Every year on November 30, WisdomTree runs a screen upon which a subsequent rebalance of WTSEI is based. The purpose of this screening and rebalancing process is simple:
• Looking to trim weight from stock positions whose prices have appreciated significantly but whose fundamentals may not have increased commensurately.
• Looking to add weight to stock positions whose prices have stagnated or even fallen but whose fundamentals may have actually exhibited positive growth.
It is in this way that WisdomTree looks to mitigate the risk of being exposed to firms that may have enjoyed strong momentum and price increases but whose price levels may be at a relatively higher risk of being classified as “expensive.”
Continual Focus on the Earnings Stream
Mechanically, WTSEI’s rebalancing process is based on the Earnings Stream, which, simply put, is derived from a firm’s earnings per share multiplied by its number of shares outstanding. This ends up being much different than the process employed by market capitalization-weighted indexes, where the weights are determined by multiplying share price with the number of shares outstanding. In essence:
• WTSEI “rewards” (with greater weights) the firms that have generated the greatest levels of earnings.
• A market capitalization-weighted index “rewards” the firms with the greatest market capitalizations, which in many cases ends up being the firms whose share prices have increased the most.
Perhaps the most interesting element of WTSEI’s rebalance is the fact that each and every year companies must demonstrate profitability to maintain their eligibility for inclusion. Put another way: firms that on the screening date cannot demonstrate a prior four quarters of cumulative positive earnings are excluded from the Index.
Conclusion
After such strong performance in U.S. small-cap stocks, we believe a focus on a disciplined rebalancing process gains significant importance. While market capitalization-weighted indexes may simply continue giving the greatest weights to the firms with the largest market caps, WTSEI focuses on fundamentals, specifically the Earnings Stream, to determine its constituent weights. We believe this gives WTSEI the potential to sell stocks that have become more expensive and buy stocks that have become less expensive relative to the earnings they have generated. In essence, this could be one way to manage risk after a market rally.
Christopher Gannatti is a research analyst at WisdomTree Investments (NasdaqGM: WETF). This post was republished with permission from the WisdomTree blog.