The Power of Fundamentals among Small Caps

WisdomTree believes that screening and weighting equity markets based on their fundamentals can help produce higher total and risk-adjusted returns over a complete market cycle

We continue to see proliferation of the term “smart beta,” which in its simplest terms indicates an index construction that does not weight constituents by market capitalization but incorporates some type of rulesbased rebalancing process. We believe that smart beta fits between traditional market capitalization-weighted approaches and active management, by offering some of the best attributes of each. A wide array of smart beta indices are starting to have live performance histories greater than five years, and we evaluated the WisdomTree Indices focused on small-cap equity markets with at least that much history. Previously we discussed how these strategies compared against active managers, but below we will compare them to market capitalization-weighted indices.

Are Markets Always Efficient?
The Efficient Market Hypothesis posits that the market price of any security reflects the most accurate possible estimate of the firm’s fundamental value—there are no “bubbles,” or periods when stocks may be bid up in price due to excitement or euphoria. We believe that this isn’t always the case, and therefore we believe that markets are not always efficient, and the default weighting shouldn’t always be based on market cap.
WisdomTree believes that screening and weighting equity markets based on fundamentals such as dividends or earnings can help produce higher total and risk-adjusted returns over a complete market cycle.

The Annual Rebalance
One of the most important elements of a fundamental index is the annual rebalance process, where the index screens the eligible universe and then weights those securities based on their fundamentals. In essence, the process takes a detailed look at the relationship between the underlying fundamentals and price performance.

WisdomTree’s Dividend Index rebalance process typically is driven by:

• Dividend Growth: Companies increasing dividends see their weight increased
• Relative Performance:
• • Underperformers typically see their weight increased
  • Outperformers often see their weight decreased

In the charts below, we compare the absolute and risk-adjusted performance for various WisdomTree SmallCap Dividend Indices against a comparative market cap-weighted index.

• WisdomTree Indices Displayed Higher Absolute Returns Since Inception: WisdomTree believes that the more inefficient the market, the greater the potential for fundamentally weighted indices to outperform market capitalization-weighted indices. Therefore, it has come as no surprise to us that, since their inception, WisdomTree’s fundamentally weighted Indices have produced some of the greatest outperformance compared to their cap-weighted peers in the small-capitalization size segments. In arguably one of the most inefficient small-cap markets, the emerging markets, the WisdomTree Emerging Markets SmallCap Dividend Index outperformed by approximately 2% per annum.
• WisdomTree Europe and Emerging Market SmallCap Indices Displayed Higher Risk-Adjusted Returns: We find it impressive that WisdomTree indices have also offered excellent performance on a risk-adjusted basis compared to their market cap-weighted peer indices since their inception, especially our Europe SmallCap and Emerging Market SmallCap indices. Inefficient markets are typically those where there is less analyst coverage and where stock prices may tend to exhibit greater fluctuations in price (i.e., higher volatility), compared to the true underlying value of the firm. Therefore, we believe fundamentals become even more important and help control for valuation risks.