Our research team is having many conversations on how one should view smart beta
indexing strategies and what factors are driving the results. We attempted to quantify the various factors at play. My colleague explained our general approach to this analysis in a prior blog post
, but in general we evaluated indexes according to their exposure to various factors, from their “market” risk
, “size” exposure, “value
” tilts and “momentum” tilts.
In this post, I want to focus on the size exposures inherent to our Index approach, as one of the most common misconceptions regarding smart beta indexes is that they “incorporate a small-cap
tilt” to their construction. Some do, but WisdomTree’s traditional Indexes do not.
For definitions of indexes in the chart, please visit our glossary.
• Equal Weighting:
We can start with the classic, intuitive example of equal-weighting the S&P 500 Index
to illustrate how different weighting methodologies can influence the size factor of a particular index. We see that the S&P 500 Index registers a negative value (meaning that it’s tilting toward exposure to larger companies) whereas the S&P 500 Equal Weight Index
registers a positive value (meaning that its size exposure is tilting toward smaller companies).
o It’s interesting that the S&P 500 Equal Weight Index has a very similar size factor to the WisdomTree MidCap Dividend Index (WTMDI)
• Size Factor Takeaways:
The WisdomTree LargeCap Dividend Index (WTLDI)
and Equity Income Index (WTHYE)
indicated size factors more than twice that of the S&P 500 Index. When critics characterize smart beta as being a tilt to small caps, they are clearly not talking about WisdomTree’s large-cap dividend or earnings approaches, which are more large cap
than the S&P 500. Part of this distinction is caused by the fact that WisdomTree selects
stocks by market capitalization
for its size-based segments, and then weights
securities by dividends or Earnings Streams®
. In our opinion, that selection rule results in purer size segmentations across the spectrum.
• Interestingly, the WisdomTree Dividend Index
, which includes all dividend payers and has more than twice the number of securities of the S&P 500, still has a great large-cap bias and more loading to large caps than the S&P 500 (more negative size factor than the S&P 500 Index).
• Most Small-Cap Tilted:
The WisdomTree SmallCap Earnings Index
had the largest factor sensitivity to small caps of all the indexes included in the analysis.
What can be done with this factor information to impact strategic investment considerations?
Take 1: Targeting Allocations to Match the Size Exposure of the S&P 500 Index
One of the most widely followed equity indexes is the S&P 500. We mentioned that our Indexes have more of a large-cap bias than the S&P 500. A natural question is, what combination of indexes with our large-cap bias would produce a size exposure similar to the S&P 500?
We think it’s interesting to consider blending WTLDI with mid-cap options in order to bring the weighted average size exposure into alignment with that of the S&P 500 Index, and the two mid-caps we use are the WisdomTree MidCap Earnings Index (WTMEI)
and the WisdomTree MidCap Dividend Index (WTMDI)
• An allocation of 77% WTLDI / 23% WTMEI achieved the same size factor as the S&P 500.
• An allocation of 64% WTLDI / 36% WTMDI achieved the same size factor as the S&P 500. WTMDI had a bigger size factor than WTMEI and thus more was necessary to lower the overall size factor to the S&P 500’s.
The WisdomTree Earnings 500 Index (WTEPS)
also has more of a large-cap bias than the S&P 500, and we analyzed what combinations targeted the S&P 500 size factor. They are:
• 91% WTEPS / 9% WTMEI
• 85% WTEPS / 15% WTMDI
As people consider ways in which to potentially outperform the S&P 500 on a risk-adjusted basis, we believe that these are examples of one approach that could be of interest. It also shows that as one looks to add in the WisdomTree large-cap options, there is a large-cap bias to construction relative to the S&P 500 that could impact desired allocations in other segments.
To read our full factor analysis on our smart beta approach, click here
Important Risks Related to this Article
Investments focusing on certain sectors and/or smaller companies increase their vulnerability to any single economic or regulatory development. This may result in greater share price volatility. The Dow Jones U.S. Select Dividend Index is calculated, distributed and marketed by Dow Jones Indexes, a licensed trademark of CME Group Index Services LLC, and has been licensed for use.