Funds using earnings weighting are outperforming market-cap competitors.
Earnings season is well underway, and while the season has gotten off to a slow start, investors looking to separate outperforming companies from their competitors may find them in three related ETFs with an earnings bent.
There are currently about 159 companies in the S&P 500, representing about a third of the value of the index, scheduled to report first-quarter earnings this week. While early earnings reports from Netflix and Harley-Davidson are positive, S&P 500 company earnings overall are expected to decrease 1.2 percent in the first quarter from the same period last year, according to data compiled by S&P IQ.
“While we believe not all investors are focused on the short-term period that is first quarter earnings season, even long-term holders will be watching for trends from favored and out-of-favor industries and sectors as well as the overall S&P 500 Index,” according to Christine Short, S&P Capital IQ director, Global Markets Intelligence, and Todd Rosenbluth, S&P Capital IQ director, ETF Research, in a research note. “ETFs offer a great way to add or reduce exposure to client portfolios.”
Indeed, three smart beta-type ETFs currently offer investors a leg-up on companies with outperforming earnings include the WisdomTree SmallCap Earnings ETF (EES | A-85), the WisdomTree MidCap Earnings ETF (EZM | A-75) and the First Trust Value Line 100 ETF (FVL | B-40).
And over the past 12 months, this approach has rewarded investors: EES has outperformed its market-cap-weighted competitor, the Vanguard Small-Cap ETF (VB | A-100), by nearly 6 percent, and EZM has beat its cap-weighted competitor, the Vanguard Mid-Cap ETF (VO | A-96), by more than 7 percent.
Also, FVL—which favors small- and micro-caps—has beaten VB by more than 6 percent.
Charts courtesy of StockCharts.com
All three ETFs track their respective indexes with an earnings focus that screens for companies with greater profits, resulting in larger allocations to them in the ETFs’ portfolios. And it’s that weighting using earnings rather than market cap that produces a decidedly different portfolio, according to Spencer Bogart, an ETF.com analyst.
“In fact, the weighted average market cap of EES is one-third that of cap-weighted competitor VB,” said Bogart. “The same is roughly true for EZM versus VO. In a rising market—which we’ve enjoyed for most of the time horizons—you want to be in smaller, higher-beta companies. Small-caps tend to outperform large-caps in a rising market.”
Bogart noted investors should recognize that market-cap weighting favors the most expensive companies. If the idea of buying something because it became more expensive seems backward, investors may want to consider fundamentally weighted indexes that weight components according to revenue, earnings or some other metric.
“Does that mean that fundamental indexing is a silver bullet? Absolutely not. However, fundamental indexing might better align with how some investors would like to allocate capital between companies,” he said.