A Fundamental Rebalance Case Study: The WisdomTree SmallCap Earnings Index

| About: WisdomTree SmallCap (EES)
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By Tripp Zimmerman

At WisdomTree, we believe strongly in relative value rebalancing. The act of rebalancing constituents of an Index back to their fundamental values is important, given our belief that stocks often overshoot their underlying fundamentals. Consequently, investors run the risk of paying too much for stocks that have become expensive compared to their fair value. A disciplined strategy of reweighting allocations back to attractively valued stocks through an annual rebalance process is an important element in managing market valuation risks. Typically, this results in the following:

  • Companies whose share prices appreciated at a faster rate than their fundamentals would typically see a reduction in their constituent weight during the rebalancing process.
  • Companies whose share prices did not appreciate or even dropped, but whose fundamentals were maintained or improved, would typically see an increase in their constituent weight during the rebalancing process.

The WisdomTree SmallCap Earnings Index (WTSEI) generally has a cyclical bias to its underlying holdings - both from its constituents being generally lower in average market cap than most other small-cap benchmarks and from its sector composition that tends to be more cyclical due to earnings weighting.

During periods when the market is worried about the U.S. economy and growth prospects, WTSEI tends to underperform large-cap stocks. Since July 8, when interest rates bottomed along with fears about economic growth, and later in November, small caps, and WTSEI in particular, started to meaningfully outperform the broader markets. In November alone, WTSEI outperformed the S&P 500 by over 10 percentage points and was ahead in 2016 YTD by an even wider margin through November 30 (24.3% vs 9.8%).

This strong performance post-U.S. election means it's a good time to rebalance and take chips away from some of the really big winners while adding weight to the stocks at lower multiples, the underperformers. Stocks that were up more than 20 percentage points since the last rebalance saw their weight reduced by almost 15 percentage points, and stocks with negative returns saw their weight increase by almost 12 percentage points.

Change in Fundamentals

Changes in Fundamentals

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  • The estimated price-to-earnings (P/E) ratio is more than 8 multiple points (and over 30%) lower than that of a comparable market cap-weighted index. WTSEI also saw large increases in profitability measures like return on equity (ROE) and return on assets (ROA).

Changes In Sector Composition

Sector Change

  • The Index saw large increases in the Consumer Discretionary (7.8%) and Health Care (3.1%) sectors, both primarily driven by poor relative price performance of those sectors and above-average earnings growth.
  • The Index saw large decreases in the Energy (-5.2%) and Industrials (-3.3%) sectors, both driven by a decrease in earnings and strong relative price performance of those sectors.

Tripp_Zimmerman.jpg Tripp Zimmerman, Associate Director of Research

Tripp Zimmerman began at WisdomTree as a Research Analyst in February 2013. He is involved in creating and communicating WisdomTree's thoughts on the markets, as well as analyzing existing strategies and developing new approaches. Prior to joining WisdomTree, Tripp worked for TD Ameritrade as a fixed income specialist. Tripp also worked for Wells Fargo Advisors, TIAA-CREF and Evergreen Investments in various investment related roles. Tripp graduated from The University of North Carolina at Chapel Hill with a dual degree in Economics and Philosophy. Tripp is a holder of the Chartered Financial Analyst designation.