Morningstar Advisor - December 2013/January 2014 - (Page 48)

Spotlight Following the Rules By Patricia Oey A look at how the rules-based methodology behind this popular ETF has led to changes that might surprise its shareholders. Since its launch in 2007, WisdomTree Emerging Markets Income DEM has grown into a $5 billion exchange-traded fund, fairly sizable given its short track record. The non-capitalization-weighted, dividend-focused fund got off to a fast start, generating about 600 basis points and 500 basis points of annualized outperformance during its first three- and five-year time periods, respectively, relative to the MSCI Emerging Markets Index. Part of that performance was due to the ETF's quality tilt, as evidenced by its lower volatility. In 2008 and 2011, years when the MSCI benchmark saw declines of 50% and 19%, respectively, the WisdomTree fund exhibited more muted declines of just 37% and 10%. However, this fund may exhibit less of a quality tilt in the medium term. Historically, its quality bias was a result of its simple rules-based dividend screens for security selection. Dividends can be used to screen for effective management and healthy fundamentals, issues that are more difficult to discern in emerging market companies. Over the past two years, though, the Chinese and Russian governments have been urging their large state-owned enterprises to pay out more dividends. These arguably lower-quality, state-owned companies now comprise a much larger percentage of this WisdomTree fund, which will likely result in more volatile performance going forward. 48 Morningstar Advisor December/January 2014 This fund serve as a case study for how political risks and the idiosyncrasies of individual emerging market countries can impact a rules-based strategy from year to year. This is an important issue, as many rules-based strategies in emerging markets were actually created for the U.S. equity market. In other words, what may have worked in the United States may not work as well in emerging markets. Investors need to understand the methodology behind what are billed as passive strategies and monitor portfolio changes during the periodic rebalances. Making Sense of the Methodology Many dividend funds weight their holdings by a stock's dividend yield, but this WisdomTree fund's methodology is different. At the end of May each year, its screens the universe of emerging-markets stocks for firms that have paid out at least $5 million in regular cash dividends over the past 12 months and have met certain market capitalization and liquidity requirements. These companies are then ranked by dividend yield and the top 30% are selected for inclusion in the fund's underlying index. Constituents are then weighted by dividends paid, measured by trailing 12 months dividends per share multiplied by shares outstanding, converted into U.S. dollars. This methodology attempts to create a relatively high-yielding fund with an emphasis on more stable, large-cap companies. The emphasis on larger companies is due to the fact that larger companies tend to pay a higher total amount of dividends. The fund also has a value tilt, thanks to the index's dividend yield screen and annual reconstitution. By rebalancing, the fund tends to sell lower yielding (more expensive) companies and buy higher-yielding (less expensive) companies. Not surprisingly, there are intricacies to this WisdomTree dividend strategy when applied to emerging markets, a very diverse universe of around 20 countries. First of all, Taiwanese and Brazilian companies tend to be higher dividend payers due to tax rules and laws that support dividend payouts. As a result, emerging-markets dividend funds, including this one, typically have substantial exposure to those two countries. Another issue is the fact that this fund's positions are weighted by dividends paid, measured in U.S. dollars, so the portfolio can be affected by exchange rate fluctuations. And finally, as mentioned earlier, governments can influence company dividend policies, which ultimately impacts which securities qualify for this fund. Market Structure, Local Rules Drive Portfolio Construction Taiwan has a relatively robust capital market and lots of well-established firms that pay dividends. That means the fund's historical overweight to Taiwan (20% to 30% of the fund)

Table of Contents for the Digital Edition of Morningstar Advisor - December 2013/January 2014

Morningstar Advisor - December 2013/January 2014
Contents
Contributors
Letter From the Editor
What’s Your Purpose?
Working for Gen Y
How to Allocate College Savings
Mobius Looks to a New Frontier
Investments á la Carte
Investment Briefs
How to Manage Bonds for Today and Tomorrow
Cloud Is the New Engine of Growth
Knowing Where to Look
Economic Vulnerability Varies by Country
Factor Investing in Emerging Markets
Following the Rules
Exploring Indexing’s Next Frontiers
Frequent Fliers
Family Blind Spots
Optimal Portfolios for the Long Run
Finding Value in a Pricey Sector
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
The Emerging-Markets Roller Coaster

Morningstar Advisor - December 2013/January 2014