The Dividends of a Quality and Growth Factor Approach

Transcription

1 WisdomTree Research MARKET INSIGHTS [ September 2015 ] The Dividends of a and Growth Factor Approach BY JEREMY SCHWARTZ, CFA, DIRECTOR OF RESEARCH & CHRISTOPHER GANNATTI, CFA, ASSOCIATE DIRECTOR OF RESEARCH There is a reason people always say to buy quality. In furnishings and retail goods, you tend to get what you pay for, and higherquality goods, though they may cost more up front, last longer and ultimately may provide a better value down the road. These lessons can be applied to investing as well. Focusing on quality characteristics may actually lead to outperformance. And while it may not sound as familiar as focusing on growth or value, it is, in fact, the cornerstone of many investment approaches, including that of Warren Buffett. In his 2015 annual shareholder letter for Berkshire Hathaway, released on February 28, Buffett wrote one passage that more than any other reveals how he thinks about attractive investment options. In it he explained that, in addition to things like large size and having management in place, Berkshire Hathaway also requires 1 demonstrated consistent earning power and will only consider businesses earning a good return on equity 2 while employing little or no debt. We believe this latter piece is of critical interest and importance. IDEA OF QUALITY INVESTING HAS A LONG HISTORY Buffett s record is certainly impressive. And there is no doubt that he is a master stock picker. But we also think that his approach can, at least in part, be traced back to his teacher, Benjamin Graham. Known as one of the fathers of value investing, Graham also had a rigorous focus on quality traits. And although many focus on his criteria for finding inexpensive companies, when looking at his list of seven purchase criteria, it becomes clear that he was at least equally focused on attributes of quality if not more so. 1 Source: Berkshire Hathaway annual letter to shareholders from Warren E. Buffett, 2/28/15. 2 Return on equity (ROE): Measures a corporation s profitability by revealing how much profit a company generates with the money shareholders have invested WISE (9473)

2 BENJAMIN GRAHAM S ATTRIBUTES OF QUALITY 3 + Adequate enterprise size, as insulation against the vicissitudes of the economy + Strong financial condition, measured by current ratios 4 that exceed 2 and net current assets 5 that exceed long-term debt 6 + Earnings stability, measured by 10 consecutive years of positive earnings + A dividend record of uninterrupted payments for at least 20 years + Earnings-per-share growth of at least one-third over the last 10 years A full five of the seven points could be said to focus more on quality than on valuation. 7 The final two points indicate that, if these criteria were met, one should not see price-to-earnings (P/E) ratios 8 or price-to-book 9 (P/B) ratios that were too high to access. OTHER VIEWS OF QUALITY Another long-standing quality investment practitioner has been Jeremy Grantham s firm, GMO. In a paper written in 2004, 10 GMO wrote of quality firms:... even though many of these corporations tend to generate high profits year after year, they are systematically underpriced because they lack volatility 11. Instead of overpaying for these companies, as finance theory would suggest given their low risk profile shareholders in fact do just the opposite: they underpay. The result is that investors in high-quality companies get to forge ahead with 15+% returns year after year without overpaying. Of course, in any given year, low-quality stocks can and do stage rallies and high-quality stocks can underperform. But the high-quality stocks have always won over longer holding periods. No matter what metric is used to identify quality stocks leverage, profitability, earnings volatility or beta 12 high-quality stocks have beaten out low-quality stocks. 3 Source: Benjamin Graham, The Intelligent Investor (4th revised edition), Harper & Row, Current ratio: Measures whether or not a firm has enough resources to pay its debts over the next 12 months, with higher values indicating a greater potential for future debt payment capability. 5 Net current assets: Also known as working capital, helps to gauge a company s short-term financial health by measuring liquid assets, like cash and short-term investments, against liabilities coming due over the next 12 months. 6 Long-term debt: Debt with maturity greater than one year. 7 Valuation: Refers to metrics that relate financial statistics for equities to their price levels to determine if certain attributes, such as earnings or dividends, are cheap or expensive. 8 Price-to-earnings (P/E) ratio: Share price divided by earnings per share. Lower numbers indicate an ability to access greater amounts of earnings per dollar invested. 9 Price-to-book ratio: Share price divided by book value per share. Lower numbers indicate an ability to access greater amounts of earnings per dollar invested. 10 The Case for The Danger of Junk, GMO white paper, 3/ Volatility: A measure of the dispersion of actual returns around a particular average level. 12 Beta: Measure of the volatility of an index or investment relative to a benchmark. A reading of 1.00 indicates that the investment has moved in lockstep with the benchmark; a reading of indicates that the investment has moved in the exact opposite direction of the benchmark WISE (9473)

