By Jeremy Schwartz, CFA, Director of Research; Christopher Gannatti, CFA, Associate Director of Research; Eswarie Subrahmanyam S. Balan, Research Analyst
The recent months have seen a wide proliferation of the term "smart beta," which in its simplest terms indicates an index construction that does not weight constituents by market capitalization but incorporates some type of rules-based rebalancing process. A wide array of strategies are starting to have live performance histories greater than five years, making them eligible for consideration across a broader clientele. What are these various smart beta index strategies really doing when one looks under the hood?
Some have called smart beta just "small-cap tilted." Some have called smart beta just repackaged value strategies, and others have even referred to it as making an active bet on the market. We undertook a rigorous regression analysis to help explain factor loadings of various indexing strategies to quantify how big a "bet" these strategies are making on various factors, which can help explain their return patterns.
Smart Beta Strategies Under Analysis
Smart beta encapsulates a wide range of strategies. In this market insight, we focus on explaining the various factor exposures and performance for WisdomTree's U.S. equity strategies with at least five years of performance history:
Dividend-Focused Strategies: WisdomTree has a family of dividend-weighted Indexes, which we compare here to three other widely followed indexes that focus on dividend payers: 1) S&P High Yield Dividend Aristocrats Index, 2) NASDAQ U.S. Dividend Achievers Select Index, and 3) Dow Jones U.S. Select Dividend Index.
Earnings-Focused Strategies: WisdomTree also has a family of earnings-weighted Indexes, which look to measure the performance of profitable U.S. firms weighted by earnings.
S&P 500 Equal Weight Index: We see "factor-based" indexes as a popular subcomponent of smart beta and therefore wanted to include this index, which indicates how the factor sensitivities look if each of the 500 constituents is weighted equally. It's one of the simplest takes on smart beta, applied to one of the most widely followed equity indexes in the world.
What Is Smart Beta?
We think an important component of these index strategies regards the exposures being generated and how those exposures explain returns. One way to do this is through the use of a statistical factor model.
Professors Eugene Fama and Kenneth French have developed a factor-based approach to analyzing the performance of a particular investment strategy or index. In essence, there are four factors, each meant to have some degree of explanatory power over returns. It's important to note that this analysis is wholly dependent upon the period of study:
Market: This factor is meant to denote exposure to the market's "risk premium"-a figure that is calculated by looking at the equity market's return minus the risk-free rate. Higher values here indicate an increased sensitivity to potentially amplify the impact of market movements.
Size: This factor is meant to denote exposure to different market capitalization size segments. More negative values indicate exposure to the larger capitalization size segments, whereas more positive values indicate exposure to smaller capitalization size segments.
Value: One of the most widely referenced strategy style distinctions is the differentiation between "value" or "growth" exposure, as each can have a very unique risk/return profile. In these results, a more positive figure indicates a greater sensitivity to the value style, whereas a more negative figure indicates a greater sensitivity to the growth style.
Momentum: One factor that has received attention more recently is momentum, which measures the propensity of an investment strategy to capture different trends exhibited by the market. A more negative value here indicates essentially a lack of momentum, whereas a more positive value indicates a greater potential sensitivity to this factor.
In theory, each one of these factors has the potential to become more or less favored over time, so if smart beta approaches give more weight to some and less weight to others, this could be of particular interest as people look to set up exposures congruent with their broader economic thinking.
Market Factor Takeaways: When viewing the market factor, it becomes clear that dividend-focused strategies exhibit lower market factor sensitivity than either earnings-weighted, equal-weighted or market capitalization-weighted approaches. This is another way of quantifying the lower volatility (lower market beta) of traditional dividend-based strategies.
Mid-Caps Have Higher Market Beta: With the WisdomTree MidCap Dividend Index as the lone exception, every index focused on exposure to the mid-capitalization size segment had a market factor above 1, possibly explaining some of the strong mid-cap performance seen in figure 1 for this period.
