Year-old WisdomTree ETF looks smart

By Tim Middleton

For the sixth straight year, foreign stocks are beating the pants off domestic equities. So it's no surprise that iShares MSCI EAFE Fund (EFA, news, msgs) has ballooned to $45 billion in assets, ranking it among the biggest exchange-traded funds.

But it's not the only, or best, ETF option for investors looking overseas. Vanguard Group has registered with the Securities and Exchange Commission to offer an almost identical fund with lower fees.

A more offbeat competitor to the iShares fund has arisen, too, and I'm planning to substitute it for iShares Emerging Markets in my model ETF portfolio. WisdomTree DEFA Fund (DWM, news, msgs) has just completed its first full year of operation, and it has run rings around iShares.

The WisdomTree fund follows a strikingly different indexing scheme than does the MSCI (Morgan Stanley Capital International) index, which iShares follows and Vanguard plans to. WisdomTree aims to capture above-average returns from high-quality companies rather than the average of all of them. It ought to work, in theory, and at the WisdomTree fund it is working in practice.

In the 12 months ending July 10, the WisdomTree fund had shot up 33.6%, which beat 80% of rival funds, according to Morningstar. The iShares fund had gained 27.6%, which ranked it at the opposite pole, in the 80^th percentile.

A large portion of this difference has come because the MSCI index weights Japan heavily, since its market accounts for about a quarter of the non-U.S. total. Japan has been a wounded swan for nearly two decades, burdened most of all by a maladroit government. The WisdomTree formula weights it much less and thus escapes its drag.

An investment, not a measuring stick

The MSCI, like Standard & Poor's, Russell and most of the other big indexers, weights its formula by market capitalization. That's the way an economist would look at the situation: Big companies have more shareholders than small ones, so weighting by market cap is a fair summary of how everybody's doing.

We aren't all economists -- but many of us are investors. We want to own the best companies, not the average ones. Fundamental indexing, as it is called, attacks this problem from various perspectives, such as earnings and, in the case of the WisdomTree fund, dividends.

Dividends are the most concrete way to share in a corporation's profits. What WisdomTree does is rank companies by the total dividends they pay, and it owns the top payers.

Crucially, it does not rank them by dividends per share. That would introduce stock prices into the equation, and those can be skewed. Internet companies got fantastic valuations in the 1990s, which is why the Nasdaq Composite Index ($COMPX) went up so much -- and then sharply down.

The EAFE (Europe, Australasia and Far East) index company that dispenses the most cash to its shareholders, HSBC Holdings (HBC, news, msgs) of Great Britain, is therefore ranked No. 1 by WisdomTree, while it's only No. 2 in the EAFE index. Both the EAFE and the WisdomTree Dividend Index of Europe, Far East Asia and Australasia (WisdomTree DEFA) choose stocks from among the same 21 European and Asian countries.

As it happens, Japanese companies pay low dividends compared with the rest of the world, so they account for only 8.7% of the WisdomTree fund's assets. iShares devotes 22.3% of assets to Japan. At the other extreme, Australian companies tend to give big payouts, so it has 8.6% of WisdomTree's assets. In the EAFE index, its weighting is 5.89%.

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Dividend weighting also leads to differences in sector allocation. Materials, energy and industrial stocks are among the top five holdings in the EAFE index. In the DEFA, WisdomTree's proprietary dividend-focused international index, energy has 8.5% of assets, but far more, 13.1%, are in new-economy communications stocks. Among the top five holdings of each fund, consumer stocks get twice the weight in the DEFA that they enjoy in the EAFE.

Utility bolt

I would like to tell you what kind of dividend yield the WisdomTree fund itself delivers, but I can't. WisdomTree says it hasn't been able to calculate that yet. Gross dividends are reduced by foreign taxes and fund expenses, which here are 0.48%. (The iShares fund is cheaper at 0.35%, and Vanguard promises to come in at 0.15%.)

Over the past year, certainly, WisdomTree has demonstrated that dividend payers can deliver capital gains; otherwise the fund would be a laggard. But there have been periods when dividends were synonymous with mediocrity.

Utilities make up 7.6% of the WisdomTree portfolio, half again their weighting in the EAFE index, and utilities are benefiting from transitory factors, such as deregulation and low global interest rates. That sector has been hot in the United States since highflying stocks collapsed in the bear market, but it was dead cold before.

Similarly, Japan is (surely!) going to turn around some day, and a foreign fund that shuns it could seriously underperform. The nice aspect about a plain-vanilla fund like iShares MSCI EAFE is that you don't have to worry about such things.

But I think an increase in returns of 6 percentage points -- more than 20% over those of iShares EAFE -- is outstanding compensation for, basically, staying awake. Indexing your portfolio doesn't require falling into a coma.

When the situation changes, which I don't expect soon, I'll be happy to dump WisdomTree in favor of iShares or possibly the new Vanguard Europe Pacific ETF.

At the time of publication, Tim Middleton didn't own any securities mentioned in this article.