The Long Portion of WisdomTree’s Long/Short Strategy

WisdomTree launched the WisdomTree Dynamic Long/Short U.S. Equity Fund (DYLS) late last year to give investors a way to dial down their exposure to the U.S. equity market when fundamentals deteriorate. Heading into 2016, the Index that DYLS seeks to track, the WisdomTree Dynamic Long/Short U.S. Equity Index, provided a market-neutral exposure: it counterbalanced its long positions by shorting S&P 500 Index futures for the month of January and February. Starting on March 2 and through the month of September, the strategy has been 100% long. So how has the long portion of this strategy performed in 2016?

Total Returns as of 9/30/2016

With 180 basis points (bps) of outperformance over the S&P 500 Index year-to-date, the WisdomTree Dynamic Long U.S. Equity Index—the long portion of the WisdomTree Dynamic Long/Short U.S. Equity Index—has shown its potential to generate alpha. Since its inception in November 2015, the long portion of the Index has beaten the S&P 500 by 56 basis points. How did the Index achieve this?
Two factors—growth and value—determine which companies are selected, and one factor—volatility—drives their weight in the WisdomTree Dynamic Long U.S. Equity Index. Stocks earn a growth score and a value score based on various measurements relevant to the sector they come from. Stocks with the highest scores are selected each quarter and assigned weights so that overall sector exposure is similar to the market. However, rather than weighting by a company’s market value, WisdomTree sets weights based on a stock’s volatility multiplied by its beta, in effect rewarding lower-volatility stocks with greater weights and refreshing those weights through a quarterly rebalance. This weighting methodology, along with sector constraints, helps the long Index correlate with the broader movement of the market while also providing the potential for some measure of downside protection.
For example, in February, the month that saw the bottom of the S&P 500 and the peak of the VIX year-to-date, the WisdomTree Dynamic Long U.S. Equity Index outperformed the S&P 500 by over 280 bps. Put another way, the WisdomTree Dynamic Long U.S. Equity Index combines quality and value in the selection process and low volatility in the weighting process in a sector-neutral attempt to add alpha on the long side of the portfolio. 

Despite the efficacy of the WisdomTree Dynamic Long U.S. Equity Index, one must remember that it is actually only one half of a “Dynamic Duo.” On a monthly basis, a hedging indicator will inform the WisdomTree Dynamic Long/Short U.S. Equity Index how much net equity exposure it wants to take on, be it 100%, 50% or 0% (market neutral). This is done by maintaining the long portion of the portfolio and shorting S&P 500 Index futures to achieve the indicated net equity exposure. It helps to think of the hedging indicator as a signal for potentially higher, medium or lower beta to the S&P 500 Index—higher beta being 100% net equity exposure, medium beta being 50% net equity exposure, and lower beta being 0% net equity exposure. The key drivers for 100% net equity exposure are expanding profits, as measured by operating profit margins, net income profit margins and profit quality. In addition, value indicators—as measured by price to book and price to cash flow—also contribute to the net equity exposure decision on a month-to-month basis. These same signals moving in the opposite direction would trigger a market-neutral position, while a mixture of readings would advise the Index to proceed with caution, or 50% net equity exposure. It is important to note that if the monthly signal is 50% net equity exposure or market neutral at a time when the market is rallying, the WisdomTree Dynamic Long/Short U.S. Equity Index will likely experience less of that upside gain. Likewise, if the signal is 100% net equity exposure when the market is falling, it could experience losses in line with those of the S&P 500 Index.

Conclusion
The WisdomTree Dynamic Long/Short U.S. Equity Index provides an interesting take on “active” downside protection. By maintaining long exposure to what we believe is a fundamentally sound, low-volatility-weighted basket of stocks, the potential for alpha always exists. Yet by using a monthly hedging indicator and changing net equity exposure by shorting S&P 500 Index futures, the beta of the strategy to the S&P 500 can change on a monthly basis, providing the potential for downside protection. We believe that as long as the hedging indicator continues to be accurate more often than not, the WisdomTree Dynamic Long/Short U.S. Equity Index has the potential to generate higher risk-adjusted returns and to complement broader equity exposure as an alternative allocation strategy.