The Factor Forces at Work
At WisdomTree’s core is the belief that it may be possible to generate greater excess return over time by taking on greater active risk and concentrating index holdings in stocks that have greater exposure to the factors that historically have been associated with excess return. We designed the WisdomTree U.S. Multifactor Index to target factors consistent with many “smart beta” approaches. But we believe our method of combining factors to maximize the potential for higher absolute and risk-adjusted returns is unique. The Index now has about nine months of live track record and has completed two quarterly rebalances, with the most recent changes highlighted below.
The WisdomTree U.S. Multifactor Index
WisdomTree blends both fundamental and technical factors to create a composite factor score for the purposes of stock selection. The composite score is an average of four factors, with value and quality being driven by fundamentals, while momentum and correlation are driven by technical factors or price. Since each factor has an equal weight, all of them are pushing or pulling the composite factor score with some force. During a market environment where you see increased volatility, correlations and return dispersions, you might expect the technical factors to generate more force through larger changes in relative rank.
At the most recent rebalance, the largest change in scores for the drops were correlation, representing 46% of the total drops, and momentum, representing a little over 31%. The largest changes in scores for the additions were momentum (47%) and correlation (31%). Now, just because we didn’t see large changes in individual fundamental scores doesn’t mean the Index’s fundamentals remain the same. The shifts, driven by the technical factors, also influenced the composition and fundamentals of the Index.
The Index has a sector-neutral constraint, so there weren’t large differences in the sectors, but there were some minor adjustments based on price changes since the last rebalance. The most notable changes to the basket are highlighted in the table below.
- Tilted Toward Mid-Cap Segment: The Index is initially weighted based on its composite factor score and volatility, which tends to result in a modified equal-weighted exposure, but it is noticeable that this rebalance saw the weighted average market cap get cut in half. The exposure to mid-cap securities, defined as $2 billion to $10 billion in market cap, saw a 15% increase to over 41%. The rebalanced Index has a larger skew to the size factor relative to even the S&P 500 Equal Weight Index.
- Lowered Interest Rate Sensitivity: As interest rates picked up over recent months, we witnessed increased volatility and poor performance from some of the “traditional” lower volatility and higher dividend yield securities. The risk-adjusted momentum score would have pushed the Index out of some of these types of securities, ultimately leading to a lower Index dividend yield. The aggregate dividend yields fell in nine out of the 11 sectors, with the largest reduction coming from Energy and Telecom. We find it interesting that the net buyback yield of the portfolio increased by about the same percentage as the dividend yield fell, so the total shareholder yield was essentially unchanged. The weighted average market cap and leverage of the Index were also lowered, both signs that point to lower interest rate sensitivity.
- Stepping Up the Quality: Since quality is one of the factors, it was no surprise to us that there was a sizable increase in the return on equity and return on asset measurements. The quality score looks at companies that are displaying strong quality metrics currently but also exhibiting an improvement in the metrics. Typically, you would expect to “pay up” for this type of quality basket, so it is encouraging to see the Index trade at a lower price-to-earnings (P/E) multiple than the S&P 500 Index.
- Lower-Priced Earnings Basket: Despite the fact that earnings yield is just part of the value score, the Index increased its earnings yield by over 1% (or lowered its P/E ratio by 3 points). Also, what is impressive about the trailing P/E ratio falling and the forward P/E ratio reaming stable is that the Index accomplished this feat with a substantial increase to mid-cap securities (which tend to be higher priced). On a trailing earnings basis, the Index is priced over 30% lower than both the S&P 500 Index and the S&P 500 Equal Weight Index, which should attract interest from those concerned about rising multiples in the U.S.
Diversifying Factor-Specific Risk
A key benefit of using a multifactor stock selection methodology is the potential to diversify factor-specific risk. Our research found that by picking stocks based on one factor at a time, we diluted the alpha potential of various factor exposures when they were combined. Therefore, we choose to score individual stocks based on our factor definitions rather than equally weighting the stocks selected for our distinct factor portfolios. This balance helps us select 200 stocks that tapped into multiple factors, resulting in a basket more likely to outperform in various environments.