Morningstar Advisor - December 2013/January 2014 - (Page 48)
Spotlight
Following the Rules
By Patricia Oey
A look at how the rules-based methodology behind this popular
ETF has led to changes that might surprise its shareholders.
Since its launch in 2007, WisdomTree Emerging
Markets Income DEM has grown into a
$5 billion exchange-traded fund, fairly sizable
given its short track record. The non-capitalization-weighted, dividend-focused fund
got off to a fast start, generating about 600
basis points and 500 basis points of annualized
outperformance during its first three- and
five-year time periods, respectively, relative to
the MSCI Emerging Markets Index. Part of
that performance was due to the ETF's quality
tilt, as evidenced by its lower volatility. In 2008
and 2011, years when the MSCI benchmark
saw declines of 50% and 19%, respectively, the
WisdomTree fund exhibited more muted
declines of just 37% and 10%.
However, this fund may exhibit less of a quality
tilt in the medium term. Historically, its quality
bias was a result of its simple rules-based
dividend screens for security selection.
Dividends can be used to screen for effective
management and healthy fundamentals,
issues that are more difficult to discern in
emerging market companies. Over the past two
years, though, the Chinese and Russian
governments have been urging their large
state-owned enterprises to pay out more
dividends. These arguably lower-quality,
state-owned companies now comprise a much
larger percentage of this WisdomTree
fund, which will likely result in more volatile
performance going forward.
48 Morningstar Advisor December/January 2014
This fund serve as a case study for how
political risks and the idiosyncrasies
of individual emerging market countries can
impact a rules-based strategy from year
to year. This is an important issue, as many
rules-based strategies in emerging markets
were actually created for the U.S. equity
market. In other words, what may have worked
in the United States may not work as well in
emerging markets. Investors need to understand the methodology behind what are billed
as passive strategies and monitor portfolio
changes during the periodic rebalances.
Making Sense of the Methodology
Many dividend funds weight their holdings by a
stock's dividend yield, but this WisdomTree
fund's methodology is different. At the end of
May each year, its screens the universe
of emerging-markets stocks for firms that have
paid out at least $5 million in regular cash
dividends over the past 12 months and have
met certain market capitalization and liquidity
requirements. These companies are then
ranked by dividend yield and the top 30% are
selected for inclusion in the fund's underlying
index. Constituents are then weighted by
dividends paid, measured by trailing 12 months
dividends per share multiplied by shares
outstanding, converted into U.S. dollars.
This methodology attempts to create a
relatively high-yielding fund with an emphasis
on more stable, large-cap companies.
The emphasis on larger companies is due to the
fact that larger companies tend to pay a higher
total amount of dividends. The fund also
has a value tilt, thanks to the index's dividend
yield screen and annual reconstitution. By
rebalancing, the fund tends to sell lower
yielding (more expensive) companies and buy
higher-yielding (less expensive) companies.
Not surprisingly, there are intricacies to this
WisdomTree dividend strategy when applied to
emerging markets, a very diverse universe
of around 20 countries. First of all, Taiwanese
and Brazilian companies tend to be higher
dividend payers due to tax rules and laws that
support dividend payouts. As a result,
emerging-markets dividend funds, including
this one, typically have substantial exposure to
those two countries. Another issue is the
fact that this fund's positions are weighted by
dividends paid, measured in U.S. dollars, so the
portfolio can be affected by exchange rate
fluctuations. And finally, as mentioned earlier,
governments can influence company dividend
policies, which ultimately impacts which
securities qualify for this fund.
Market Structure, Local Rules Drive
Portfolio Construction
Taiwan has a relatively robust capital market
and lots of well-established firms that pay
dividends. That means the fund's historical
overweight to Taiwan (20% to 30% of the fund)
Table of Contents for the Digital Edition of Morningstar Advisor - December 2013/January 2014
Morningstar Advisor - December 2013/January 2014
Contents
Contributors
Letter From the Editor
What’s Your Purpose?
Working for Gen Y
How to Allocate College Savings
Mobius Looks to a New Frontier
Investments á la Carte
Investment Briefs
How to Manage Bonds for Today and Tomorrow
Cloud Is the New Engine of Growth
Knowing Where to Look
Economic Vulnerability Varies by Country
Factor Investing in Emerging Markets
Following the Rules
Exploring Indexing’s Next Frontiers
Frequent Fliers
Family Blind Spots
Optimal Portfolios for the Long Run
Finding Value in a Pricey Sector
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
The Emerging-Markets Roller Coaster
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