3 More recent academic research has also supported these practitioner ideas. Robert Novy-Marx wrote The Other Side of Value: The Gross Profitability Premium in June In that paper, he wrote: 13 Profitability, as measured by the ratio of a firm s gross profits (revenues minus cost of goods sold 14 ) to its assets, has roughly the same power as book-to-market predicting the cross-section of average returns. Strategies based on gross profitability generate value-like average excess returns, even though they are growth strategies that provide an excellent hedge for value. The two strategies share much in common philosophically, however, despite being highly dissimilar in both characteristics and covariances 15. Because the value and profitability strategies returns are negatively correlated, the two strategies work extremely well together. In fact, a value investor can capture the full profitability premium without taking on any additional risk. FAMA-FRENCH OPERATING PROFITABILITY FACTOR Research done by Kenneth French and Eugene Fama arrives at a similar place. In their draft of A Five-Factor Asset Pricing Model from September 2014, they cite operating profitability, defined as annual revenues minus cost of goods sold, interest expense 16 and SG&A 17, all divided by book value of equity 18, as another highly explanatory factor in looking at different equity returns. Note, this is similar to Buffett s criteria in the opening of the piece: a company earning a good return (profits) on its equity (book value) in other words, a high ROE. ANALYZING QUALITY PERFORMANCE Arranging the U.S. market into quintiles based on operating profitability demonstrates that high-quality stocks have won over longer holding periods. Consider that: + Over the 52-year period shown, the market delivered 10.16% average annual returns, leading to a Sharpe ratio of The two highest quintiles outperformed on the basis of average annual return (delivering 11.80% and 10.56%, respectively) and Sharpe ratio (achieving 0.45 and 0.36, respectively). 13 Robert Novy-Marx, The Other Side of Value: The Gross Profitability Premium, 6/ Cost of goods sold: This amount includes the cost of the materials used in creating the good along with the direct labor costs used to produce the good. 15 Covariance: Measure of how two or more variables move in relation to one another, with positive values indicating general movement in a similar direction and negative values indicating general movement in an opposite direction. 16 Interest expense: Expense incurred due to taking on debt. 17 SG&A: Specifically, selling, general and administrative expenses; in other words, the costs related to running a company s day-to-day operation. 18 Book value of equity: The value of shareholders equity reported on the balance sheet of a firm WISE (9473)