Size Factor Takeaways: The WisdomTree LargeCap Dividend and Equity Income Indexes indicated size factors more than twice that of the S&P 500 Index. When critics characterize smart beta as being a tilt to small caps, they are clearly not talking about WisdomTree's large-cap dividend or earnings approaches, which are more large cap than the S&P 500. Part of this distinction is caused by the fact that WisdomTree selects stocks by market capitalization for its size-based segments, while weighting securities by the dividends or Earnings Streams. In our opinion, that selection rule results in more pure size segmentations across the spectrum.
Interestingly, of all the dividend payers, the WisdomTree Dividend Index, which includes more than twice the securities of the S&P 500 over this entire period, still has a greater large-cap bias and more loading to large caps than the S&P 500 (more negative size factor than the S&P 500 Index).
Value Factor Takeaways: With the exception of the NASDAQ U.S. Dividend Achievers Select Index (the only dividend-focused index shown here to be weighted by market capitalization), the dividend-focused strategies all tilt significantly toward the value end of the spectrum. On the other hand, the earnings-weighted strategies in each respective size segment tilt much more toward core15 exposures. The WisdomTree MidCap Earnings Index, the best-performing Index over this period, is the only fundamentally weighted Index shown here with a slight growth tilt, illustrated by its negative sensitivity to the value factor.
The WisdomTree LargeCap Dividend Index had a value loading of .303, which was greater than the Russell 1000 Value Index's of .298, but below that of the S&P 500 Value Index, which was .310. But its value orientation was clear over this period.
Momentum Factor Takeaways: Most of the indexes shown exhibit either a negative sensitivity to the momentum factor or a tiny positive sensitivity to the momentum factor. The largest positive sensitivity is shown by the NASDAQ U.S. Dividend Achievers Select Index, the only index shown that both requires historical dividend growth as part of its stock selection and weights by market capitalization. The rules-based rebalancing of smart beta indexes typically involves a process to sell the stocks that outperform their fundamentals-which, to a large extent, is an anti-momentum process. This negative momentum factor exposure was strongest in the WisdomTree MidCap Earnings, WisdomTree Equity Income and WisdomTree SmallCap Earnings Indexes. The negative momentum of these three WisdomTree Indexes was even stronger than the negative factor exposure to momentum in the S&P 500 Equal Weight Index, which by definition-in order to maintain its equal-weight strategy-adds weight to all losing positions and subtracts weight from all winning positions with no regard to fundamental changes in those companies.
Zooming In On The Size Factor
In figure 1, we definitely saw a potential for mid-cap indexes to outperform the others over this particular period, whereas some of the largest indexes actually delivered some of the lowest returns. However, as we introduce different weighting methodologies, it is of particular interest to note how that influences the size exposure picture.
Equal Weighting: We can start with the classic, intuitive example of equal-weighting the S&P 500 Index to illustrate how different weighting methodologies can influence the size factor of a particular index. We see that the S&P 500 Index registers a negative value (meaning that it's tilting toward exposure to larger companies) whereas the S&P 500 Equal Weight Index registers a positive value (meaning that its size exposure is tilting toward smaller companies).
It's interesting that the S&P 500 Equal Weight Index has a very similar size factor to the WisdomTree MidCap Dividend Index.
Considering The "Forgotten Size Segment"-Mid-Caps
While many allocate specifically to large caps and/or small caps, mid-caps tend to become something of a forgotten size segment. We thought it'd be interesting to strip away all the non-mid-cap indexes in order to emphasize the size variation across the different mid-cap indexes that we show in this piece.
Fundamentally Weighted "Book-Ends": It's interesting that the WisdomTree MidCap Dividend Index (WTMDI) is the largest mid-cap Index shown, whereas the WisdomTree MidCap Earnings Index (WTMEI) is the smallest: 0.20 to 0.52 represents a wide variation in size exposure, in our opinion, and therefore very different potential risk and return characteristics.
Two Blends Worth Considering: Based on these figures, a blend of approximately 75% WTMDI and 25% WTMEI would match the size factor of the Russell Midcap Index, whereas a blend of approximately 72% WTMEI and 28% WTMDI would match the size factor of the S&P MidCap 400 Index. These are very different portfolios, which helps us emphasize that benchmark selection is very important when considering mid-cap equities in the U.S. Figure 2c provides the other relevant factor exposures and average annual returns for these blends.
