WisdomTree: Riding the ETF Wave

In the United States, there are currently about 300 ETFs with total assets under management of $363 billion [as of September 2006]. This compares with over 8,000 mutual funds that have over $10 trillion under management in the United States. The assets under management by ETFs are no more than a drop in the bucket right now, and there is still a lot of room to grow. It appears that new ETFs are being launched almost every day, covering everything from emerging markets to commodities like corn and copper.

So is it time for us to own a piece of "Utopia"? The theory of investing in companies that actually run mutual funds instead of investing in the mutual funds has been around for a while. With the explosive growth in assets under management for ETFs, why not apply this theory to the companies that are offering these ETFs? Money has been flowing out of mutual funds consistently for the last five months and instead of assuming that it is going to the sidelines, I am willing to wager that some of it is actually ending up in ETFs.

When the investment company WisdomTree (WSDT) was created with a star management team and launched 20 ETFs on June 16, 2006 it made quite a splash on Wall Street. However the stock of the company, which currently trades on the pink sheets, received little attention. Following the concept of investing in the companies riding the current ETF wave, I considered State Street Corp (STT) as a potential candidate last month, and also looked at WisdomTree after reading this blog post by the Confused Capitalist.

Since WisdomTree is not traded on one of the regular exchanges, it is very hard to find financial data for the company and I could not even find information about assets under management. A few weeks later, the stock popped up almost 20% when WisdomTree announced that in addition to the 30 ETFs that it already offers, it has filed to offer another 31 ETFs. You can find a list of these 31 ETFs on ETFTrends.com. Even after this pop, I remained uncertain about picking up the stock, due to the aforementioned lack of data.

On November 13, WisdomTree announced that assets under management have reached $1 billion. This number lit another fire under the WisdomTree stock and it jumped up another 42% since the news came out. So is it still a good time to get into WisdomTree after it has already run up more than 60% in a single month?

WSDT 1-yr chart

Let us use the limited amount of public information we have available for WisdomTree to arrive at a rough valuation for the company. With expense ratios for their ETFs ranging from 0.28% to 0.58% and with a majority of their ETFs sporting an expense ratio of 0.58%, I am going to assume an average expense ratio of 0.5%. To keep calculations simple and because WisdomTree does not provide this data, I am also going to assume that assets under management are equally distributed amongst the 30 ETFS that are currently offered. Based on assets under management of $1 billion over the first six months, revenue and gross profits for the company would work out to about $50 million [$1,000,000,000 X 0.05]. Revenue and gross profits for small asset management companies is usually the same as you can see from the income statements of other asset management companies like Westwood Holdings Group (WHG), U.S Global Investors (GROW) and the recently tainted GAMCO Investors (GBL).

If WisdomTree were to grow assets under management over the next six months to the same extent as they did in the first six months [it is probably going to be much higher as they will have 61 ETFs instead of the current 30], they should see gross profits of about $100 million from $2 billion in assets under management. Assuming a conservative profit margin of 25%, which is about the same as the profit margin for GAMCO Investors but a little higher than the 18% margins of ETF gorillas like State Street and Barclays, we get net income of $25 million a year. With a market cap of $600 million, I arrive at a rough forward P/E of 24. Please note that it is possible that WisdomTree may not even be profitable, as many new companies tend to utilize every dollar available to grow the business at the expense of earnings. Astute investors will also realize that since WisdomTree did not start the year with $2 billion in assets under management, the actual gross profits during the first year of operations may be much lower. It should also be noted that ETFs charge their expenses on a daily basis. Based on some of the information provided here, investors should be able to build a more sophisticated model to arrive at a valuation for WisdomTree.

Given that WisdomTree currently trades on the pink sheets and has appreciated more than 60% in less than a month, it could be considered a highly speculative investment by some. But it is also highly unusual to find a former SEC Chairperson in the management team of a company that is trading on the pink sheets. WisdomTree may eventually end up listing its shares on one of the main exchanges or get acquired by a company like Fidelity that has oddly enough failed to launch its own ETFs. While my guesstimated P/E of 24 is not exactly inexpensive, the prospects for high double-digit growth combined with the fact that my calculations are probably conservative, lead me to believe that WisdomTree may prove to be a good investment even after this amazing run-up.