4 FIGURE 1: HIGHER OPERATING PROFITABILITY HAS OUTPACED LOWER OPERATING PROFITABILITY $800,000 $80,000 Operating Profitability Quintile Avg. Ann. Return Sharpe Ratio Lowest 8.27% 0.18 Low 9.31% 0.28 Mid 9.96% 0.33 High 10.56% 0.36 Highest 11.80% 0.45 Market 10.16% 0.34 $331,470 $185,608 $154,036 $139,730 $102,946 $62,565 Growth of $1,000 $8,000 Lowest Low Mid High Highest Market $800 6/30/1963 6/30/1967 6/30/1971 6/30/1975 6/30/1979 6/30/1983 6/30/1987 6/30/1991 6/30/1995 6/30/1999 6/30/2003 6/30/2007 6/30/2011 6/30/2015 Source: Kenneth French Data Library, with data as of 6/30/2015. Period based on availability of operating profitability returns sorted into quintiles, which begins 6/30/1963. Past performance is not indicative of future results. You cannot invest directly in an index. What was driving these results? One important aspect is that the highest quintile is not driven by its sensitivity to the value factor. In figure 2, we used the Fama-French three-factor model to see the impact of size and value factors: + The highest-quality basket actually had a negative value factor which suggests it was more of a growth portfolio (which means it was facing a headwind, given that value strategies outperformed growth over this period). Next, we compared the quintiles based on operating profitability to those based on book to market a common method for measuring value. In both cases, the highest quintile delivered strong performance. But while the book-to-market option did deliver the stronger performance, it also came with higher risk. Why? + For the book-to-market option, the market factor was 1.07, indicating the potential for greater-than-market volatility. Additionally, the size factor was 0.25, leading us to see a tilt toward mid- and small-cap companies. + Conversely, the operating profitability option had a market factor loading below 1.0 and a size factor loading of -0.12, meaning below-market volatility AND exposure to predominantly large-cap firms WISE (9473)

5 FIGURE 2: PUTTING OPERATING PROFITABILITY & BOOK TO MARKET THROUGH THE 3-FACTOR MODEL [ 6/30/1963 6/30/2015 ] Portfolios Formed on Operating Profitability Market Factor 1 Size Factor 2 Value Factor 3 Total Return Standard Deviation Sharpe Ratio Highest Quintile % 15.38% 0.45 Fourth Quintile % 15.48% 0.36 Third Quintile % 15.13% 0.33 Second Quintile % 15.42% 0.28 Lowest Quintile % 18.95% 0.18 Portfolios Formed on Book to Market Market Factor 1 Size Factor 2 Value Factor 3 Total Return Standard Deviation Sharpe Ratio Highest Quintile % 17.36% 0.53 Fourth Quintile % 15.05% 0.51 Third Quintile % 15.08% 0.40 Second Quintile % 15.66% 0.36 Lowest Quintile % 16.70% Market Factor: Component of the Fama-French three-factor model meant to denote sensitivity to the movements of the broad equity market. Values above 1.0 indicate a greater degree of sensitivity; values below 1.0 indicate a lesser degree of sensitivity. 2 Size Factor: Component of the Fama-French three-factor model meant to denote size exposure, with higher values indicating greater exposure to the returns of small stocks and lower, especially negative, values indicating greater exposure to the returns of large stocks. 3 Value Factor: Component of the Fama-French three-factor model meant to denote exposure to value or growth stocks; greater positive values indicate greater exposure to the returns of value stocks, and lower negative values indicate greater exposure to the returns of growth stocks. Source: Kenneth French Data Library, with data as of 6/30/2015. Period based on availability of operating profitability returns sorted into quintiles, which begins 6/30/1963. Past performance is not indicative of future results. You cannot invest directly in an index. Our point is not necessarily to say that focusing on operating profitability is better or worse than focusing on book to market each has potentially positive attributes. But we do believe that understanding the tilts resulting from each and how they may complement each other is of prime importance WISE (9473)

