WisdomTree Not Into ETF Pollution

My February 22nd article appeared with an unfortunate title that may have suggested that WisdomTree was "Moving From ETF Evolution to ETF Pollution". As mentioned in that article, I did find it surprising that WisdomTree would introduce a new lineup of ETFs based on a new fundamental factor (earnings) when all of their previous product development had focused investors' attentions on the benefits of dividend-based indexation. My main inquiry was whether a portfolio construction process based on earnings as the determinant for weightings within an index would provide a significant divergence in performance versus one similarly based on dividends.

Not a surprise, I soon had a call from WisdomTree . Many thanks to Luciano Siracusano, Director of Research for ETF firm WisdomTree Asset Management, for taking the time to give me some of the thinking behind WisdomTree's new product line. Luciano is no stranger to the blogging environment and here are some of the main points I gathered from our phone conversation:

If the Russell 3000 represents the broad US equity market, an indexing strategy based on dividends will provide a subset of roughly 1500 stocks or 76% of the market. Based on this, if the remaining 1500 stocks represent the remaining 24%, you get an idea of the capitalization that is left out. Of course, investors in this strategy would be still be missing out on certain big names like Google (GOOG) but it's fair to say that you have a fairly strong value and large cap bias.

A fundamental indexing methodology that uses earnings instead of dividends would have broader representation. Clearly, you have to have earnings before you can give out dividends. But, the difference is quite significant: Using the Russell 3000 as the overall market again, with an earnings based filter, you have access to roughly 2450 companies or 95% of the market.

The earnings based methodology provides a strategy and fund that appears to be a lot more like the traditional market cap weighted index fund. Sector weights are more similar, especially compared to the dividend based methodology. Overall returns for the earnings based funds should be highly correlated to market cap weighted funds.

Perhaps the idea from WisdomTree is to use dividend based indexation as a highly defensive measure and earnings based indexation as a pure replacement for traditional index exposures. In other words, if you have a broad US equity position like SPY, an investor could consider the WisdomTree LargeCap Dividend Fund (DLN) as a potential compliment (or outright defensive replacement) and the WisdomTree Earnings 500 Fund (EPS) as a potential substitute.

The evidence on non market cap weighted indexation (equal weighted such as Rydex's RSP, or fundamental weighted from PowerShares/Research Affiliates and WisdomTree) seems to suggest an outperformance relative to market cap weighted indexation of at least 200bps per annum on average over the long term. Dimensional Fund Advisors is in the same boat as they also have de-linked from traditional indices ... although they've been doing it for a very long time. DFA has shown incredible strength in their asset gathering despite focusing on the mutual fund structure and not joining the ETF bandwagon. Whether they do a "Vanguard" or not, the continued interest and product development in non market cap weighted index instruments will surely continue. It's just one of many trends away from the origins of passive management, CAPM.

Like I said in my earlier piece, I'm not sure about the future success of WisdomTree's new earnings based ETFs. The dividend based ETFs seems to make sense and a serious down market will surely prove their worth as a diversifier. If the earnings based funds are somewhere between the dividend based fund and the traditional index fund, I wonder if enough interest can be created based on something that seems "stuck in the middle". Frankly, I see a lot more marketing for WisdomTree versus the FTSE-RAFI based ETFs coming out from PowerShares, so I would not be surprised to see them have success with their new products. Thinking for a second about the FTSE-RAFI fundamental index methodology which is based on four factors, I wonder if WisdomTree is considering the remaining two factors or, more broadly, any other fundamental factors for future product development?

It makes me think of the FTSE-RAFI funds like a BRIC fund. It could make sense to have separate funds for Brazil, Russia, India and China for global asset allocation decisions. But what about comparing the FTSE-RAFI based funds versus WisdomTree's focus on dividends and now earnings? For now, I understand the reasoning behind WisdomTree's launch of the earnings based funds to go along with their dividend based funds. I don't see much use in bringing out further product lines focusing on other fundamental factors, the remaining two from Research Affiliates (the "RA" in the rather convoluted FTSE-RAFI acronym) being book value and sales. I'm sure there are a plentiful number of academic papers to suggest other factors (cash flow?) which may also outperform the market cap weighted index and provide other tangible portfolio benefits.

We'll see. I am sure that the marketing minds at WisdomTree are many miles ahead of me. And I am now even more interested than I was a few days ago about the future success of WisdomTree's recent efforts.