With equity markets forging new all-time highs, we think it is especially important to ask whether these moves are justified by the underlying fundamentals. We also think it is important to be mindful of how an annual rebalance, steering a portfolio back to an underlying fundamental such as dividends, can help manage valuation risks —a key factor in the inclusion of non-cap-weighted indexes 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 figure 1, we quantify the dividend growth for companies that received increases in weight or decreases in weight and compare that to the overall universe.1
Figure 1: WisdomTree Dividend Index (WTDI) Trends
For definitions of terms in the chart, please visit our glossary.
• Dividend Growers Saw Weight Increase: The companies that saw their weight increase at the rebalance had a median dividend growth of 13.3%, which was greater than the median dividend growth of all companies (at 8.0%). Companies that saw their weight lowered at the rebalance had a median dividend growth of just 4.5%.
• 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 8 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 13 percentage points above all stocks. This is one of the keys to managing valuation risks.
A Detailed Look at the Individual Drivers
The above was a higher-level overview of the total Index, but in figure 2, we highlight a few of the top additions and deletions to further specify the contributors.