6 MSCI S APPROACH TO QUALITY MSCI has a family of Indexes that focus on both value and quality and can enable us to make further comparisons between these two approaches. It s interesting to note that the specific quality metrics used by MSCI are very closely related to the 2004 GMO definition of quality we discussed previously. MSCI s Key Factors + Return on Equity (ROE): Trailing 12-month earnings per share 19 divided by the current book value per share 20 + Debt to Equity: Latest fiscal year total debt divided by the total book value + Earnings Stability: Standard deviation 21 of year-over-year earnings-per-share growth over the past five fiscal years MSCI s Key Value Factors + Book-value-to-price ratio (note the parallel to the Fama and French book to market that we looked at earlier) + 12-month forward earnings-to-price ratio 22 + Dividend yield 23 To compare quality and value approaches within the United States, we compared the risk and return of the MSCI USA Index and the MSCI USA Value Index to the MSCI USA Index. We noticed the following results: + Outperformance of : The MSCI USA Index outperformed the MSCI USA Value Index over the 5-, 10-, 20- and 30-year and full periods. In each case, it also maintained a higher Sharpe ratio. + Correlation 24 and Beta: The MSCI USA Index had a very similar correlation to the MSCI USA Index as the MSCI USA Value Index, but interestingly had a significantly lower beta over the 5-, 10- and 20-year periods. 19 Trailing 12-month earnings per share: Earnings per share measured over the prior 12-month period. 20 Book value per share: Shareholders equity divided by the number of shares outstanding. Higher numbers indicate greater shareholders equity per unit of share price. 21 Standard deviation: Measures the spread of actual returns around an average return during a specific period. Higher risk indicates greater potential for returns to be farther away from this average month forward earnings-to-price ratio: Captures a measure of analyst expectations of earnings over the next 12 months divided by the current share price. Higher values indicate greater levels of earnings expected relative to the current share price. 23 Dividend yield: Also the trailing 12-month dividend yield. A financial ratio that shows how much a company pays out in dividends each year relative to its share price. 24 Correlation: Statistical measure of how two sets of returns move in relation to each other. Correlation coefficients range from -1 to 1. A correlation of 1 means the two subjects of analysis have moved in lockstep with each other. A correlation of -1 means the two subjects of analysis have moved in exactly opposite directions WISE (9473)

7 FIGURE 3: MSCI S USA QUALITY, VALUE AND BROAD BENCHMARK [ 11/30/1975 6/30/2015 ] Avg. Ann. Return Avg. Ann. Std. Dev. Sharpe Ratio Maximum Drawdown Information Ratio Up Capture Down Capture Alpha Beta Correlation MSCI USA Index 15.84% 9.13% % % % -1.65% Year MSCI USA Value Index 16.08% 8.82% % % % -0.91% MSCI USA Index 17.51% 8.56% % % % 0.00% MSCI USA Index 17.89% 11.20% % % 82.63% 2.08% Year MSCI USA Value Index 15.71% 11.96% % % % -0.99% MSCI USA Index 17.53% 12.08% % % % 0.00% MSCI USA Index 9.36% 13.12% % % 83.86% 2.03% Year MSCI USA Value Index 6.81% 15.07% % % % -1.05% MSCI USA Index 8.05% 14.79% % % % 0.00% MSCI USA Index 10.48% 14.42% % % 86.80% 1.89% Year MSCI USA Value Index 8.35% 15.30% % % 96.14% -0.22% MSCI USA Index 9.00% 15.28% % % % 0.00% MSCI USA Index 12.42% 15.00% % % 89.65% 1.79% Year MSCI USA Value Index 10.16% 15.02% % % 96.67% -0.20% MSCI USA Index 10.84% 15.21% % % % 0.00% Full Period MSCI USA Index 12.23% 14.99% % % 94.85% 1.04% MSCI USA Value Index 11.56% 14.60% % % 92.37% 0.65% MSCI USA Index 11.30% 14.92% % % % 0.00% Sources: MSCI, Zephyr StyleADVISOR. Period based on data availability of the MSCI USA Index. Referred to as full period, which is 11/30/1975 6/30/2015. Past performance is not indicative of future results. You cannot invest directly in an index. We also compared these indexes using the Fama and French three-factor model. It was notable that over the full period, from November 30, 1975, to June 30, 2015, both the MSCI USA and the MSCI USA Value Indexes outperformed the MSCI USA Index. How was this achieved? + : The MSCI USA Index had a market factor below 1.0 (just as we saw with operating profitability earlier), as well as a distinct tilt toward the larger size segment, indicated by the negative size factor of nearly This Index also had a negative factor of to value (in other words, tilting toward growth). + Value: As expected, the MSCI USA Value Index had a significant loading to the value factor, with a positive And similar to what we saw between operating profitability and book to market, value didn t necessarily lower the market factor as significantly as quality did WISE (9473)

