New ETFs highlight belief that simple is good

Mar 5, 2007 @ 12:01 am

By David Hoffman

PHILADELPHIA — WisdomTree Investments Inc. of New York is betting that when it comes to fundamental indexing — indexes weighted not by market capitalization but by other factors — the simpler, the better.

That is one reason why it decided to launch last month a group of six exchange traded funds that follow earnings-weighted indexes.

The group will complement WisdomTree’s existing ETFs, which follow dividend-weighted indexes.

The move illustrates WisdomTree’s belief that the best fundamental indexes are those that follow a single factor. That belief is at odds with those of other proponents of fundamental indexing, such as Robert Arnott, chairman of Research Affiliates LLC in Pasadena, Calif.

His fundamental indexes — which are tracked by ETFs offered by PowerShares Capital Management LLC of Wheaton, Ill. — select and weight index components, based on a combination of sales, income, book value and dividends.

Mr. Arnott couldn’t be reached for comment.

But WisdomTree thinks that such an approach, while valid, can confuse the investor.

A multifactor index “crosses over” into what some people view as active management when what they want is passive investment, said Luciano Siracusano, director of research for WisdomTree.

At least one industry expert, however, disagrees.

Just because an index uses multiple factors doesn’t mean that it is actively managed, and investors are “smart enough” to know that, said Jim Lowell, Needham, Mass.-based editor of the Forbes ETF Advisor, a monthly newsletter.

Other experts aren’t so sure.

“Once you start moving beyond one factor, it sort of blurs the line between active and passive,” said Jack Ablin, chief investment officer of Harris Private Bank, a unit of Harris Bankcorp. Inc. in Chicago.

Combining multiple factors within an index also can make it more difficult for a sophisticated investor to “mix and match” various investments and investment strategies, said Allen Gillespie, a principal with GNI Capital Inc. in Greenville, S.C.

That point was reiterated by Mr. Siracusano.

Depending on their outlook, investors could own either WisdomTree’s dividend-weighted ETFs, which favor higher-yielding, less volatile stocks, or its earnings-weighted ETFs, weighted to give investors exposure to companies with an earnings track record.

Either way, back-testing indicates that both dividend- and earnings-weighted indexes upon which WisdomTree’s ETFs are based would have outperformed traditional market-cap indexes, Mr. Siracusano said.

Within the past five years, however, earnings-weighted indexes have outperformed dividend-weighted indexes, he said.

But that doesn’t mean that investors will rush out to buy the new earnings-weighted ETFs.

Time will tell

If WisdomTree, which has about $2.4 billion in assets, wants to win over more investors, it will have to wait until its ETFs — both dividend- and earnings-weighted — spend some time in the real world, industry experts said.

That is especially true for its earnings-weighted ETFs, said Sonya Morris, editor of Morningstar ETFInvestor, a newsletter published by Morningstar Inc. of Chicago.

“I’m sort of viewing these skeptically,” she said. “Earnings can be manipulated, or at least are more prone to be manipulated, by accounting tricks than cash flows or dividends.”

Even those who like the idea of earnings-weighted ETFs said they plan to wait and see how WisdomTree’s ETFs perform.

“It’s a great concept,” said Jack White, partner, director of research and a senior equity portfolio manager at Todd Investment Advisors Inc. in Louisville, Ky. “But I’m not sure how predictable these portfolios are, and that’s something that needs to be examined.”

WisdomTree said that it thinks investors eventually will come to see the benefits of its ETFs.

The company is so sure of itself that it is planning additional ETFs, though Mr. Siracusano said that it has no plans to offer anything other than dividend- and earnings-weighted ETFs.

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