WisdomTree: Riding the ETF Wave

| About: WisdomTree Investments, (WETF)

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 (NYSE: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 (NYSE:WHG), U.S Global Investors (NASDAQ:GROW) and the recently tainted GAMCO Investors (NYSE: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 (NYSE:BCS) as a second less volatile play on the ETF space. Barclays also has a very attractive dividend yield of 3.7%. 

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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.