8 FIGURE 4: EXAMINING THE FACTOR LOADINGS OF THE MSCI USA INDEXES [ 11/30/1975 6/30/2015 ] MSCI USA Indexes Market Factor 1 Size Factor 2 Value Factor 3 Total Return Standard Deviation Sharpe Ratio MSCI USA Index % 14.99% 0.49 MSCI USA Value Index % 14.60% 0.46 MSCI USA Index % 14.92% Market Factor: Component of the Fama-French three-factor model meant to denote sensitivity to the movements of the broad equity market. Values above 1.0 indicate a greater degree of sensitivity; values below 1.0 indicate a lesser degree of sensitivity. 2 Size Factor: Component of the Fama-French three-factor model meant to denote size exposure, with higher values indicating greater exposure to the returns of small stocks and lower, especially negative, values indicating greater exposure to the returns of large stocks. 3 Value Factor: Component of the Fama-French three-factor model meant to denote exposure to value or growth stocks; greater positive values indicate greater exposure to the returns of value stocks, and lower negative values indicate greater exposure to the returns of growth stocks. Sources: MSCI, Zephyr StyleADVISOR. Past performance is not indicative of future results. You cannot invest directly in an index. DOES QUALITY ALWAYS OUTPERFORM? No strategy always outperforms. The three-year period within figure 3 shows a period when quality wasn t necessarily outperforming the market. And in its aforementioned 2004 paper, GMO listed the following rationale for this phenomenon: 25 As a result of a casino mentality in the stock market, risky stocks are generally overpriced because investors are trying to own the next big thing, be it a Starbucks or an ebay. The tantalizing prospect of generating stratospheric returns from a small investment seems to blind people to the overwhelming probability of loss. Similarly, investors tend to underpay for less risky stocks because these companies do not offer the theoretical possibility to shoot the lights out with one great stock selection. MARRYING QUALITY & VALUE Clearly the focus in value strategies is on how price relates to fundamentals such as dividends, earnings or book value. factors focus instead on the inherent stability of the fundamentals themselves. These make them interesting complements. Novy- Marx wrote: 26 Because strategies based on profitability are growth strategies, they provide an excellent hedge for value strategies, and thus dramatically improve a value investor s investment opportunity set. In fact, the profitability strategy, despite generating significant returns on its own, actually provides insurance for value. 25 The Case for The Danger of Junk, GMO white paper, 6/ Robert Novy-Marx, The Other Side of Value: The Gross Profitability Premium, 6/ WISE (9473)

9 We tested this premise using the MSCI USA and MSCI USA Value Indexes. To function as an insurance characteristic, you would hope that the MSCI USA Value and MSCI USA Indexes would not be outperforming or underperforming at the same time and indeed, they typically did not: + Excess Returns Appear to Offset: When the MSCI USA Index was outperforming the MSCI USA Index, the MSCI USA Value Index was underperforming it and with a similar degree of magnitude. With the exception of the very recent three-year rolling periods, the potential that Novy-Marx cited appears intact. FIGURE 5: MSCI USA QUALITY VS. MSCI USA VALUE EXCESS RETURNS AGAINST THE MSCI USA INDEX[ Rolling 3-Year ] 10% 8% 6% Rolling 3-Year Excess Returns 4% 2% 0% -2% -4% -6% -8% -10% MSCI USA Index MSCI USA Value Index -12% 11/30/ /30/ /30/ /30/ /30/ /30/ /30/ /30/ /30/ /30/ /30/ /30/ /30/ /30/ /30/ /30/ /30/ /30/2012 6/30/2015 Sources: MSCI, Zephyr StyleADVISOR, with data from 11/30/1975 to 6/30/2015. Past performance is not indicative of future results. You cannot invest directly in an index. We also wanted to further test another statement made by Novy-Marx cited earlier in this paper, namely the idea that adding a profitability strategy on top of an existing value strategy actually reduces overall portfolio volatility. This is important because one of the most focused-upon categories in investment management is large-cap value. So, complementarity of quality strategies to value strategies could naturally lead to very broad appeal and usability. In figure 6 on the following page, the Value & Blend refers to a 50% allocation to the MSCI USA Index and a 50% allocation to the MSCI USA Value Index. Here s what we found: + Excess Returns: The Value & Blend outperformed the MSCI USA Index over rolling periods 75.2% of the time, compared to 53% for the MSCI USA Value Index. + Behavior of Excess Returns: Looking at the median excess return of the Value & Blend versus the MSCI USA Index, we find that for each of the rolling intervals beyond three years, the median excess return was between 0.70% on the low end and 0.78% on the high end. This was much more stable than what we saw with the median excess return of the MSCI USA Value Index versus the MSCI USA Index, which ranged from -0.07% on the high end (excluding the three-year time frame) to -0.34% on the low end WISE (9473)

