U.S. equity markets1 performed strongly through much of 20132. And one of the most impressive pockets of performance occurred in the small-cap size segment, with the Russell 2000 Index up more than 36%. For context, the S&P 500 Index, which was up slightly less than 30%. WisdomTree’s SmallCap Earnings Index (WTSEI) was up even more over this same period, with a return of more than 40%3.
Behavioral finance teaches us that when it comes to their portfolios, investors tend to hold on to their “winners” too long and sell their “losers” too quickly. But without a crystal ball, how can one really know what the right decision will turn out to be? Due to the futility of trying to time market tops and bottoms for individual stocks on a consistent basis, we believe that there are benefits to undertaking disciplined practices that take some weight away from particularly well-performing positions and reallocating toward areas that may not have kept up.
WTSEI as a Case Study
Mapping the Performance Picture
While the whole Index was up about 50%4 between annual rebalance screenings, we know that this is an average and not every stock was up by this amount. If we think broadly in terms of sector performance5:
• Four Sectors Greater Than 50%: Consumer Discretionary (57.5%), Industrials (55.1%), Information Technology (52.8%) and Telecommunication Services (51.4%).
• Two Sectors Less Than 30%: Energy (26.4%) & Utilities (19.3%).
We believe that performance dispersion such as this leads to potential opportunities for a relative value rebalance to go to work.
How Chips Were Taken Off the Table
Shifting to a constituent level, it’s important to remember that WTSEI is unique within the U.S. small-cap equity space in that it weights constituent firms by earnings.
• Greater Earnings = Road to Greater Weight: The typical firm receiving increased weight in WTSEI will have grown or at least maintained its earnings but have had lackluster price performance. Conversely, the typical firm receiving lower weight will have had stronger price performance but earnings growth that did not keep pace.
• Losses Lead to Deletion: Every constituent of WTSEI must prove its cumulative profitability over the four quarters prior to the November 30 screening. Lack of profits leads to lack of representation.
The Chips Coming Off the Small-Cap Table