ZOOMING IN ON THE VALUE VS. GROWTH DISCUSSION
One of the primary points visible in figure 1 was the outperformance of growth indexes during this particular period. For those expecting a continuation of that trend, it could be useful to note how WisdomTree's earnings-weighted approaches tend to be less tilted toward the value end of the spectrum. For those potential contrarians believing that the longer-term performance of value over growth has the potential to come back into focus, the dividend-focused strategies can be of particular interest.
The WisdomTree MidCap Earnings Index: It makes sense to call this Index out as the top performer among the indexes shown over this period. Of the WisdomTree's U.S. Equity Indexes with at least five years of history, this was the one closest to being on the growth end of the spectrum.
Bias toward Value: There are many indexes that do not necessarily have the word "value" in their name but tend to exhibit positive, albeit small, value factor sensitivities. Of the indexes shown, there are far fewer that exhibit negative factor sensitivities to value.
Taking Action: Developing Investment Themes Based On Factor Exposures
Now that we've calculated the factor exposures and highlighted some of the results, the logical next question is what to do with this information. The real issue is how this data might be used strategically for the construction of portfolios looking for exposures to certain factors.
Take 1: Matching The Size Exposure Of The S&P 500 Index
One of the most widely followed equity indexes is the S&P 500, viewed as a measure of the performance of large-cap U.S. equities. Of course, we believe many are more interested in the concept of utilizing different strategies with the potential to outperform the S&P 500 Index consistently on a risk-adjusted basis.
Looking at the results in figure 1 is one way to come up with a framework from which to build such strategies. Now, the S&P 500 Index over this particular period had:
- A market factor of 1.00
- A very slight value factor of 0.03
- A momentum factor of 0.00
- A size factor of -0.15
Therefore, the only factor to really consider based on these figures is size. Now, while many think of the S&P 500 Index as a large- cap option, with a size factor of -0.15 it clearly isn't the largest option shown in figure 2a-the WisdomTree LargeCap Dividend Index (WTLDI), with a size factor of -0.348 is significantly larger. The WisdomTree Earnings 500 Index (WTEPS) is also larger than the S&P 500 Index, with a size factor of -0.214. We think it's interesting to consider blending WTLDI and WTEPS with mid-cap options in order to bring the weighted average size exposure into alignment with that of the S&P 500 Index, and the two mid-caps we use are the WisdomTree MidCap Earnings Index (WTMEI) and the WisdomTree MidCap Dividend Index (WTMDI).
Lowering the Market Factor: The market factor statistic is very similar in its interpretation to what many view as the beta statistic, so a value of less than 1.00 could indicate the potential for reduction in volatility.
Raising the Value Factor: Each of the blends applies an annual rebalance with a focus on relative value. On the other hand, the 500 stocks selected by Standard & Poor's for the S&P 500 Index are weighted by their market capitalizations, and it is not an approach that is sensitive to relative valuation.
Potential for "Anti"-Momentum: Another attribute of a relative value rebalance is the disciplined way in which it tends to remove weight from stocks whose price increase exceeded the growth of their fundamentals. In essence, this disciplined removal of weight from stocks that have tended to perform strongly and redeployment into the potential performers of tomorrow could account for the minus sign in front of the momentum factor.
As people consider ways in which to potentially outperform the S&P 500 on a risk-adjusted basis, we believe this is an example of one approach that could be of interest. It also shows that as one looks to add in the WisdomTree large-cap options, there is a large-cap bias to their construction, at least relative to the size factor of the S&P 500 that could impact desired allocations in other market capitalization size segments.
Take 2: What Does Lower Beta (Lower Market Exposure) Really Mean?
One framework for analysis: Given that dividend-weighted indexes historically show a lower market beta or market factor exposure, which could be interpreted as a way of reducing equity market risk, one question is: How much cash combined with a market capitalization-weighted index would blend to target the market factor exposure of a dividend-weighted index?
A Note about the Period: In any analysis such as this, period selection is of paramount importance. The most influential event occurring over the period we are able to study is the global financial crisis of 2008-09, where it would actually have been beneficial to be in a strategy that was not exposed to the risks of the equity market. The fact that the WisdomTree LargeCap Dividend Index and the WisdomTree SmallCap Dividend Index each outperformed their respective blended benchmarks with cash components, we believe, is quite impressive. Over longer time frames, we would expect the lower expected return of cash and the higher expected return of equities to come through with greater clarity in the illustration.