10 + Sharpe Ratio: As the length of the rolling periods increased, the percentage of times the Value & Blend offered an improved Sharpe ratio increased as well similar to what we saw with the excess returns earlier. Even on the shorter end, over rolling three-year periods, the Sharpe ratio increased more than half the time. FIGURE 6: DOES A BLEND OF QUALITY & VALUE IMPROVE THE SHARPE RATIO RELATIVE TO VALUE ALONE? [ 11/30/1975 6/30/2015 ] Rolling Periods Percentage of Periods Where MSCI USA Value Index Outperformed MSCI USA Index Percentage of Periods Where Value and Blend Outperformed MSCI USA Index Percentage of Periods Where Value and Blend Increased Sharpe Ratio over MSCI USA Value Index Total Number of Periods Median Excess Return of MSCI USA Value Index vs. MSCI USA Index Median Excess Return of Value and Blend vs. MSCI USA Index Median Incremental Change in Sharpe Ratio from MSCI USA Value Index to Value and Blend 3-Year 53.0% 75.2% 55.5% % 0.59% Year 48.1% 84.6% 59.9% % 0.78% Year 43.6% 95.2% 68.6% % 0.77% Year 41.0% 96.1% 79.5% % 0.74% Year 40.9% 99.7% 91.6% % 0.73% Year 16.1% 100.0% 94.5% % 0.70% Year 36.9% 100.0% 100.0% % 0.73% Year 37.1% 100.0% 100.0% % 0.73% Sources: MSCI, Kenneth French Data Library. Period based on data availability for the MSCI USA Index, 11/30/1975 6/30/2015. Past performance is not indicative of future results. You cannot invest directly in an index. QUALITY IN SMALL-CAP STOCKS Typically, when focusing on the concept of quality, the first place people look tends to be large-cap multinational firms. But we believe small caps can also be of potential interest and we re not the only ones. Cliff Asness and his colleagues at AQR have explored this topic, writing the very memorably titled Size Matters, If You Control Your Junk in January And, of course, Eugene Fama and Kenneth French have published different size sorts of their data on operating profitability. In fact, when people familiar with different investment factor premia hear the names Fama and French, a common thought immediately jumps to mind: the small-cap value premium. But we believe there should be an equal focus on the small-cap quality premium: + Value or? In figure 7, quality and value were quite similar over the period both handily outperformed the Russell During other periods, it is most likely that the two would ebb and flow in and out of favor, with neither outperforming or underperforming all the time. As we discussed with the large caps, the idea of blending small value and small quality could be of potential interest WISE (9473)

