Siracusano: Fundamental Indexing Not Niche

 

The U.S. ETF market is maturing, coming off of the 20th anniversary since the inception of the very first U.S.-listed ETF—the SPDR S’P 500 (SPY)—amid record asset levels, now hovering around the $1.4 trillion mark. It’s a milestone that has many looking for what the next chapter will be in a market that continues to captivate investor attention, but one that remains highly linked to market-capitalization strategies.

It may very well be that the days of market-cap dominance are over, Luciano Siracusano, chief investment officer at WisdomTree, recently told IndexUniverse’s Cinthia Murphy. As one of the heads behind WisdomTree’s proprietary fundamentally weighted indexes, and ETFs that track them, Siracusano argues that real-time performance would suggest that fundamentally weighted approaches don’t belong in the market’s fringes, but rather in the core of investors’ portfolios.

 

IU.com:There are a lot of people who look at fundamental indexing as one of the next big trends in the ETF market, but some say that fundamental indexing is really just another form of active management. How do you respond to that?

Siracusano: Well, often the people who are calling fundamentally weighted indexing a kind of active strategy are the defenders of cap-weighted indexing; they’re defenders of the status quo. I think after five years of real-time data, people should just look at what’s actually happened over the last five years. I remember when WisdomTree launched in 2006, there was a lot of media attention around fundamentally weighted indexing. I wrote an article in Index Universe in 2007 laying out the philosophical case for it. And at the time, people really had three or four criticisms.

One, they said, it’s based on backtested data. It’s based on stuff that worked over the last 40 years; no guarantee it’ll work in the future. But now you’ve had five, six, seven years of real-time results, and what you’ve seen in equity markets all around the world—not just in the United States—the fundamentally weighted indexes have consistently outperformed the comparable capitalization-weighted index.

Secondly, many said fundamentally weighted indexing was nothing but a value strategy dressed up in something different. But it’s not just a value index because we’re owning all of the securities in an equity market; we’re not just selecting value stocks—we’re taking stocks that would qualify for value indexes, we’re taking the core part of the market, and we’re taking growth stocks.

IU.com:So there’s no stock picking in what WisdomTree does?

Siracusano: In America, we’ll take any company that’s profitable and put it into our earnings-weighted index. In the dividend index, there are 1,300 stocks that pay dividends. We don’t care if they pay a high dividend or a low dividend; if they pay a dividend, they go in our index.

And what we do is we reweight once a year based on income, earnings or dividends. And what’s happened overwhelmingly is that the fundamentally weighted have beaten the cap weighted over the last five years in an environment where growth indexes beat value indexes in the United States.

IU.com:You have to ask the question, How did that happen?

Siracusano: Exactly. How could you have done that if all you have is a value strategy? How did you beat the market if growth beat value? Well, the conclusion is that there’s something else going on here in addition to a core value tilt. And we believe it’s just a flaw in cap weighted that we’re taking advantage of, the fact that cap weighted never rebalances back to any measure of relative value. Fundamentally weighted indexes do that once a year.

 

 

IU.com:Maybe one of the key distinctions here is the idea that fundamental indexing in this case is about the weighting and not about the security selection?

Siracusano: Exactly. That’s why we never use the phrase “fundamental indexing.” That’s not part of the WisdomTree lexicon. The original WisdomTree vision was to own equity markets and reweight once a year based on income—the notion of owning an income stream in proportion to each company’s contribution to it.

We invented dividend-weighted indexes. The WisdomTree approach is patented, it’s unique and proprietary. And we said before anyone else that we believed this was a better approach than cap weighted, not just because it could get you better absolute returns, but it could get you better risk-adjustment returns. And it could do so while correlating highly to the market.

IU.com:Another criticism we hear is that your approach has a small-cap bias. Is that fair?

Siracusano: There’s no small-cap bias in the WisdomTree approach because we select our size cuts based on market capitalization size. So, on our large-cap dividend index, we’re including the 300 largest companies in the country by market cap that pay dividends, which makes our large-cap index more large-cap than the S’P 500—more of the weight is in companies with market caps above $10 billion than the S’P.

The average weighted market cap is higher than it is in the S’P. It’s also true to say that our midcap index is more midcap than the Russell or the S’P midcap, and our small-cap index is more small-cap. There’s more purity to the WisdomTree index in terms of size.

