WisdomTree LargeCap Growth (ROI): Different Enough from Peers to Justify Expenses?

A Different Approach

WisdomTree Investments (WSDT.PK) has taken its unique brand of fundamental indexing to a new level with today's launch of the WisdomTree LargeCap Growth ETF (NYSEArca: ROI), the first ETF of its kind. While other large-cap growth ETFs have used a traditional market cap-based approach to weight their components, ROI weights its underlying holdings according to cumulative net income over the prior four quarters, leading to some interesting indexing results. Before it can weight components, the WisdomTree LargeCap Growth Index, upon which ROI is based, whittles down a list of the top 1,000 companies by market cap to a mere 300 components, by focusing on earnings per share, sales per share, book value per share and price per share.

It should be noted that ROI is different from other WisdomTree Earnings funds in that it calculates the net income of its components by excluding special items, while WisdomTree's Earnings ETFs (such as EPI and EPS) weight components according to "core earnings" which is a standardized calculation "designed to include expenses, incomes and activities that reflect the actual profitability of an enterprise’s ongoing operations." (source: WisdomTree 'Investment Philosophy')

Comparison to Market-Cap Weighted Funds

An early proponent of a fundamentals approach to indexing, Wharton Professor and Senior Advisor to WisdomTree, Jeremy Siegel, points out that market cap-weighted funds are the antithesis of the broadly accepted adage 'buy low, sell high'. By increasing a company's weight within a portfolio when its price goes up (i.e. its overall market cap increases) and shedding shares as its price decreases, cap-weighted indexes track past performance instead of approaching the market from a forward-looking perspective. ROI's P/E ratio is significantly lower than that of its peers due to its focus on earnings fundamentals.

Along this line of reasoning, WisdomTree CEO Jonathan Steinberg adds,

“We believe growth’s historic underperformance may have more to do with how the major growth indexes are constructed, than with growth stocks themselves. WisdomTree’s investment philosophy can be applied across the entire field of equity investing. Bringing our fundamental weighting methodology to the growth universe is an important extension of our effort to address what we believe to be the flaws of traditional, market capitalization-weighted indexes.”

This may help explain ROI's outperformance in back-testing versus more traditional large-cap growth funds like iShares Russell 1000 Growth Index (NYSEArca: IWF) and iShares S&P 500 Growth Index (NYSEArca: IVW). This doesn't apply over the short-term but going back five and 10 years, the index underlying ROI significantly outperformed its peers, as the chart below shows.

click to enlarge

chart courtesy of WisdomTree

That being said, the indexes are all highly correlated to each other despite the difference in weighting approach, as the next chart shows. Longer term comparisons are not currently available.

chart courtesy of WisdomTree

Components, Weightings

By taking growth stocks and picking the ones with the best valuations, ROI is essentially a blended fund. For one thing, any growth company with cumulative negative earnings over the prior four quarters is excluded from ROI (the underlying index is reconstituted each April). And since the components are weighted according to cumulative net earnings instead of cap size, the overall weightings are skewed differently in ROI than its top competitor funds.

One blatant example of this is pointed out by Index Universe. He notes that Apple (AAPL) is given a larger weighting than Occidental Petroleum (OXY) in IVW and IWF with its market cap of about $85 billion vs. Occidental's of around $39 billion. However, in ROI OXY is weighted at around 2.3% vs. just 1.9% for AAPL, as it reported around $5 billion in net profits compared to Apple's $4 billion. Another variation is Berkshire Hathaway (BRK.B) accounting for 7% of ROI - the fund isn't included in either IVW or IWF due to the different selection processes underlying the respective funds.

Drawbacks

One obvious disadvantage to ROI is its significantly higher expense ratio (0.38%) than both IVW (0.18%) and IWF (0.20%). WisdomTree's unique approach has also generally meant its ETFs have gathered significantly less assets than traditional, market cap-weighted alternatives. IVW has already gathered $4.01 billion in assets and averages 3.72 million shares traded daily while IWF has amassed an impressive $8.41 billion in assets and volume of 7.96 million shares a day. This means bid/ask spreads that are usually just a penny; it's unlikely ROI will sport such tight spreads in the near future, unless it can steal investor funds away from a cap-weighted approach, to its unique brand of fundamental indexing. It remains to be seen if it can.

• "The Opportunity of Growth Stocks at a Reasonable Price" [pdf file]
• Press Release [pdf file]
• ROI Webpage
• Prospectus

• More on choosing the right ETF