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 Quote) and the WisdomTree High-Yielding Equity Fund (DHS Quote).

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

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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

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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.