THE DIFFERENCE QUALITY MAKES

The idea of quality investing has a long and rather prestigious history.

From Warren Buffett—arguably one of the most famous and successful investors of all time—and Benjamin Graham to Eugene Fama and Kenneth French, each focuses on quality attributes such as profitability and low debt ratios as part of their selection criteria. Even academics such as Robert Novy-Marx believe in the superiority of quality investments over time. And the performance certainly backs up their belief in quality.

A LOOK AT PERFORMANCE

Arranging the U.S. market into quintiles based on operating profitability, for example, demonstrates that high-quality stocks have won over longer holding periods. In the chart below, consider that, over the period, the two highest quality quintiles not only outperformed the lower-quality quintiles, but also the market—and with higher Sharpe ratios as well.

 ANALYSIS OF OPERATING PROFITABILITY QUINTILES (6/30/1963 – 12/31/2017)

Source: Kenneth French Data library, with data as of 12/31/2017. Period based on availability of Operating Profitability returns sorted into quintiles, which begins 6/30/1963. Universe is U.S. listed equities grouped on the basis of operating profitability. Past performance is not indicative of future results. You cannot invest directly in and index.

SMALL CAPS. BIG QUALITY.

Quality is not limited to large-cap stocks. Fama and French, as well as other notable investors, have explored the idea of small caps and quality factors. And while they may be best known for discovering the “small-cap value premium,” the data below suggests that a small-cap quality premium exists as well—as illustrated by small cap, high quality outperforming low quality over the period.

Source: Kenneth French Data library, with data from 6/30/1963 to 12/31/2017. Universe is U.S. listed equities grouped on the basis of size and book-to-market, and size and operating profitability. Past performance is not indicative of future results. You cannot invest directly in and index.

Small-High Quality refers to the universe of listed stocks in the United States within the bottom 30% of the market capitalization that have exhibited the highest 30% of observations of operating profitability. Small Value refers to the bottom 30% of market capitalization of U.S.-listed stocks that have exhibited the highest 30% on the basis of book value-to-market value ratio. Small refers to the bottom 30% of market capitalization U.S.-listed stocks.

MARRYING QUALITY AND VALUE

WisdomTree has long been a proponent of the benefits of value investing. And Fama and French are well-known advocates as well, helping to prove the existence of the “value” premium.

It’s interesting to examine how quality and value perform against—and complement—each other. We used Kenneth French Data Library data focused on quality and value to make the comparisons.

QUALITY AS A HEDGE FOR VALUE?

While value strategies focus on how price relates to fundamentals such as dividends, earnings or book value, quality factors focus on the inherent stability of the fundamentals themselves—making them interesting complements.

Further, academic research has suggested that, as quality and value typically perform at different times, quality can act as a “growth” engine, essentially providing a potential “hedge” for value strategies when they may be out of favor. We tested the theory below. When the USA Quality was outperforming, the USA Value was underperforming to a similar degree—and vice versa.

ROLLING 3-YEAR AVERAGE ANNUAL EXCESS RETURNS (6/30/1963 - 12/31/2017)

Source: WisdomTree, Kenneth French Data library. Quality refers to top 30% of U.S. listed stocks on basis of operating availability. Value refers to top 30% of U.S. listed stocks on basis of book to market value ratio. Past performance is not indicative of future results. You cannot invest directly in and index.

The USA Quality refers to the universe of listed stocks in the United States within the top 30% of the operating profitability. The USA Value refers to the universe of listed stocks in the United States within the top 30% of book to market.

QUALITY AROUND THE WORLD

The advantages of quality are not limited to the United States.

In fact, with the exception of a challenging ten- and fifteen-year period in the Japan Quality Stocks, quality tended to outperform around the world—especially over longer periods.

Source: WisdomTree, Kenneth French Data Library. Data as of specified dates. Universes are publicly listed and traded stocks with book to market and operating profitability data within each specified region. Quality refers to top 30% of U.S. listed stocks on basis of operating profitability. Value refers to top 30% of U.S. listed stocks on basis of book to market value ratio. Past performance is not indicative of future results.

THE FUTURE OF DIVIDENDS

Not only do some of the dividend growth ETFs fail to look at quality factors, they also tend to use backward-looking screens that require a history of 10, 20 or even 25 years of dividend growth before they can be eligible for inclusion.

While this may sound like a good idea, we believe that investors desire today’s highest dividend payers, rather than those from a decade ago or more.

SCREENING FOR GROWTH OR EXCLUDING IT?

Dividends have been growing at an incredible pace in recent years, with the technology industry leading the pack. But ETFs that utilize backward-looking screens will not include these dividend leaders, possibly for many years. Consider that:

• The U.S. Dividend Stream® hit a record high of $481.15 billion on November 30, 2017.
• Technology firms have been the greatest contributors to dividend growth over the past 10 years—accounting for more than 27% of the increase in dividends between November 30, 2007, and November 30, 2017.

One popular index today is the NASDAQ US Dividend Achievers Select Index (DVG). One of the most critical differences between WTDGI and DVG is that DVG uses a backward-looking growth screen that requires 10 consecutive years of dividend growth to qualify for inclusion, while WTDGI does not. Dividend indexes with backward-looking growth screens may fail to capture growth opportunities. A simple example of the difference is the case of Apple. As one of the largest dividend payers in the United States, Apple is included in WTDGI—but it won’t be eligible for inclusion in DVG until 2023. While WTDGI does not require a history of dividend growth, it does use numerous quality screens, and it weights by dividends and rebalances annually. DVG, however, does not.

WISDOMTREE QUALITY DIVIDEND GROWTH FAMILY

WisdomTree's family of forward-looking quality dividend growth Funds is designed to help you capitalize on today’s quality and dividend growth trends across domestic and international markets.

INDEX METHODOLOGY

WisdomTree looks at quality characteristics in addition to dividends. In fact, return on equity, return on assets and earnings growth are key drivers of the stock selection in our Dividend Growth family. Why? In addition to the outperformance demonstrated by quality, finance theory and the dividend discount model suggest that return on equity is intimately related to dividend growth—so in theory, the higher the ROE, the higher the sustainable dividend growth of that company. Our family is where this theory meets reality.

INDEX METHODOLOGY SUMMARY

The following general principles are used in creating the WisdomTree Quality Dividend Growth Indexes:

• Companies must have a dividend ratio greater than 1.0x. Companies that are paying out more dividends than they have earnings are less likely, we believe, to be dividend growth leaders.
• The Indexes combine the companies with the best quality and growth rankings from their respective universes:
  
  • Growth Ranking 50%: Derived from analysts’ long-term earnings growth expectations, which ultimately encompass the estimated growth in operating earnings per share over the company’s next full business cycle, typically three to five years
  • Quality Ranking 50%: Split evenly between the three-year average return on assets and return on equity

Weighting: The indexes are Dividend Stream-weighted to reflect the proportionate share of the aggregate cash dividends. This gives greater weight to companies growing their dividends, as well as having the potential to raise the trailing 12-month dividend yield of the total portfolio. The Dividend Stream weighting methodology also brings a value tilt to the quality and growth selection.