In fact, there are some market-cap-weighted small-cap indexes out there that have 40 percent of their weight in midcap stocks. It’s a travesty. And the naysayers never call the cap-weighted indexes out on that deficiency, but they accuse the fundamental weighters of having a small-cap bias. It’s a myth in the case of WisdomTree; it does not exist.

IU.com:Do you see fundamentally weighted indexing actually threatening the market-cap status quo?

Siracusano: I think people were asking the same question 30 years ago, and the question was, Would indexing threaten the mutual fund active manager status quo? It’s the same argument. If you can get data over time that says the average active manager underperforms indexes the majority of the time by 100-200 basis points, whatever it is, that’s a very strong argument to use an indexing approach.

If you have a body of data that’s going back 40, 50 years, and now five, six, seven years of real time, that’s saying that cap-weighted indexing is underperforming fundamentally weighted in the same market segments by 100, 200, 300 basis points per year, eventually there’s going to be a change in people’s behavior, because they’re going to realize they’re not serving their clients as well as they should be.

Think about it practically. There’s $1 trillion in America invested in equity ETFs. Overwhelmingly, that’s in cap-weighted strategies. If you underperform by 100 basis points a year, you’re talking about billions of dollars.

IU.com:Being bled out?

Siracusano: Yes. They’re being lost because you’re underperforming what you could be doing with a fundamentally weighted approach. There’s a lot of evidence building up, and it’s overwhelming. We have a U.S. small-cap earnings index, which has beaten the Russell 2000 by 4 percentage points annualized over five years.

Our midcap beat the S’P 400 by 250 basis points annualized over five years. Our emerging markets small-cap beat cap weighted by 400 basis points annualized over five years. And emerging market equity income beat the MSCI emerging market index by more than 600 basis points annualized over five years. Those are phenomenal index returns. And that’s while you’re correlating very highly to the market with a broad diversified portfolio.

 

 

IU.com:Does fundamentally weighted indexing belong in the core of a portfolio, or is it a niche approach?

Siracusano: This is not a niche strategy, which is another misrepresentation in terms of what we’re doing. People like to bunch it in as an alternative strategy, like price weighted or equal weighted. You can’t apply equal weighting to broad asset allocation—you can’t equal-weight the entire world, because you’ll be giving the same weight to a small company that you give to a large company; there’s not enough investment capacity.

Fundamentally weighted scales, so it’s a strategy that can accommodate hundreds of billions of dollars in inflow and still work well in most markets because you’re giving greater weight to larger companies. You’re taking the dividend per share and multiplying by the common shares outstanding. You’re just substituting dividend per share by price per share. You’re delinking stock price from your weight.

The reality is that beta, ultimately—like beauty—is in the eye of the beholder. Which is the best small-cap beta in the United States? Is it the Russell 2000 or is it the S’P 600? They’re both cap-weighted strategies. Does it make a difference? Well, the Russell 2000 underperformed the S’P 600 by 70 basis points a year, going back a decade, with something like 180 basis points a year going back 15 years.

So there’s a real difference in return, even in the cap-weighted indexes. Now you have a debate in emerging markets:Should you be MSCI emerging markets or should you be FTSE emerging markets? Billions of dollars of ETF money depend on that decision. Well, you have a choice now. What’s beta for emerging markets? If you can’t decide, you probably should be looking at WisdomTree emerging markets and say there might be a third choice here.

IU.com:So looking ahead, you make a convincing argument that fundamentally weighted indexing can be part of your core portfolio?

Siracusano: Yes. We’re 10 years into the ETF industry. People were taught 10 years ago to go core and explore. They were taught to use low-cost beta in the core of the portfolio, tracking cap-weighted indexes, and to explore to try to get alpha in the periphery. Today, we think you should be exploring the core to see if you can actually generate the alpha in the core of your portfolio relative to traditional cap-weighted indexes..

We think there’s an opportunity there to use fundamentally weighted indexes, not at the niche, not at the margin, but in the core of your portfolio. I think that as people get educated and as the information gets out there, they are going to conclude that there’s a risk to being 100 percent cap weighted—just like you wouldn’t use one active manager in every asset class around the world, you would diversify your approach. And all we’re saying is there’s probably more than one way to get your passive index exposure.

 

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