Building a Better Index Fund

• Email
• Share
• Print

With the dollar diving against most major currencies and U.S. economic growth stalling, international investing is becoming essential for generating decent returns. WisdomTree Trust, with its exchange-traded funds based in the fundamentals, offers one smart way to go international with fewer hassles from investing directly in individual companies.

Wisdom Tree launched both international and domestic dividend ETFs in June 2006 that were based on indexes of stocks weighted by cash dividends or dividend yields. Since then, WisdomTree Pacific ex-Japan Total Dividend Fund (NYSE: DND) has cashed in on the Asian boom to become its top international performer, delivering cumulative returns over 87%, more than tripling the 26.5% from its top domestic one, WisdomTree Dividend Top 100 Fund (NYSE: DTN).

Benchmark-beating performance for the intelligent investor
Typically, index investors seek only to match their benchmarks. Yet WisdomTree's Pacific fund handily beat its benchmark, the MSCI Pacific ex-Japan Index, which delivered cumulative returns of 79% in that period.

Both indexes focus exclusively on companies incorporated and listed in Australia, New Zealand, Hong Kong, and Singapore, with Australia making up the largest portion of the fund's assets. As a result, they are heavily weighted toward some major financial companies operating out of these markets.

Yet the two indexes use different strategies to determine which stocks to include. The MSCI index is weighted by the traditional market capitalization method, favoring widely held and highly valued companies like BHP Billiton (NYSE: BHP), with a $220 billion market capitalization. Because it doesn't include the business fundamentals of its selected companies, one criticism of this method is that it biases the index toward overvalued companies and away from undervalued ones, thus raising the risk of capital loss in a downturn.

In contrast, the innovative methodology of WisdomTree's index is that it includes only companies that are paying regular cash dividends. This focus on earning and returning hard cash to investors is quite a stringent criterion and it's exactly what an intelligent investor should look for.

Relatively mature, slow-growing companies tend to be the ones that pay regular dividends. This index fishes in the same waters as its MSCI benchmark, but only where there's good visibility into the quality of the underlying business.

Given WisdomTree's conservative approach, one would expect this ETF to underperform its MSCI Index benchmark. However, its top holding is Hong Kong-listed high performer China Mobile (NYSE: CHL), which not only declared a 43% dividend payout ratio target for 2007 but also nearly doubled its stock price year-to-date October. Clearly, this ETF has done well in capturing both growth and good business fundamentals.

Highly competitive expenses, too!
Although WisdomTree bases this ETF on a proprietary index, its expense ratio is fractionally lower than the 0.50% of its direct competitor, iShares MSCI Pacific ex-Japan Index Fund (NYSE: EPP). The series of iShares MSCI ETFs are designed to mirror their respective MSCI indices. Thus far, the WisdomTree ETF beats it on both costs and returns.

With only a year of experience, it remains to be seen whether the WisdomTree method will continue to outperform other indexes. The WisdomTree Pacific fund has certainly started out on the right foot.

Related Foolishness:

• ETFs for Tomorrow
• Today's Historic Bubble and the One Guarantee
• The Mother of all Mergers, Part 2?
• Fool Video: China Mobile, Cold Crocs, and the Next Starbucks