Publish date:

Pay Attention to Earnings-Based ETFs

WisdomTree's newest funds may improve on a formula.

Roll out the earnings! That's what WisdomTree is doing with its new batch of ETFs, all fundamentally weighted on the basis of trailing earnings. Generally speaking, the more a company earns, the more it's weighted in the index that forms the basis for the WisdomTree ETF in question.

Some of the press literature notes that these funds will track a little closer to the makeup of the more traditional cap-weighted indices than do WisdomTree's previously listed dividend-weighted ETFs.

The new funds mark WisdomTree's further commitment to the belief that fundamental indexing is superior to market-cap weighting. Although even its oldest funds haven't been around very long, the successful (if short) track record of actual results and lengthy backtest (especially for the dividend ETFs) means this new crop of ETFs at least merits consideration:

There are a few specifics with these funds to touch on, but all will require a more in-depth study by anyone looking to buy these funds. Four of the funds -- EES, EZM, EXT and EPS -- weight companies by total dollars earned, so $1 billion earned would weigh more than $900 million, for example. The Top 100 fund weighs its constituents by earnings yield, which not so simply is earnings divided by market capitalization, with a couple of other particulars. The low-price-to-earnings-ratio fund is a little easier to grasp; it weights the stocks with the lowest P/E ratios most heavily.

Excluding the small-cap and mid-cap variations, these ETFs seem to be different shades of the same color.

Favorable Comparisons

My first inclination with these funds is to compare them with similar funds from WisdomTree's already existing dividend-weighted funds. It seems that most are comparable with at least one other fund. Given that this new batch of ETFs will correlate a little more closely to cap-weighted indices, I believe they'll be a little more growth-oriented than the dividend funds but still tilt toward the value end of the spectrum.

The Top 100 Earnings Fund seems to compare with the

WisdomTree Dividend 100 Fund

(DTN) - Get WisdomTree Dividend ex-Financials Fund Report

to capture large-cap value; both benchmark to the Russell 1000 Value Index. The back-test doesn't go as far back for EEZ as for DTN, but much to my surprise, the nod might go to the earnings fund, EEZ. For three years, EEZ's back-test outperforms the Russell 1000 Value Index by 2.93% annually, compared with just 0.98% average annual outperformance for DTN.

The one-year number shows a lag for EEZ, but for the length of the back-test, not quite five years, the average annual outperformance of EEZ over DTN is 2.84%.

The SmallCap Earnings Fund has some eye-popping numbers compared with the

TheStreet Recommends

SmallCap Dividend Fund

(DES) - Get WisdomTree U.S. SmallCap Dividend Fund Report

. Both funds outperform the Russell 2000 at every turn, but according to the back-test, EES fares better. It has better three-year numbers (17.59% return vs. 15.54%) and better (almost)-five-year numbers (19.14% vs. 18.23%), though EES' back-test did lag slightly for one year.

Speaking casually, the WisdomTree product line generally has delivered the goods in the short time frame it has operated. I've even integrated several of WisdomTree's narrower funds into client accounts. I'm convinced that these funds are worthy of further study by investors who use broad-based products in their own accounts. I believe that if you watch these for a few months, at least one or two of them will prove themselves to be better mousetraps than some of the old standbys.

Know Your Composition

There are some composition issues to be aware of. Remember that the driver for inclusion is the last four quarters of reported earnings. If one area of the market is doing especially well, that area is likely to have a large weighting in all the funds.

For now, that means energy is heavy in all the funds. Energy comprises roughly 10% of the

S&P 500

but ranges from 13% to 21% in the four larger-cap funds. It has only mid-single-digit representation in the small- and mid-cap funds.

Over time, the sector makeup is likely to change. That means you'll need to check the holdings every so often.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider WisdomTree Total Earnings Fund, WisdomTree Earnings 500 Fund, WisdomTree MidCap Earnings Fund, WisdomTree Small Cap Earnings Fund, WisdomTree Earnings Top 100 Fund, Wisdom Tree Low P/E Fund, WisdomTree Dividend 100 Fund and SmallCap Dividend Fund to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

At the time of publication, Nusbaum had no positions in any of the funds mentioned in this column, 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.