Why “Passive” Doesn’t Always Mean “Average”

In February 2007, WisdomTree launched the WisdomTree U.S. MidCap Earnings Index, and the WisdomTree U.S. MidCap Earnings Fund (EZM) to track it. With an almost 11-year live track record for reflection, we review why WisdomTree chose to weight this Index by earnings and how this decision has helped the exchange-traded fund (ETF) achieve returns at the top of its Morningstar Category of active and passive peers.

How Valuation Has Been Important

Over a variety of long-term periods, work by Professor Jeremy Siegel in his book The Future for Investorshas indicated that the after-inflation returns of equities have held a very close relationship to their earnings yield—the reciprocal of the price-to-earnings (P/E) ratio. In short:

Higher earnings yields (or lower P/E ratios) have been associated with stronger real returns.

Lower earnings yields (or higher P/E ratios) have been associated with weaker real returns.

If, for instance, we’re looking at the S&P MidCap 400 Index with a trailing 12-month P/E ratio of 26.1x as of January 31, 2018, that is associated with a 3.8% earnings yield, and it becomes more challenging to see real after-inflation returns to U.S. equities that are too different from this 3.8% level—at least if history is any guide.¹

Where WisdomTree’s U.S. MidCap Earnings Strategy Can Help

The WisdomTree U.S. MidCap Earnings Index follows two big-picture steps at its annual rebalance, screened on November 30 of each year:

Include only profitable companies

Weight companies by their core earnings

This process has tended to raise earnings yields (same thing said a different way: lower P/E ratios) compared with market capitalization-weighted universes of similar stocks. Below, we focus on the WisdomTree U.S. MidCap Earnings Index P/E relative to the S&P MidCap 400 Index historically.

The WisdomTree U.S. MidCap Earnings Index Has Had a 26.5% Average P/E Ratio Discount Compared with the S&P MidCap 400 Index over Its Live History