By Jeremy Schwartz, CFA, Director of Research, WisdomTree
I believe in the importance of rebalancing a portfolio back to target allocations each year. But how many indexes follow this advice? Market cap-weighted indexes, for example, may add and remove companies each year, but as they are weighted based on market capitalization, they would not necessarily be sensitive to potential changes in the relationship between share price and fundamental value.
At WisdomTree, we rebalance our indexes annually based on changes in relative value. For our Global and Emerging Market Indexes, this occurs in June. Some of the largest changes at this year's global re-balance occurred in our Emerging Market Indexes, specifically the WisdomTree Emerging Markets Equity Income Index (WTEMHY). An apt illustration of the relative value of a re-balance can be seen through an analysis of the top 10 added and deleted constituents for this Index.
-The top 10 additions to the WTEMHY had an average price-to-earnings (P/E) ratio of about 5x while the top 10 deletions had average P/E ratio of over 15x.
-The top 10 deletions had positive price performance averaging about 4% from May 31, 2011, through May 31, 2012, but displayed negative trailing 12-month dividend-per-share growth over that same period. These stocks out-performed the MSCI Emerging Markets Index, which returned -20.32% over this period, by nearly 25 percentage points. This fact, combined with their declining dividends, is why we deleted them.
-The WTEMHY was significantly under-weighting the equities of China and Russia prior to the re-balance because their share prices were high relative to their trailing 12-month dividends. But this year key additions were made to these two countries, because their stock prices were down and their dividends up.
I believe emerging markets will continue to provide the bulk of global economic growth in the coming years. And I know that weighting an equity portfolio by a measure of fundamental value such as dividends helps manage valuation risk-which is critical in emerging markets. That's why it's so important to rebalance indexes-and portfolios-every year.
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 Market capitalization weighting: Market cap = share prices x number of shares outstanding. Firms with the highest values receive the highest weights in approaches designed to weight firms by market cap.
 Fundamental value: The value of a firm that is related to a company's actual operations and production as opposed to changes in share price.
 Relative value: The relationship between a particular attribute, e.g., a dividend, and the firm's share price compared to that of another firm.
 A subset of the WisdomTree Emerging Markets Dividend Index measuring the performance of the top 30% of stocks with the highest trailing 12-month dividend yields, weighted by cash dividends.
 Price-to-earnings (P/E) ratio: Share price divided by earnings per share. Lower numbers indicate an ability to access greater amounts of earnings per dollar invested.
 Trailing 12-month dividend per share: A firm's dividends paid over the prior 12-month period, divided by the number of shares outstanding.
 MSCI Emerging Markets Index: A free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets.
 Valuation risk: The risk of buying or over-weighting a particular stock that has appreciated significantly in price relative to its dividends, earnings or any other fundamental metric.
Disclosure: I am long DEM.