The Crux of Dividend Weighting: What we see is the need to use a cash component to bring down each of the value cuts of the respective market capitalization-weighted benchmarks in order to match the market factor of the dividend-weighted indexes. Additionally, we also see how the value factor is emphasized.
Take 3: Building Exposure To The Market Capitalization Size Spectrum
We believe that people tend to clearly allocate in the large-cap and small-cap directions-these are widely followed sections of the U.S. equity markets. However, one area that tends to garner much less focus is the mid-cap space, and we know from our analysis thus far that for this period in particular mid-caps have delivered very strong performance. What we look to do here is provide one logical framework in which to think about mid-cap allocations.
In essence, our approach was to take the Russell 3000 Index as of December 31, 2013, and cut it as follows. Approximate weights:
+ Large caps: Over $10 billion in market capitalization (78.4% weight)
+ Mid-caps: Between $2 billion and $10 billion in market capitalization (16.4% weight) + Small caps: Below $2 billion in market capitalization (5.2% weight)
What if we allocated to the WisdomTree Large-, Mid- and SmallCap Indexes in the same proportions as large, mid- and small caps appear in the Russell 3000 Index?
Dividend Blend: Simply put, the major attributes of the dividend blend, compared to the Russell 3000 Index, are 1) lower beta, 2) exposure to larger companies, and 3) a greater tilt toward the value style. We believe that this is congruent with what we've shown about the WisdomTree Dividend Indexes earlier in this piece.
Earnings Blend: The major attributes of the earnings blend, compared to the Russell 3000 Index, are 1) slightly lower beta, 2) very similar size, and 3) very similar "core" allocation with such a low value factor. The crucial point is that all of this was accomplished with nearly 100 basis points16 of incremental average annual performance ahead of the Russell 3000 Index.
The Total Return Picture
At the end of the day, what brings all of this together is the total return. Over this particular period, which strategies performed the most strongly? This allows us to look in the rearview mirror and identify the types of factor sensitivities that performed the best.
Over this particular period in time, a few interesting themes emerged:
Growth Outperformed Value: The S&P MidCap 400 Growth, S&P 500 Growth, S&P SmallCap 600 Growth and Russell 2000 Growth indexes performed strongly-much more so than their "value" counterparts. So, in essence, much of the research from Professors Fama and French, which discussed the exposures of the "value premium" and hence the model to estimate exposure to value, did not hold over this period. There was some headwind for the WisdomTree Indexes, which have a high loading to the value sensitivity factor-which was especially true for the Dividend Indexes.
The fact that the WisdomTree MidCap Earnings Index had the highest return of all indexes shown and the WisdomTree SmallCap Earnings Index outperformed the Russell 2000 Index shows that earnings indexes in particular should be thought of as more than just value-tilted strategies.
Moreover, the WisdomTree LargeCap Dividend Index, MidCap Dividend Index and SmallCap Dividend Index had value-loading factors either similar to or higher than the Russell 1000 Value, Russell Midcap Value or Russell 2000 Value, yet in each of those size-based comparisons, the WisdomTree Indexes had better returns over the period studied, despite the deeper value-loading factors. This illustrates to us that the performance of the WisdomTree Dividend Indexes was more than just the value factor exposures, especially since value underperformed and the WisdomTree Indexes had higher value-loading factors.
Mid- & Small Caps Outperform Large Caps (index families exhibiting this ranking):
- WisdomTree MidCap, SmallCap and Earnings 500 Indexes
- WisdomTree MidCap Dividend, SmallCap Dividend and LargeCap Dividend Indexes
- S&P MidCap 400, SmallCap 600 and 500 indexes
- Russell Midcap, 2000 and 1000 indexes
So, what we noted was not necessarily small-cap outperformance but mid-cap outperformance. Mid-caps tend to get much less focus than either large or small caps, so this performance picture is very interesting to us.