11 FIGURE 7: SMALL HIGH QUALITY VERY SIMILAR TO SMALL VALUE, WITH BOTH HANDILY OUTPERFORMING THE RUSSELL 2000 INDEX [ 12/31/1978 6/30/2015 ] $1,000,000 Avg. Ann. Return Sharpe Ratio Small-High 16.29% 0.60 Small-Low 8.92% 0.18 Small-Value 16.66% 0.65 Russell 2000 Index 11.84% 0.36 $278,269 $247,212 $100,000 Growth of $1,000 $59,527 $22,621 $10,000 Small-Low Russell 2000 Index Small-High Small-Value $1,000 12/31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/2012 6/30/2015 Sources: Bloomberg, Kenneth French Data Library. Period selected due to data availability for the Russell 2000 Index. Past performance is not indicative of future results. You cannot invest directly in an index. QUALITY BEYOND U.S. BORDERS Next, we show a similar analysis outside the United States using both simple excess return differentials and Sharpe ratios to illustrate risk-adjusted return differentials: + While in general the three-year period was a difficult one for quality, the longer periods as GMO suggested did in fact indicate outperformance. This outperformance seemed most volatile in Japan and least volatile in Europe, based on the periods and Indexes shown in figure WISE (9473)

12 FIGURE 8: AVERAGE ANNUAL RETURNS IN EXCESS OF MSCI BASE INDEXES [ 6/30/1995 6/30/2015 ] 6.0% Returns in Excess of Base Index 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% -1.0% -2.0% -3.0% 1-Year 3-Year 5-Year 10-Year 15-Year 20-Year 4.9% 4.1% 3.3% 3.0% 3.0% 3.1% 2.7% 2.8% 2.7% 2.7% 2.7% 2.3% 2.2% 2.2% 1.5% 1.3% 0.8% 0.8% 0.6% 0.4% 0.5% -0.3% -0.2% -0.2% -1.4% -1.7% 2.5% 1.6% 1.1% -0.5% -4.0% -5.0% -3.9% -4.2% USA EAFE Emerging Markets Japan Europe ACWI ex-usa Source: MSCI. MSCI EAFE vs. MSCI EAFE and MSCI Japan vs. MSCI Japan comparisons are done in local currency terms. All others are done in U.S. dollar terms. Neither the MSCI Emerging Markets Indexes nor the MSCI ACWI ex-usa Indexes had 15 or 20 years of data availability. Past performance is not indicative of future results. You cannot invest directly in an index. FIGURE 9: SHARPE RATIOS IN EXCESS OF MSCI BASE INDEXES [ 6/30/1995 6/30/2015 ] Incremental Change in Sharpe Ratio Against Base Index Year 3-Year 5-Year 10-Year 15-Year 20-Year USA EAFE Emerging Markets Japan Europe ACWI ex-usa Source: MSCI. MSCI EAFE vs. MSCI EAFE and MSCI Japan vs. MSCI Japan comparisons are done in local currency terms. All others are done in U.S. dollar terms. Neither the MSCI Emerging Markets Indexes nor the MSCI ACWI ex-usa Indexes had 15 or 20 years of data availability. Past performance is not indicative of future results. You cannot invest directly in an index WISE (9473)

13 CONCLUSION While quality can be measured in a variety of ways, we think the broad themes of earnings consistency or growth, low debt and high return on equity are common threads to many different approaches. We ve seen that, over time, focusing on quality whether through MSCI s approach or through Fama and French s method of looking at operating profitability has generated outperformance over different periods. And we believe that quality can make an excellent complement to value approaches across market caps and geographies. WisdomTree developed a family of Dividend Growth Indexes that attempt to capitalize on both the power of quality and the power of dividends. Within these indexes, we try not to dilute the potential power of what others have found before by applying too many stock selection rules or complex weighting schemes. We believe the key is to be as simple and broad-based as possible. We employ the Buffett factor of three-year average return on equity (ROE) and return on assets (ROA) 27 as a driving force for stock selection ROA penalizes the use of debt (leverage 28 ) in delivering ROE; therefore, the resulting list of companies that qualify for our Indexes tend to also employ lower levels of debt. We believe the focus on ROE and low debt is an important common thread across the many varied interpretations of what quality means to different practitioners. WisdomTree s Dividend Growth strategies could be interesting, in that they are designed to focus on long-term earnings growth expectations as well as on three-year average return on equity and return on assets. If equity markets do become more expensive, there is also an annual rebalancing process, which tilts weight toward qualifying firms whose dividends have become less expensive compared to their prices. Bottom line, these strategies have the potential to capture the quality theme but also to maintain a reasonable valuation while doing so. For more information on WisdomTree or our family of Dividend Growth strategies, visit wisdomtree.com or call WISE (9473) WISE (9473)

