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During periods of strong short-term performance, as seen in 2013, it is especially important to ask whether these moves are justified by the underlying fundamentals. We think it is important to be mindful of how an annual rebalance back to an underlying fundamental such as dividends can help manage valuation risks-a key factor in why the non-cap-weighted indexes are included in the "smart beta" category of indexes.

Quantifying the Fundamental Rebalance

With market capitalization-weighted indexes, when constituents increase in price compared to other stocks, they gain greater weight and increase their impact on the performance of the index.

WisdomTree Indexes employ a rules-based rebalancing mechanism that adjusts relative weights based on underlying dividend trends. During the rebalancing process, which occurs once per year for each Index, the relationship between price change and dividend growth is measured. In the table below we quantify the dividend growth for companies that received increases in weight or decreases in weight, and compared that to the overall universe.

Figure 1: WisdomTree Dividend Index (WTDI) Trends

Dividend Growers Saw Weight Increase: The companies that saw their weight increase at the rebalance had a median dividend growth of 17.0%, which was greater than the median dividend growth of all companies (at 8.4%). Companies that saw their weight lowered at the rebalance had a median dividend growth of just 5.1%.

Underperformers Typically Saw Weight Increase: Performance is also a key driver of relative changes. The typical stock that saw its weight increase had a median total return that was over 15 percentage points lower than the median of all stocks.

Outperformers Reduced at Rebalance: The typical stock that saw its weight lowered at the rebalance had a median total return 9 percentage points above all stocks. This is one of the keys to managing valuation risks.

A Detailed Look at the Individual Drivers

The above was a higher-level overview of the total Index, but in the chart below we highlight a few of the top weight increases and decreases to help further specify the contributors.

Figure 2: WisdomTree Dividend Index (WTDI) Details

For current holdings of the WisdomTree Dividend Index, please click here.

Information Technology Earned Largest Increase: The biggest increase in weight for any sector in WTDI occurred in Information Technology-an increase of 0.9%, which was driven primarily by its dividend growth. As noted above; Apple (NASDAQ:AAPL), Oracle (NYSE:ORCL) and IBM (NYSE:IBM) all helped contribute to this increase in weight, having grown their dividends faster than their prices over the period and thus ultimately improving the fundamental relationship between price and dividends.

Health Care Saw Weight Lowered: Over the period, the Industrial and Health Care sectors saw the largest reduction in weight within WTDI. Both sectors saw strong absolute returns over the period, which made it harder for their dividend growth to keep pace. The three examples above that saw a reduction in weight help illustrate this trend, with an average return of 62% over the period, but an average dividend growth below 8%.

Importance of Incorporating a Relative Rebalance

The WisdomTree annual rebalance is a key element of the added value of WisdomTree's Index methodology and can help manage valuation risks. WisdomTree Indexes use dividend growth as a key factor in determining which companies get increased weight at a rebalance. We interpret another year of double-digit dividend growth as a very positive indicator of underlying market fundamentals and believe it helps provide a notable foundation for potential future gains.

Jeremy Schwartz, Director of Research

As WisdomTree's Director of Research, Jeremy Schwartz offers timely ideas and timeless wisdom on a bi-monthly basis. Prior to joining WisdomTree, Jeremy was Professor Jeremy Siegel's head research assistant and helped with the research and writing of Stocks for the Long Run and The Future for Investors. He is also the co-author of the Financial Analysts Journal paper "What Happened to the Original Stocks in the S&P 500?" and the Wall Street Journal article "The Great American Bond Bubble."

Source: Managing Valuation Risk By Rebalancing