From WisdomTree: As the investment world begins to accept equity factors such as value, quality, momentum and low correlation as best-practice investing, increasingly we find advisors attempting to measure their assets’ factor exposure in ways that are familiar to them.
Regressions are helpful, but they often represent an analysis that is unfamiliar, operating in a completely different universe than traditional performance attribution, for example. With this in mind, WisdomTree set its sights on creating a more familiar factor attribution framework.
For instance, a commonly used measurement for the quality factor is return on equity (ROE), which measures how efficiently a company captures profits based on shareholder investments. Below, we segmented the USA Equity universe into five ROE quintiles, the first being the top 20% measured by ROE (representing the highest-quality segment of the market) and the fifth quintile being the bottom 20% (representing the lowest-quality segment). Not only does this allow for differentiation among the highest- and lowest-quality baskets of the U.S. equity market, but we can compare other indexes’ overlap with these baskets and pinpoint where quality exposure helped or hurt historically. For example, let’s look at the WisdomTree U.S. Quality Dividend Growth Index (WTDGI) versus the S&P 500 Index.
Quality Factor Attribution Using Return on Equity
How to Interpret Results: Row 1 Example
Allocation: WTDGI received 29 basis points (bps) of relative outperformance due to its corresponding percentage weight in the first ROE quintile versus the S&P 500.
Selection: WTDGI received 3 bps of relative underperformance due to its stock selection in the first ROE quintile versus the S&P 500.
Interaction: WTDGI received 3 bps of relative underperformance due to the interaction between allocation and selection in the first ROE quintile versus the S&P 500
Total Contribution: The stocks and weights of WTDGI attributable to the first ROE quintile of the market added 23 bps of relative outperformance versus the S&P 500.
WisdomTree Weight: An average 42.13% total WTDGI weight was in the first ROE quintile of the market.
Benchmark Weight: An average 23.07% total S&P 500 Index weight was in the first ROE quintile of the market.
Active Weight: WTDGI was 19.06% overweight in the first ROE quintile of the market relative to the S&P 500.
WisdomTree Group Return: The group of stocks in WTDGI within the first ROE quintile of the market returned 14.89%, while the aggregate S&P 500 Index returned 13.55%.
Benchmark Group Return: The group of stocks in the S&P 500 within the first ROE quintile of the market returned 15.02%, while the aggregate S&P 500 returned 13.55%.
Interestingly, the two largest differences in active weight came in the first and fifth quintiles; that is, WisdomTree’s quality Index was 19% overweight in the highest-quality segment of the market and underweight 13% in the lowest-quality segment of the market. These allocation differences amounted to over 50 bps of excess return, highlighting the power of the quality factor and reminding investors it is not just about being long quality stocks, but also about avoiding allocations to “junkier” stocks. In beta benchmarks, you will most likely find a more even allocation mix among these fundamental quintiles, whether you sort by earnings yield, dividend yield or ROE, compared to a targeted earnings, dividend or, in this case, quality Index. More specifically, the S&P 500 had more than 30% weight dedicated to the two worst ROE quintiles of the U.S. equity market, whereas the WisdomTree Index possessed only 7% weight. This is why fundamental investing truly is a two-pronged approach, and why, since its inception, the WisdomTree U.S. Quality Dividend Growth Index has managed to get the better of the S&P 500 Index.
The WisdomTree U.S. Quality Dividend Growth ETF (DGRW) was trading at $40.07 per share on Tuesday morning, up $0.13 (+0.33%). Year-to-date, DGRW has gained 22.96%, versus a 17.79% rise in the benchmark S&P 500 index during the same period.
This article is brought to you courtesy of WisdomTree.