WT Earnings Indexes Outperform WT Dividend Indexes: For each respective market capitalization size segment, the WisdomTree Earnings Index outperformed its WisdomTree Dividend Index counterpart. Another way to think about this is that since we already saw "growth" outperform "value" over this period and that dividend-focused strategies-especially those that weight by cash dividends-tilt further toward the value end of the spectrum than those that weight by earnings, it doesn't surprise us that over this particular period our earnings indexes outperformed our dividend indexes.
This paper quantified the exposures within the WisdomTree Index family using a rigorous framework across the spectrum of factors academics often study: market, size, value and momentum. We addressed some of the common critiques of "smart beta" indexes. A common perception is that smart beta indexes always involve a small-cap bias in their index construction. This is just not true for WisdomTree's broad-based and large-cap Indexes, which often have a larger-cap bias than traditional market cap-weighted indexes, and we quantified in this piece how much more large cap they are. We also addressed the comment that smart beta indexes inherently are value-tilted strategies. We showed there was a headwind for value-based exposure over this period, yet WisdomTree Earnings Indexes especially, but also the Dividend Indexes, performed well given those headwinds and the value-loading factors of the WisdomTree Dividend Indexes. As is common with index analyses, we believe it makes sense to look under the hood of strategies to see the desired exposure. We hope this paper helps frame why and how WisdomTree's U.S. Index family achieved the results it did over the time period of live performance analyzed.
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WisdomTree Dividend Index: Measures the performance of dividend-paying companies incorporated in the United States that pay regular cash dividends and meet WisdomTree's eligibility requirements. Weighted by indicated cash dividends. WisdomTree LargeCap Dividend Index: A fundamentally weighted index that measures the performance of the large-capitalization segment of the U.S. dividend-paying market. The Index comprises the 300 largest companies ranked by market capitalization from the WisdomTree Dividend Index. WisdomTree MidCap Dividend Index: A fundamentally weighted index that measures the performance of the mid-capitalization segment of the U.S. dividend-paying market. The Index comprises the companies that constitute the top 75% of the market capitalization of the WisdomTree Dividend Index after the 300 largest companies have been removed. The Index is dividend weighted annually to reflect the proportionate share of the aggregate cash dividends each component company is projected to pay in the coming year, based on the most recently declared dividend per share. WisdomTree SmallCap Dividend Index: A fundamentally weighted index that measures the performance of the small-capitalization segment of the U.S. dividend-paying market. The Index comprises the companies that constitute the bottom 25% of the market capitalization of the WisdomTree Dividend Index after the 300 largest companies have been removed. The Index is dividend weighted annually to reflect the proportionate share of the aggregate cash dividends each component company is projected to pay in the coming year, based on the most recently declared dividend per share. WisdomTree Equity Income Index: Measures the performance of the 30% highest-yielding dividend-paying equities in the WisdomTree Dividend Index; weighted by indicated cash dividends. S&P High Yield Dividend Aristocrats Index: Designed to track the performance of dividend-paying companies in the U.S. that have increased their annual dividend payments for the last 20 or more consecutive years. NASDAQ U.S. Dividend Achievers Select Index: Designed to track the performance of dividend-paying companies in the U.S. that have increased their annual dividend payments for the last 10 or more consecutive years. Dow Jones U.S. Select Dividend Index: A modified market capitalization approach and weights by dividend yield. Stocks are selected for fundamental strength relative to their peers, subject to various screens such as dividend quality and liquidity. WisdomTree Earnings Index: A fundamentally weighted index that measures the performance of earnings- generating companies within the broad U.S. stock market. WisdomTree Earnings 500 Index: A fundamentally weighted index that measures the performance of earnings-generating companies in the large-capitalization segment of the U.S. stock market. Companies in the Index are incorporated and listed in the U.S. and have generated positive cumulative earnings over their most recent four fiscal quarters prior to the Index measurement date. The Index comprises the 500 largest companies ranked by market capitalization in the WisdomTree Earnings Index. WisdomTree MidCap Earnings Index: A fundamentally weighted index that measures the performance of the top 75% of the market capitalization of the WisdomTree Earnings Index after