As the equities markets push toward new heights and valuations look pricey, mid- and small-cap investors may turn to a smart beta ETF strategy to add greater value to a diversified portfolio.
The S&P 500 Index and the Russell Top 200 Index have trailing 12-month price-to-earnings ratios of slightly below 22.0x, Christopher Gannatti, Associate Director of Research for WisdomTree, said in a research note. The S&P MidCap 400 and the Russell Midcap Indexes showed P/E ratios of between 24.0 and 25.0x. Meanwhile, the small caps were among most expensive based on price and earnings, with the S&P SmallCap 600 Index trading at about 29.0x and the Russell 2000 Index trading slightly below 50.0x.
Some may question the 50.0x figures for the Russell 2000 Index, but Gannatti pointed out that 20% of companies in the index showed negative earnings, which bring down the earning per share of the full index and leads to a higher P/E ratio. Lower-quality small-caps tend to have high P/E ratios.
Alternatively, investors interested in the mid- and small-cap space but are wary of heightened valuations may consider a smart beta ETF play that specifically focuses on more quality companies, which also provides a greater value tilt. For instance, the WisdomTree MidCap Earnings Fund (NYSEArca: EZM) and WisdomTree SmallCap Earnings Fund (NYSEArca: EES) have outperformed the vast majority of peers in their respective Morningstar categories over the decade-long period they have been active.
The ETFs track earnings-weighted indices that screen for positive cumulative earnings over their most recent four fiscal quarter period and assigns weights to components to reflect the proportionate share of the aggregate learning’s each company generated, so those with greater earnings have larger weights. Due to this particular indexing methodology, the ETFs lean toward value and quality factors, and within the mid- and small-cap ETFs, the size factor, which have all been historically associated with excess returns compared to the broader market over the long-haul.
The current P/E ratios of 19.6x for EZM’s underlying WisdomTree U.S. MidCap Earnings Index and 17.9x for EES’s underlying WisdomTree U.S. SmallCap Earnings Index, while slightly elevated, still represent discounts to the market, which may help investors better manage the valuation risks of rising multiples, especially in an ongoing bull market run.
“This methodology has provided a capability to raise the earnings yield (or lower the P/E ratio) compared to a similar market capitalization-weighted universe of stocks,” Gannatti said. “When searching for a strategy in an environment where the markets are experiencing overall lower earnings yields (or higher P/E ratios), this approach could be even more important when considering longer-run returns.”
For more information on the small-capitalization market, visit our small-cap category.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.