include a small long exposure to the stock. Scalper1 News

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