Europe, The Small-Cap ETF Way

In the wake of Spanish equities tumbling on allegations of graft aimed at Prime Minister Mariano Rajoy and Italian stocks coming under pressure on speculation that Silvio Berlusconi will win that nation's upcoming election, controversy again surrounds the European investment thesis.

Declining European stock prices amid the familiar themes of escalating controversy and uncertainty could increase the allure of valuations some analyst have recently said are already attractive.

"Generally speaking, we believe that European equity markets are particularly ripe with potential bargains, given the ongoing uncertainty regarding their potential for sluggish economic growth," WisdomTree Research Director Jeremy Schwartz said in a new research note.

Amid those potential bargains, investors willing to embrace some level of risk can consider European small-caps, a market segment that is surprisingly underrepresented in the ETF universe. While small-cap ETFs tracking the likes of Brazil, China and other emerging markets have proven popular with investors, there is just one Europe small-cap ETF listed in the U.S. today.

The WisdomTree Europe SmallCap Dividend Fund (NYSE:DFE) is that fund, and as its name implies, there is compensation in the form of dividends for investors willing to roll the dice on small European equities. Home to nearly $52 million in assets under management, DFE has a 30-day SEC yield of 3.74 percent.

Importantly, DFE's index methodology helps expose investors to those stocks with rising payouts and compelling valuations.

The WisdomTree Europe SmallCap Dividend Index (WTESC) "targets small-cap dividend-paying European companies and weights these companies by the dollar value of the cash dividends that they have paid," according to Schwartz.

"This dividend-focused methodology helps tap into where we see valuation opportunitiesmost typically, firms that increase their dividends over the course of the year but whose share prices fall or stagnate would see increases in weight during the annual Index rebalance, while firms that simply maintain or shrink their dividends but whose share prices rise would typically see decreases in weight," he added.

At the country level, DFE offers exposure to 16 nations, six of which are not eurozone members. The U.K. is by far the ETF's largest country at almost 24 percent, roughly 900 basis points ahead of second-place Italy. Overall, about 40 percent of DFE's country weight goes to non-eurozone members. PIIGS nations represent about 26 of DFE's weight, though Greece is not found in the ETF's lineup.

Given that small-caps typically dwell in highly cyclical sectors, DFE could be an interesting play on thesis that the worst news is already priced into European stocks. Schwartz notes that cyclicality was seen in 2012 when DFE and the MSCI Europe Small Cap Index outpaced two prominent Europe large-cap indexes by health margins.

The MSCI EMU Index, the index tracked by the iShares MSCI EMU Index (NYSE:EZU) performed better than DFE's index during the global financial crisis, but in the past two years, DFE is the winner, though both ETFs are in the red.

"If investors moving into European ETFs are starting to bank on a cyclical recovery coming out of Europe and are trying to get access to some of the relatively low prices of European equities, I believe the European small-cap equity story and specifically DFE is worthy of strong consideration," said Schwartz.

One strategy investors can consider to mitigate Europe risk is to pair DFE with the WisdomTree Europe Hedged Equity Fund (NYSE:HEDJ). Like DFE, HEDJ focuses on European dividend payers.

However, in the case of HEDJ, that ETF is "designed to have higher returns than an equivalent non-currency hedged investment when the value of the U.S. dollar is increasing relative to the value of the euro, and lower returns when the U.S. dollar declines against the euro," according to WisdomTree.

DFE does not offer a hedge against EUR/USD fluctuations, but paired with HEDJ, that strategy could give investors some level of coverage should the common currency's volatility increase.

For more on Europe ETFs, click here.

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