Many investors allocate their portfolios to traditional asset classes only—namely equity and fixed income, investing on a long
-only basis. And unless investors have a premonition and really good timing, their portfolios usually suffer during bear markets
. On the other hand, short
portfolios have the potential to profit from negative price movements, but as John Maynard Keynes has been attributed with saying, “The market can stay irrational longer than you can stay solvent.” So while equity markets do have bear cycles, allowing an investor to potentially profit from going short, it may be prudent to have the flexibility to adjust your short position. Also, over long periods, the expected return of equities is positive, making it difficult to profit from a long-term, net-short position.
A dynamic bearish strategy is designed to be net short or market neutral (equal long and short positions) when the market environment is judged to be poor or mixed, and net long when the environment is deemed more attractive. We believe this may be a better long-run strategy than being 100% net short over the long term.
Figure 1 below illustrates the power of being flexible by comparing a dynamic short strategy against a strategy that remains 100% net short, both layered on top of the S&P 500 Index
• Dynamic Bearish Outperformed—
Applying a dynamic short strategy to the S&P 500 Index based on the hedging indicator
resulted in returns of almost 74%, while shorting the S&P 500 resulted in a loss of more than 66% over the period.
Figure 1: Incorporating a Dynamic Hedge Ratio
Introducing the WisdomTree Dynamic Bearish U.S. Equity Index
We believe this new Index can provide a passive dynamic bear approach—generating alpha
at the core through quantitative and fundamental
stock selection—while also having the ability to hedge market risk or profit from market pullbacks. Unlike traditional long-only indexes, the Index includes both long and short components, with the short percentage changing monthly, depending on market characteristics.
Generating Alpha at the Core
The long portion of the Index comprises approximately 100 stocks with the best grades (as defined below), is weighted to reward lower-volatility
stocks and is rebalanced quarterly 1
• Fundamental Selection—
Stocks are graded on a combination of growth
indicators, and the most attractive stocks within each sector are selected for inclusion. Each sector has its own unique factor scoring system. A subset of the variables analyzed includes:
• Sector Weighting—The Indexes target a sector-neutral allocation compared to the largest 500 U.S. stocks by market capitalization. The number of stocks in each sector is based on the sector weight of the 500 largest U.S. companies. For instance, if the Information Technology sector represents 20% of the market cap of those 500 companies, then 20 Information Technology stocks (20% of 100) would be selected for the Index, and their collective weight in the index would also be 20%.2
• Stock Weighting—
Within each sector, the Index gives higher weights to stocks that exhibit lower volatility characteristics, as measured by the stock’s standard deviation
to the market.
Incorporating a Dynamic Hedge Ratio
The short component of the Index is determined by a hedge indicator that considers a combination of both growth and value indicators:
Looks at operating profit margins
, net income profit margins
and profit quality (or operating cash flow
over operating income
Looks at price to book and price to cash flow
Profits are a key driver of the market. So when the growth fundamentals, or profits, of the eligible index universe are deteriorating, the dynamic indicator would look to hedge the portfolio. Similarly, as valuations
become more stretched, adding risk to the portfolio, the indicator would look to hedge as well. Over time, being able to limit or buffer losses during unfavorable markets has been critical to increasing portfolio returns while reducing risk.
Index Component Exposure
As we discussed, the WisdomTree Dynamic Bearish U.S. Equity Index contains both long and short components. And while the underlying eligible components will be fixed on a quarterly basis, the net exposure will change monthly based on the hedge ratios.
Based on the growth and value indicators of the market, the component weights will be one of the following:3
• Valuation and Growth Both Attractive—
100% long and 75% short (i.e., 25% net long)
• Valuation and Growth Mixed—
100% long and 100% short (i.e., 0% net long)
• Valuation and Growth Both Poor—
100% long Treasury bills and 100% short (i.e., 100% net short equity)
Introducing the WisdomTree Dynamic Bearish U.S. Equity Fund (DYB)
The launch of DYB, the Fund designed to track the WisdomTree Dynamic Bearish U.S. Equity Index before fees and expenses, brings the opportunity to take a dynamic bearish position in U.S. equities, enabling investors to access the ability to profit from market pullbacks with all the benefits of exchange-traded funds. DYB offers investors:
• A dynamic strategy designed to profit during falling markets
• Diversification to traditional long-only asset classes
• Access to alternative investments with no investment minimums, no sales loads, no lockup periods and no redemption fees (ordinary brokerage commissions apply)
• Full transparency of strategy and holdings with intraday liquidity
• No K-1
filing—and all the other benefits of ETFs
Components must be listed on a U.S. exchange, domiciled in the U.S., have a market cap of $2 billion and share price of at least $3 at time of screening.
There might not be 100 stocks due to rounding issues when determining number of stocks per sector based on market cap weighting (i.e., 19.3% sector weight results in 19 stocks, while 19.7% sector weight results in 20 stocks).
Due to the long component rebalancing quarterly and short component rebalancing monthly, other combinations are possible.