Until fairly recently, investors relied principally on actively managed mutual funds to gain exposure to the markets—especially for small-cap options around the world, where many believe that opportunities are ripe for active managers to add value. Small-cap stocks, generally speaking, do not garner the same level of analyst coverage, and many believe informational inefficiencies provide richer opportunity sets for stock pickers to potentially outperform index benchmarks. After a strong performance during 2013, many have set their sights on European small caps1 in particular, and significant levels of assets have flowed into Europe (as Zach discussed in this prior blog post).

Index-Based Strategies Offer a New Option

Although Europe is an important focus for developed international investors, there are limited choices available to those interested in targeting exposure to European small-cap companies. Looking at the U.S.-listed mutual funds and exchange-traded funds (ETFs) in Morningstar’s Europe Stock category, as of December 31, 2013, there was only one ETF and three mutual funds specifically focused on small caps.2

To give readers some idea of the size of these traditional mutual funds focused on European small caps, as of December 31, 2013, the largest had slightly over $650 million, and the smallest almost $28 million in assets. To put this in context, the largest U.S.-listed mutual fund in this same category had almost $20 billion in assets as of that same date. As of December 4, 2013, the largest mutual fund strictly focused on small caps in the Morningstar Europe Stock category was actually closed to new investors.3

This highlights a central concern many have for active strategies in the small-cap space: managers often reach capacity because the companies being targeted for exposure within the funds are small, and for a fund to maintain a significant enough exposure in high-conviction ideas to potentially impact performance, larger and larger positions have to be taken.

A Benefit to Index-Based Investing: Breadth of Holdings Creates More Capacity

One of the benefits to index-based strategies is the breadth of holdings. Index-based strategies are not trying to make a small selection of stocks to outperform a market segment; they are trying to identify liquid and investable companies representative of a specific investment theme. In our view, the larger size of the investing universe for index-based strategies creates greater investment capacity.

Of course, index methodology is crucial to determining both capacity and representation, as not every index tracking the performance of equities is designed with scale in mind. WisdomTree has built its Indexes with this potential for scalability in mind. To accomplish more capacity in its Index-tracking strategies, WisdomTree designed its European-focused equity Indexes to emphasize the cash dividends each company pays—but to do so in a way that looks at aggregate dividends paid, which gives greater weight to bigger companies. In most cases, WisdomTree weights and rebalances its Indexes annually according to their Dividend Stream®.

Dividend Stream = Dividends per share x shares outstanding

By including shares outstanding in the weighting, we believe we introduce greater potential capacity to the strategies tracking the performance of our Indexes after costs, fees and expenses.