Update: A number of diligent investors noticed a problem with the revenue and earnings assumptions posted above. I calculated the revenue for WisdomTree as $50 million based on a 0.5% or fifty basis points fee for AUM of $1 billion. The actual revenue and gross profits work out to $5 million and not $50 million. I regret this error. An alternate method to valuing WisdomTree would be look at what London based asset management company Amvescap (AVZ) paid to acquire ETF provider PowerShares. The acquisition closed on September 18th and PowerShares had $6.3 billion under management at closing. The total price for the acquisition could be as high as $730 million if PowerShares hits certain targets. PowerShares currently has about 66 ETFs and after WisdomTree's new ETFs are approved, they would have over 60 ETFs as well. WisdomTree's market cap is currently $679 million and the company appears to have better visibility and momentum on Wall Street. Hence I do see additional upside over the long-term. The stock is volatile and could move either way short-term and that is why I also picked Barclays (BCS) as a second less volatile play on the ETF space. Barclays also has a very attractive dividend yield of 3.7%.

Competitors:

WisdomTree faces competition not only from 800 pound gorillas like State Street (STT), Barclays (BCS), and Amvescap (AVZ) that offer ETFs but also from mutual funds powerhouses like Fidelity and Vanguard that have certain funds with expense ratios so low that they would put some ETFs to shame.

The Good:

* ETFs currently have about $363 billion in assets under management and a lot of room to grow.
* WisdomTree is a young company with an excellent management team and a defined focus on dividend based ETFs.
* WisdomTree already has $1 billion in assets under management and has filed to launch an additional 31 ETFs.
* Based on my rough valuation model, WisdomTree could see further price appreciation as assets under management grow.
* Former SEC Chairman Arthur Levitt recently joined WisdomTree as a senior advisor.

The Bad:

* WisdomTree currently trades on the pink sheets and there is little financial data available for the company.
* The stock has seen an astonishing 60% run-up in less than a month and is susceptible to a dramatic drop.
* If the economy continues to weaken and the markets drop, investors may lose their appetite for newly launched ETFs.

Disclosure: I plan to start a position in WisdomTree for my personal portfolio.

Comments

[Byrne Hobart]

Your revenue number appears to be off by an order of magnitude: $1,000,000 * .005 = $5,000,000. And it's hardly 'conservative' to assume that they'll have a profit margin 39% higher than the best companies in the industry when they 1) Manage a fraction of the capital, and 2) Are paying for the reputations of their board members/representative... instead of getting a good reputation of their own.

WisdomTree does nothing that other companies in the business can't do. How did you arrive at a 25% profit margin for a small, inefficient startup in a hyper-competitive business surrounded by aggressive, better-funded, better-branded competitors? Given that your revenue estimate was ten times too high, is your valuation of the company now 90% lower?

[Dan Silagi]

Bryne is absolutely correct; the revenue number is off by a factor of 10. But the revenue from fees in Wisdomtree's case is only a small part of the story; most ETF's earn income from securities lending. In Wisdomtree's case, the indexes are tailor-made to lend the underlying securities to short-sellers, notably from hedge funds. (This is one reason why there many of Wisdomtree's indexes are narrowly defined.

Remember, when one sells a stock short, the dividends belong to the lender, not the short seller. As Wisdomtree's indexes are based on dividends, and thus tend to overweight them as compared with the traditional market-cap indexes, this is even more important to Wisdomtree in generating income from securities lending.

Moreover, a next-year P/E of 23 is extremely conservative for a rapidly growing company. Google's is on the order of 60.

Watch the trading patterns of WSDT. While $10 a share is expensive now, if WSDT grows to $5 billion in assets in the next couple of years, which should be a piece of cake, you'll be kicking yourself saying "I shoulda bought at 10..."

Disclosure: We own 6800 shares, at an average price of 3 and change, and are kicking ourselves for not getting in at 1.25, which is when we starting watching the stock back in the days when it was IXDP.

[Asif]

Byrne is absolutely right. I messed up and that was a major oversight. I should have used a different valuation method based on the amount Amvescap paid for PowerShares.

