This Day On The Street
Continue to site right-arrow
ADVERTISEMENT
This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here
Cramer's Action Alerts PLUS - See his portfolio and get alerts BEFORE every trade. Learn more NOW!

The Downside of Fundamental Indexing

I have written a number of generally positive articles about WisdomTree's dividend-weighted and earnings-weighted exchange-traded funds since they debuted earlier this year.

My only caveat was that they could lag their benchmark indices.

Now that the funds have been trading for a while, it might be a good time to revisit a couple of them to see whether my concern was justified.

The two funds I'll focus on today are the WisdomTree Total Earnings Fund (EXT) and the WisdomTree High-Yielding Equity Fund (DHS).

By definition, these products are a different mix of stocks than their benchmarks; they invest in the same names, but weight them according to fundamental criteria -- in this case, earnings or dividends -- rather than market capitalization.

So both ETFs will underperform at times and outperform at others.

I should note that EXT and DHS each have different benchmarks, and although neither one benchmarks the S&P 500, each benchmark has a correlation of 0.98 or greater to the S&P. So I feel the comparison in the first chart below is valid.

As you can see in the chart, both ETX and DHS have lagged the S&P 500 since the former was launched; DHS has lagged by a wide margin.

Note: Just about every specialized ETF will be vulnerable to something, so when a given fund's something comes into play that fund will lag. This does not make a fund bad or good.

The important thing in selecting ETFs is to identify a potential stumbling block, understand what impact it could have and whether or not, given this stumbling block, you should own it.

EXT is weighted by earnings; the more dollars earned by a company, the larger its weight in the fund. This implies the fund has a value bent.

The lag for EXT has been very slight and I believe can be attributed to this slight tilt to value (as I assess the holdings). For the year to date, large-cap growth stocks have outperformed value by roughly 5%.

The lag for DHS is far more pronounced and also much easier to analyze. DHS, like most broad-based dividend-weighted ETFs, has a very large weight in the financial sector. DHS allocates 35.41% to financials, compared with just 18.66% for the S&P 500.

And as you know, the financials have been pounded by the mortgage crisis and resulting credit crunch.

I believe the abnormally sloped yield curve has played a big part in the current market dislocation and I predicted this might become a problem for the sector and the fund in the first article I wrote about DHS.


Achilles' Heel
DHS has underperformed for most of the year due to its heavy financials weighting
Click here for larger image.
Source:

This issue of vulnerability is not unique to fundamentally weighted ETFs. Market-cap-weighted funds tend to overweight growth stocks, so obviously anything that hurts growth stocks tends to hurt market-cap-weighted funds relative to funds that use other weighting methods. During the tech bubble aftermath, the broader S&P 500 did much worse than large-cap value.


Every Investment Style Has its Day
Value stocks outperformed after the tech bubble burst
Click here for larger image.
Source:

The conclusion has to be that, just as a stock-picker interested in diversification would have stocks from various sectors, cap sizes and volatilities, indexers should understand a fund's weakness before they buy it and should have funds with different kinds of methodologies.

This can include cap weighting, fundamental weighting and equal weighting. They will each lead at some points and lag at others. Diversification means not having too much ride on any one method and hopefully will result in smoother returns.

At the time of publication, Nusbaum had no positions in either EXT or DHS, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

Check Out Our Best Services for Investors

Action Alerts PLUS

Portfolio Manager Jim Cramer and Director of Research Jack Mohr reveal their investment tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
Quant Ratings

Access the tool that DOMINATES the Russell 2000 and the S&P 500.

Product Features:
  • Buy, hold, or sell recommendations for over 4,300 stocks
  • Unlimited research reports on your favorite stocks
  • A custom stock screener
Stocks Under $10

David Peltier uncovers low dollar stocks with serious upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
14-Days Free
Try it NOW
Only $9.95
Try it NOW
14-Days Free
Try it NOW

Check Out Our Best Services for Investors

Dividend Stock Advisor

David Peltier identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.

Product Features:
  • Diversified model portfolio of dividend stocks
  • Updates with exact steps to take - BUY, HOLD, SELL
Trifecta Stocks

Every recommendation goes through 3 layers of intense scrutiny—quantitative, fundamental and technical analysis—to maximize profit potential and minimize risk.

Product Features:
  • Model Portfolio
  • Intra Day Trade alerts
  • Access to Quant Ratings
Options Profits

Our options trading pros provide over 100 monthly option trading ideas and strategies to help you become a well-seasoned trader.

Product Features:
  • Actionable options commentary and news
  • Real-time trading community
Try it NOW
Try it NOW
Try it NOW
To begin commenting right away, you can log in below using your Disqus, Facebook, Twitter, OpenID or Yahoo login credentials. Alternatively, you can post a comment as a "guest" just by entering an email address. Your use of the commenting tool is subject to multiple terms of service/use and privacy policies - see here for more details.
Submit an article to us!
SYM TRADE IT LAST %CHG
DHS $61.94 0.00%
EXT $75.40 0.00%
AAPL $129.36 0.00%
FB $79.60 0.00%
GOOG $573.64 0.00%

Markets

DOW 18,203.37 -85.26 -0.47%
S&P 500 2,107.78 -9.61 -0.45%
NASDAQ 4,979.9010 -28.1950 -0.56%

Partners Compare Online Brokers

Free Reports

Free Newsletters from TheStreet

My Subscriptions:

After the Bell

Before the Bell

Booyah! Newsletter

Midday Bell

TheStreet Top 10 Stories

Winners & Losers

Register for Newsletters
Top Rated Stocks Top Rated Funds Top Rated ETFs