the 500 largest companies have been removed. WisdomTree SmallCap Earnings Index: A fundamentally weighted index that measures the performance of earnings-generating companies in the small-capitalization segment of the U.S. stock market. The Index comprises the companies in the bottom 25% of the market capitalization of the WisdomTree Earnings Index after the 500 largest companies have been removed. S&P 500 Equal Weight Index: Designed to track the equally weighted performance of the 500 constituents in the S&P 500 Index. Russell 1000 Index: A measure of the performance of the 1,000 largest companies by market capitalization in the Russell 3000 Index. Russell 1000 Value Index: A measure of the large-cap value segment of the U.S. equity universe, selecting from the Russell 1000 Index. Russell 1000 Growth Index: A measure of the large-cap growth segment of the U.S. equity universe, selecting from the Russell 1000 Index. S&P 500 Index: A market capitalization-weighted benchmark of 500 stocks selected by the Standard and Poor's Index Committee, designed to represent the performance of the leading industries in the United States economy. S&P 500 Value Index: A market capitalization-weighted benchmark designed to measure the value segment of the S&P 500 Index. S&P 500 Growth Index: A market capitalization-weighted benchmark designed to measure the growth segment of the S&P 500 Index. Russell Midcap Index: Measures the performance of the mid-cap segment of the U.S. equity universe. The Russell Midcap is a subset of the Russell 1000 Index. It includes approximately 800 of the smallest securities based on a combination of their market cap and current index membership. Russell Midcap Value Index: Measures the performance of the mid-cap value segment of the U.S. equity universe. It includes those Russell Midcap Index companies with lower price-to-book ratios and lower forecasted growth values. Russell Midcap Growth Index: Measures the performance of the mid-cap growth segment of the U.S. equity universe. It includes those Russell Midcap Index companies with higher price-to-book ratios and higher forecasted growth values. S&P MidCap 400 Index: Provides investors with a benchmark for mid-sized companies. The index covers over 7% of the U.S. equity market and seeks to remain an accurate measure of mid-sized companies, reflecting the risk and return characteristics of the broader mid-cap universe on an ongoing basis. S&P MidCap 400 Value Index: Provides investors with a measure of the performance of the value segment of the S&P MidCap 400 Index. S&P MidCap 400 Growth Index: Provides investors with a measure of the performance of the growth segment of the S&P MidCap 400 Index. Russell 2000 Index: Measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 is a subset of the Russell 3000 Index, representing approximately 10% of the total market capitalization of that index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership. Russell 2000 Value Index: Measures the performance of the small-cap value segment of the U.S. equity universe. It includes those Russell 2000 Index companies with lower price-to-book ratios and lower forecasted growth values. Russell 2000 Growth Index: Measures the performance of the small-cap growth segment of the U.S. equity universe. It includes those Russell 2000 Index companies with higher price-to-book ratios and higher forecasted growth values. S&P SmallCap 600 Index: A market capitalization-weighted measure of the performance of small-cap equities within the United States, with constituents required to demonstrate profitability prior to gaining initial inclusion. S&P SmallCap 600 Value Index: A market capitalization-weighted measure of the performance of small-cap value equities within the United States, with constituents required to demonstrate profitability prior to gaining initial inclusion. S&P SmallCap 600 Growth Index: A market capitalization-weighted measure of the performance of small-cap growth equities within the United States, with constituents required to demonstrate profitability prior to gaining initial inclusion. Russell 3000 Index: Measures the performance of the 3,000 largest U.S. companies based on total market capitalization. Russell 3000 Value Index: Measures the performance of the Russell 3000 Index constituents with value characteristics. Russell 3000 Growth Index: Measures the performance of the Russell 3000 Index constituents with growth characteristics.
WisdomTree Funds are distributed by ALPS Distributors, Inc.
Jeremy Schwartz, Christopher Gannatti and Eswarie Subrahmanyam S. Balan are registered representatives of ALPS Distributors, Inc.
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."
Christopher Gannatti, Research Analyst
Christopher Gannatti began at WisdomTree as a Research Analyst in December 2010, working directly with Jeremy Schwartz, CFA®, Director of Research. He is involved in creating and communicating WisdomTree's thoughts on the markets, as well as analyzing existing strategies and developing new approaches. Christopher came to WisdomTree from Lord Abbett, where he worked for four and a half years as a Regional Consultant.