During periods of strong short-term performance, as seen in 2013, it is especially important to ask whether these moves are justified by the underlying fundamentals. We think it is important to be mindful of how an annual rebalance back to an underlying fundamental such as dividends can help manage valuation risks—a key factor in why the non-cap-weighted indexes are included in the “smart beta” category of indexes.
Quantifying the Fundamental Rebalance
With market capitalization-weighted indexes, when constituents increase in price compared to other stocks, they gain greater weight and increase their impact on the performance of the index.
WisdomTree Indexes employ a rules-based rebalancing mechanism that adjusts relative weights based on underlying dividend trends. During the rebalancing process, which occurs once per year for each Index, the relationship between price change and dividend growth is measured. In the table below we quantify the dividend growth for companies that received increases in weight or decreases in weight, and compared that to the overall universe.
Figure 1: WisdomTree Dividend Index (WTDI) Trends
• Dividend Growers Saw Weight Increase: The companies that saw their weight increase at the rebalance had a median dividend growth of 17.0%, which was greater than the median dividend growth of all companies (at 8.4%). Companies that saw their weight lowered at the rebalance had a median dividend growth of just 5.1%.
• Underperformers Typically Saw Weight Increase: Performance is also a key driver of relative changes. The typical stock that saw its weight increase had a median total return that was over 15 percentage points lower than the median of all stocks.
• Outperformers Reduced at Rebalance: The typical stock that saw its weight lowered at the rebalance had a median total return 9 percentage points above all stocks. This is one of the keys to managing valuation risks.
A Detailed Look at the Individual Drivers