The 25% profit margin was based on the margins of GBL and GROW. I did acknowledge that these margins may be too high for a startup when I wrote:

"Please note that it is possible that WisdomTree may not even be profitable, as many new companies tend to utilize every dollar available to grow the business at the expense of earnings".

Thanks for the information about making money from lending Dan. I will have to explore that theory.

[rajiv1]

You are way off. Revenue is not $50 million but $5 million based on your assumptions.

[Tim Eriksen]

In the Sep qtr, revenue was $0.5 million and quarterly expenses were $5.9 million for Wisdom Tree. The big question to me is how much of expenses is one-time, fixed and variable. The $5.9 million in costs was for the Sep quarter in which they ended with about 0.5 billion in ETF assets. We know that there has to be some variable costs. If I assume no start up costs and no varialbe costs (obviously quite optimistic) then it would still require $4 to $5 billion in assets to breakeven, and $15 to $20 billion to report an after tax EPS of 10 cents. So, it looks to me that a lot of growth is priced into the stock.

If anyone has any insights I would appreciate hearing them.

[Dan Silagi]

Let's assume Wisdomtree has a steady $4 billion under management, and makes no money from securities lending, or any other source other than management fees. Let's further assume they make 50 basis points on each dollar (0.5%). Then their revenues would be $20 million.

I would be hard-pressed to figure out how a company operating out of not-very-expensive space in lower Manhattan, with a dozen or so employees, would spend $20 million. On what? Salaries? These guys aren't paid A-Rod money. Advertising? Compare with advertising expenses of listed corporations running ETF's.

The key to Wisdomtree's future growth is whether the alphas posted in backtesting (around 2%) are achievable in real-time. For that, a 3-year track record is needed before most institutions start commiting funds in a big way to a start-up. I personally want to see a years' worth of live data before I move the money I have in traditional index funds and market-cap ETF's into Wisdomtree, and I'm a big fan.

Assuming that Wisdomtree can maintain its alphas, the sky's the limit here. But that's a big assumption.

[Slappy White]

Here's my own back of the envelope analysis using numbers from Yahoo Finance:

Assets under Management: $ 1 billion, Market Cap: $ 700 Million

If you think about it, to say Wisdomtree is fairly valued, you have to assume a value of $0.70 for every dollar *under management*. Since the "conservative&quo... estimate is that they charge 50 basis points on AUM or $ 0.005 per $ 1.00 under management, you get to the point where this is just silly. Subtracting money paid to "advisors" for lending their good name to the operations of a discredited newsletter operator, and whatever Jono is skimming, and you get to the absurd.

Add to this that there are a dozen competitors in the market already and probably another hundred waiting in the wings.

For context, Janus, with $ 158 Billion under management, has a market cap of $ 4 Billion.

The people who are making the big money are the ones who have a basis in the cents, not at $ 9.00.

YMMV

[Dan Silagi]

Comparing Janus to Wisdomtree is comparing apples to oranges. Janus has a market cap of $4 billion, 200 million shares outstanding, and about $160 billion under management. While they were very hot years ago, recently, their track record has been average -- in other words, they perform with the markets, not better. (Most mutual funds don't beat the market averages, and for that matter, neither do most hedge funds.)

The interesting thing about Janus is they only earned $100 million, or about 0.06% (0.0006) on each dollar invested. This, in spite of the fact that they charge 1% or so as a management fee. This is in part due to the legions of analysts and others they have working there.

Wisdomtree, and other ETF's, have computers do most of the work. Their overhead (and fees) will be much, much lower than Janus and its competitors. If Wisdomtree ever managed $160 billion in assets, you could be sure that they'll earn orders of magnitude more than $100 million.

[Slappy White]

Overhead is a valid point in WSDT's favor. However, I think it's besides the point.

WSDT might or might not get to $160 Billion in assets. However, right now, it is at $1 Billion. Even assuming the full expense ratio is 0.5% goes to the shareholders (which would be silly), that would be $5 Million relative to a market cap of $700 Million.

By comparison, Mr. Suria points out that Amvescap's purchase of Powershares could, if targets are hit, be worth $730 Million. That is on 6X the assets under management relative to WSDT.

