A lot of investors are interested in assembling a diversified portfolio using just a handful of exchange-traded funds. Like all strategies, this has its positive and negative points. The biggest drawback to ETF-only investing is that dividend yields are lower than might be available with a diversified portfolio of common stocks.

Recently, the New York investment-management firm WisdomTree brought 20 new ETFs to the market that help offset the dividend issue. The WisdomTree funds are constructed with an innovative methodology that weights fund components by their dividends, rather than by market cap, so the ETFs yield more than similar funds from other providers.

In addition to the use of dividends in the index construction, the WisdomTree funds capture parts of the market that aren't touched by other ETFs. Among those that are specifically unique are the funds that invest in small- and mid-cap stocks in regions outside the U.S.

There are a lot to explore, but the first one that caught my eye is the WisdomTree International MidCap Dividend Index ( DIM) fund, or DIM.

DIM's composition is complex, making the fund very diversified. The largest component, the Australian industrial company Wesfarmer, has just a 1.07% weight in the fund, and there is only one other stock with greater than a 1% weight. In total, DIM holds 709 stocks.

In trying to decide whether to buy DIM, it's worthwhile to compare it with a common benchmark such as the iShares MSCI EAFE Index ( EFA) fund, or EFA. Investors who don't want the risk of investing in a single stock but who do want diversified foreign exposure may be well served to add a position in DIM in conjunction with a core holding such as EFA.

For starters, DIM has a dividend yield of 3.99%, well above the EFA's 1.7% yield. DIM trades at 14.8 times earnings and has an average market cap of $3 billion. Unfortunately, iShares does not maintain fundamental data for its foreign ETFs because of what it calls inconsistent accounting in some of the countries included in the funds.

The country comparisons between the two funds show some differences. The U.K. is the largest country in each fund, with 25% in EFA and 23% in DIM. Japan comes next at 23% and 13%, respectively. One big difference in country weights is Australia, which is weighted 5% in EFA and 12% in DIM.

The sector makeup between the two is very similar, save for consumer staples and telecom. DIM is much heavier in the two; this makes sense when you think about the domestic stocks in those sectors. Many of them, such as Altria ( MO) or BellSouth ( BLS), have very high dividend yields.

WisdomTree has performed back-testing (calculating how an index might have performed if it had existed in the past) on all of its funds on a year-by-year basis.

Foreign Focus
Year Fund Performance
EFA DIM (back test)
2002 -15.42% -0.46%
2003 40.32% 52.45%
2004 18.93% 33.20%
2005 13.32% 16.32%

The results show that DIM significantly outperforms can add value during certain points in the stock market cycle, such as flat and down periods.

I attribute DIM's somewhat smaller improvement over EFA in 2005 to its underweight position in energy, which had strong gains last year. DIM currently has 2.36% of its assets in energy, while EFA has a much bigger 8.17% weighting in the category.

As a whole, DIM's dividend yield, combined with its decent returns, makes it an adequate replacement for EFA, or at least something that can be owned in conjunction with the popular foreign benchmark.
As originally published, this story contained an error. Please see Corrections and Clarifications.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, Ariz., and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.