New funds promise all-season performance

By Tim Middleton

Would you like to grow your stock-market wealth two ways: making more in good markets and losing less in bad ones?

Of course you would. And a new family of exchange-traded funds (ETFs) says it can deliver exactly that doubling of virtues.

Are you skeptical? Of course you are. In investing, if something worked, everybody would do it, and if everybody did it, it wouldn't work. That's the efficient-markets theory in a nutshell. Its advice: The best you can do is match the market by indexing it.

Well, to paraphrase a famous New Yorker cartoon, I say that's spinach, and I say to hell with it. Indexing stinks. At least the prevailing type, which gives the most weight to the highest-priced stocks.

Efficient-market nonsense

"The problem is you get a lot of very overvalued stocks in an index, particularly when you have a frothy market," says Bruce Lavine, president of WisdomTree Investments. During the late 1990s Internet bubble, Cisco Systems (CSCO, news, msgs) accounted for 4% of the S&P 500 Index ($INX). At the same time, says Robert Arnott, editor of the Financial Analysts Journal, Cisco accounted for 0.02% of the U.S. economy.

As for the efficient-market theory, which says it's not possible to outperform the market because securities prices already reflect all relevant information, I say nonsense. By some reckoning, half of daily stock-trading volume is attributable to hedge funds, which often pursue strategies unrelated to the fundamental values of the securities in which they invest. And stockbrokers manage to sell thousands of mutual funds that aren't any good, because their customers don't know any better.

So along comes WisdomTree, a family of 20 exchange-traded funds that use a new kind of indexing that aims to boost returns, and limit losses, simply by shunning overpriced stocks.

The company is new, but I have no doubt its basic approach is the right one for today's choppy market. It focuses strictly on dividends, and by definition stocks paying the highest yield have relatively low prices. So-called value stocks have trounced growth since the bear market began in 2000.

And WisdomTree's family is extensive, offering portfolios of small- and mid-capitalization stocks, both domestic and foreign. They are also cheap to operate, sporting annual expense charges that are one-third as high as traditional mutual funds.

Looking for value

The S&P 500 and most other popular indices rank their constituent stocks by the total value of their outstanding shares. A stock that is overpriced is correspondingly overweighted, as was Cisco (and plenty of other stocks) in 2000.

WisdomTree takes a contrary approach, giving the most weight to stocks paying the highest dividends -- that is, with the lowest relative prices. Academic research has demonstrated that value stocks deliver higher returns than growth stocks over very long periods.

Spurning conventional wisdom is not unique to WisdomTree. Dimensional Fund Advisors employs an equally contrary form of indexing to create what I have called the best mutual funds you can't buy.

Dimensional Fund Advisors uses secret formulas to create portfolios tilted toward value stocks. WisdomTree uses a transparent formula -- high dividends -- to achieve the value tilt. It holds down costs by using the ETF format, which is cheaper to operate than mutual funds.

WisdomTree also offers large-cap as well as small-cap portfolios. Six funds focus on domestic stocks. WisdomTree Total Dividend Fund (DTD) potentially invests in any domestic dividend-paying stock, and the index it follows currently yields 3.07%.

Like value funds in general, it invests most heavily in financial stocks (32% of assets) and consumer staples (21%), while shunning high-growth sectors like technology (4%). Like all WisdomTree funds, it was launched in June, and so doesn't have a performance record.

The funds' expense ratios vary between 0.28% for Total Dividend to 0.58% for most of the foreign funds. That's higher than Vanguard Group, the index leader, charges for its offerings, but a fraction of the equity-fund average of 1.45%.

According to Jeremy Siegel, the Wharton finance professor (and a WisdomTree consultant) who is author of "Stocks for the Long Run," a dividend-weighted index outperformed the capitalization-weighted Russell 3000 ($RUA.X) total-market index by 1.23 percentage points a year between 1964 and 2005.

In the recent bear market, when the Russell went down nearly 50%, the dividend index declined only 20%. "The dividend-weighted index is now about 40% above its March 2000 close, whereas the S&P 500 and Russell 3000 are still not yet back to even," Siegel says.

Untested, but promising

WisdomTree also offers 14 ETFs targeting foreign bourses. They range from WisdomTree DIEFA Fund (DWM), which takes in all foreign developed markets, to WisdomTree International SmallCap Dividend Fund (DFJ), which ferrets out the smallest players overseas.

The index followed by the DIEFA fund is currently yielding 3.72%. The SmallCap fund follows an index yielding 4.14%. The index behind WisdomTree Pacific ex-Japan High-Yielding Equity (DNH) is yielding of 6.52%.

The biggest problem with WisdomTree is that its funds are unproven. Lots of things that look good on paper don't perform in the real world. My column on Dimensional Fund Advisors makes reference to the failed hedge fund, Long Term Capital Management, whose backers included Nobel Prize-winning economists who virtually guaranteed it could not fail.

But dividend-paying stocks are the most attractive kind currently. iShares Dow Jones Select Dividend Fund (DVY) is up 9.3% this year, as of Aug. 30, half again as much as the broad market.

I expect funds like these to underperform during strong bull markets, when growth stocks are favored. I don't expect an extended bull market for at least a decade, however, so I think the odds are that funds like these will outperform about two years of every three for the foreseeable future.

Those are good odds. Unless the WisdomTree funds have some flaw I cannot now imagine, I think they'll offer investors a host of opportunities for above-market returns.

Middleton was, for a time, a contributing editor of the now-defunct Individual Investor magazine, whose chief executive, Jonathan Steinberg, is founder and CEO of WisdomTree. Middleton is the author of "The Bond King: Investment Secrets from PIMCO's Bill Gross," and the former mutual funds columnist of The New York Times. He works from home in Short Hills, N.J. At the time of publication Middleton didn't own any securities mentioned in this article.