I have no idea whether WSDT will maintain its rate of growth. However, I am happy to let others find out, one way or the other. I think there is an irony in a company whose share price is driven solely by speculation hawking a conservative, passive investment approach based on dividends and earnings. I'm going to venture a guess and say that I don't think WSDT will be added to any of WSDT's funds anytime soon.

I'm also sorry for people who bought at $9 a few days ago only to lose 15%. I have the sneaking suspicion that they might ultimately have been happier putting their money in WSDT's DTD fund rather than WSDT itself. For disclosure's sake, I hold shares of DTD and have no interest in WSDT.

[marc salz]

I think the whole point that you all are arguing with Wisdomtree at $1billion in assets is kind of funny.
On September 22 they had about 550 million in assets. On November 13, they hit $1 billion. Today, they have about (I rounded my millions) 1,364,000,000. That's pretty staggering growth, adding about 1/3 of a billion per month. When they add the new etfs, they will probably break 2 billion within a few weeks. So, with 2 billion within reach in February and strong performance compared to benchmarks in a bull market (I think they'll look even better in a bear) we can reasonably expect 4 billion by 2007's end.
Stock is certainly overvalued for a value investor, but for growth it looks pretty good.
Assets under management are available at the Wisdomtree website.
Cheers

[Slappy White]

What was that about trees growing to the sky?

[Yehuda Fruchter]

Quick facts: Michael Steinhardt invested in WSDT at $0.16 per share in late 2004, at a post-market valuation of about $14 million. He is now up 4,800% in less than two years, turning a $9 million investment into over $450 million. FYI, Jeremy Siegel is in at $1.30.

You can get the press release here: www.wisdomtreeinvestme...-$9-Million-Financing....

Without getting into the seemingly insane valuation, just looking at the above prices, I venture to guess that anyone who is buying now is a bit late to this game. But congrats to those who bought lower and to the insiders. This is an unbelievable example of how capitalism magically creates massive wealth out of thin air.

[Dan Silagi]

Nothing wrong with investing in Wisdomtree's funds. My family and I intend to invest several hundred thousand, perhaps considerably more, into WSDT's funds, once they achieve a 1-year track record, assuming the funds at least perform in-line with the overall market.

But to value WSDT's current $1+ billion in assets (after 6 months) they way one would value, say, Procter & Gamble (in which I own far, far more stock than I do in WSDT) is missing the point. ALL growth stocks are ridiculously overvalued in their early stages, e.g., Google. The trick here is to determine which companies will remain growth companies three years from now, and which are selling "vaporware," of which there were many in the heady markets of 1998, 1985, 1967, and 1961, just to name four off the top of my head.

I suspect WSDT's recent growth spurt is due to its employees exercising stock options at year-end. Think they'd do it if they weren't optimistic about the company's future?

Also, consider the huge bonuses being paid to Wall Street employees this year. Most of these bonuses will be handed out in January. Some of that money will find its way into WSDT's funds. In addition, most institutions require a 3-year track record, meaning you need to wait 2 1/2 years before WSDT's funds meet that hurdle. I'm a (relatively) patient man.

I have read much of Jeremy Seigel's material, and as a University of Chicago MBA, who was schooled in the efficient market theory, am intellectually satisfied with his take on market inefficiencies, and with WSDT's prospects for exploiting them.

Of course, I could be dead wrong, which is why we own 6800 shares of WSDT, not 68,000 or 680,000. (Yes, I would have bought more if I have had access to tomorrow's paper today, but I don't.) Hence, I follow the cardinal rule of the efficient markets hypothesis, which is to diversify.

[Steve Saker]

I am very late to the party in buying WSDT having bought in over the past few days. However, I bought several of their funds in July and have been delighted with the performance in this (albeit short) period. I can only assume that the performance, if it continues even on a relative basis, will drive AUM growth poerfully higher. Little eles will be more important to the price of WSDT - unless Michael Steinhardt unloads!

[Yehuda Fruchter]

BTW, company just sold equity to institutional investors at $3 per share. Wonder how on earth anyone is buying this at $8. Defies any logic.