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Contrarian Rebalancing Gives This Earnings-Focused ETF an Edge

WisdomTree MidCap Earnings' rebalancing approach should keep its valuation in check.

Adam McCullough, CFA, 04/07/2017

WisdomTree MidCap Earnings ETF EZM is one of the few passive mid-cap equity strategies focused on its holdings' earnings. This exchange-traded fund effectively diversifies risk and rebalances into stocks as they become cheaper relative to their earnings, which should give it an edge over its peers in the long run. It offers a cost advantage compared with actively managed peers, but there are cheaper index-tracking peers available. It earns a Morningstar Analyst Rating of Bronze.

The fund offers broad exposure to profitable U.S. mid-cap stocks and weights them by the value of earnings that each stock has generated over the prior year. This approach injects a contrarian rebalancing discipline, causing the fund to increase its exposure to stocks that have become cheaper relative to their earnings to restore its target weightings and trim those that have become more expensive. Not surprisingly, this fund's rebalancing process inserts a value and profitability tilt, but its exposure to low valuation and highly profitable stocks isn't consistent because it doesn't explicitly target them. While stocks with larger absolute earnings tend to have larger market capitalizations, the fund has persistently exhibited a smaller market-cap orientation than most of its peers. Over the trailing 10 years through March 2017, the fund's average market capitalization measured about half of the mid-cap blend Morningstar Category average's.

So far, this fund's approach has paid off. Over the trailing 10 years through March 2017, it bested the mid-cap blend category average and S&P MidCap 400 Index by 2.6 and 0.6 percentage points annually. Compared with the index, most of the fund's performance advantage came from underweighting financial stocks during the financial crisis and adding exposure back after the crisis. The fund largely benefited from the timing of its rebalancing, which shouldn't be expected to persist. Over the trailing three- and five-year periods through March 2017, this fund still handily topped the category average but lagged the index. 

Fundamental View
A stock's price is the primary input into market-cap-weighted indexes, so they may overweight expensive stocks and underweight cheap stocks. Proponents of fundamental indexing dub stocks' random straying prices as the "noisy market hypothesis," an alternative theory to the efficient-market hypothesis. Fundamental indexing seeks to break the link between market prices and portfolio weightings. Instead it weights its holdings by economic metrics such as earnings, sales, or dividends to reduce exposure to expensive stocks.

Morningstar's Paul Kaplan published a paper titled "Why Fundamental Indexation Might--or Might Not--Work" and highlights that fundamental indexing implicitly assumes that all companies should trade at the same valuation multiples. Efficient-market advocates counter that stocks should, and empirically do, trade at different multiples based on their risk and growth profiles. Kaplan also asserts that without knowing a stock's fair value or fair valuation multiple beforehand, it is impossible to conclude in advance that a stock's current market price is too high or low, and whether stocks that command high valuations are overpriced.

Fundamental-indexing proponents point out that fundamental weightings simply serve to sever the link between price and portfolio weightings and allow the strategy to rebalance into stocks as they become cheaper relative to their fundamentals. They argue that this is a more efficient form of value investing. This strategy is more broadly diversified and representative than traditional targeted value-oriented funds because unlike traditional value funds, it holds growth stocks, but at smaller levels than market-cap-weighted funds.

This fund breaks the link between stock prices and its portfolio weightings, which can increase turnover and transaction costs. However, the absolute earnings metric it uses to weight its holdings is positively correlated with market capitalization, which should help keep turnover down. Even with this alternative weighting technique, the portfolio's average five-year turnover is 39%, less than half of the category average's but still higher than pure market-cap-weighted peers', whose holdings naturally move with the ebbs and flows of the market.

The strategy uses the prior four quarters' S&P core earnings as its fundamental metric. S&P core earnings adjust for nonoperational business activities such as hedging, pension, and acquisition gains or losses. This earnings measure is more stable than GAAP earnings because it better represents earnings from a company's ongoing business operations. But relying on a backward-looking metric may cause the fund to hold stocks with deteriorating fundamentals, whereas a stock's price incorporates a forward view of a company's outlook. Also, because accounting practices differ across sectors, those sectors with more-aggressive revenue and expense recognition could be over-represented in the portfolio. To reduce concentration risks, this fund caps single-stock and sector weightings. Despite the caps, this fund is consistently overweight the industrials and utilities sectors and underweight the healthcare and information technology sectors compared with the category average sector weightings.

Portfolio Construction
This fund follows a well-crafted earnings-weighted strategy that diversifies risk and rebalances into stocks as they become cheaper relative to their earnings. It earns a Positive Process Pillar rating.

The fund tracks the mid-cap portion of the WisdomTree Earnings Index, which includes most profitable U.S. companies. Qualifying stocks must have positive cumulative earnings over the prior year, a market capitalization greater than $100 million, and a price/earnings ratio of at least 2 on the screening date (Nov. 30 each year). This index weights its holdings by their cumulative earnings over the prior four quarters, relative to the aggregate earnings of the selection universe. WisdomTree uses S&P core earnings instead of as-reported GAAP earnings because it believes that this measure more accurately represents a stock's operational earnings. S&P core earnings remove gains or losses from noncore business activities such as hedging, asset sales, and litigation.

This index selects stocks representing the largest 75% of the WisdomTree Earnings Index by market capitalization after the largest 500 companies are removed. Historically, this fund has held between 500 and 700 stocks. The portfolio rebalances annually in December. To manage concentration risk, it caps individual security and sector weightings at 5% and 25%, respectively, on the annual rebalance date. Throughout the year, stocks with weightings at or greater than 5% cannot make up more than 50% of the fund.

WisdomTree charges a 0.38% expense ratio, which lands in the lowest quintile of all mid-cap blend funds, supporting this fund's Positive Price Pillar rating.

While cheaper index options are available, the fund's fee still ranks in the bottom half of all index mutual funds and ETFs in the category. The fund has trailed its index by 28 basis points annually over the trailing five years--less than its fee. The fund passes along securities-lending revenue to investors to help offset its fee.

Schwab Fundamental U.S. Small Company ETF FNDA (0.25% fee) carries a Morningstar Analyst Rating of Bronze and offers broad exposure to small-cap U.S. stocks and weights them on fundamental measures of size, including sales (adjusted for leverage), retained operating cash flow, and dividends plus share buybacks. Despite landing in the small-cap blend category, this fund's average market cap is only slightly less than EZM's.

PowerShares FTSE RAFI US 1500 Small-Mid ETF PRFZ (0.39% fee) offers broad exposure to small-cap stocks, with a few mid-caps in the mix. It weights its holdings based on fundamental measures of size, including book value, cash flow, sales, and dividends. This approach gives the fund a modest value tilt, though it falls in the small-blend Morningstar Category and still includes growth stocks. Unlike FNDA, PRFZ's weighted-average holdings are about half the size of EZM's.

Bronze-rated WisdomTree MidCap Dividend ETF DON (0.38% fee) may be a more compelling fundamentally weighted alternative for investors looking for income. DON weights its holdings by the dollar value of dividends it is expected to pay out during the next year relative to the aggregate projected dividend payments from all the stocks in the fund. This approach gives DON a higher dividend yield and a stronger value orientation than EZM.

Silver-rated Vanguard Mid-Cap Value ETF VOE (0.08% fee) offers market-cap-weighted exposure to value-oriented mid-cap stocks. VOE exhibits a stronger value tilt and lands in the mid-cap-value category. But market-cap weighting skews toward the largest stocks in the category, and its holdings' average market cap is 3 times the size of EZM's.



Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.


Adam McCullough, CFA, is an analyst on Morningstar’s manager research team, covering passive strategies.

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