14 Dividends are not guaranteed, and a company s future ability to pay dividends may be limited. A company currently paying dividends may cease paying dividends at any time. Diversification does not eliminate the risk of experiencing investment losses. You cannot invest directly in an index. Investors should carefully consider the investment objectives, risks, charges and expenses of the Fund before investing. To obtain a prospectus containing this and other important information, please call WISE (9473) or visit wisdomtree. com. Investors should read the prospectus carefully before investing. There are risks associated with investing, including possible loss of principal. Investments focusing on certain sectors and/or smaller companies increase their vulnerability to any single economic or regulatory development. This may result in greater share price volatility. Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. Derivative investments can be volatile, and these investments may be less liquid than other securities, and more sensitive to the effects of varied economic conditions. As investments can have a high concentration in some issuers, they can be adversely impacted by changes affecting those issuers. Investments in emerging, offshore or frontier markets are generally less liquid and less efficient than investments in developed markets and are subject to additional risks, such as risks of adverse governmental regulation and intervention or political developments. The Global Industry Classification Standard ( GICS ) was developed by and is the exclusive property and a service mark of MSCI Inc. ( MSCI ) and Standard & Poor s ( S&P ), a division of The McGraw-Hill Companies, Inc., and is licensed for use by WisdomTree Investments, Inc. Neither MSCI, S&P nor any other party involved in making or compiling the GICS or any GICS classifications makes any express or implied warranties or representations with respect to such standard or classification (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability and fitness for a particular purpose with respect to any such standard or classification. Without limiting any of the foregoing, in no event shall MSCI, S&P, any of their affiliates or any third party involved in making or compiling the GICS or any GICS classifications have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. S&P 500 Index: A market capitalization-weighted benchmark of 500 stocks selected by the Standard & Poor s Index Committee, designed to represent the performance of the leading industries in the United States economy. CRSP U.S. Small Cap Index: A market capitalization-weighted measure of the performance of small-cap equities in the United States. MSCI EAFE Index: A market cap-weighted index composed of companies representative of the developed market structure of developed countries in Europe, Australasia and Japan. MSCI Emerging Markets Index: A broad market cap-weighted index showing the performance of equities across 23 countries defined as emerging markets by MSCI. MSCI Europe Index: A free float-adjusted market capitalization-weighted index designed to measure the performance of developed equity markets in Europe. MSCI Japan Index: A market cap-weighted subset of the MSCI EAFE Index that measures the performance of the Japanese equity market. JPX-Nikkei Index 400: Composed of common stocks whose main market is the TSE First Section, Second Section, Mothers or JASDAQ market (in principle). The components are reviewed annually to keep the representativeness of the market. The annual review shall be conducted at the end of August as follows: (1) 1,000 stocks are selected based on trading value in the past three years and the market value on the selection base date (the end of June) of the annual review. (2) Each stock is scored by three-year average ROE, three-year cumulative operating profit and market value on the selection base date with the weights on each indicator 40%, 40% and 20%, respectively. (3) 400 stocks are selected by the final ranking with the scores calculated in (2) and qualitative factors from the perspectives of corporate governance and disclosure. In case of delisting of the components due to a merger or bankruptcy, etc., new stocks shall not be added in principle. When the annual review is conducted, the number of components is back to 400; therefore, the Index is calculated with fewer than 400 components until then. MSCI ACWI ex-us Index: A free float-adjusted market capitalization-weighted index designed to measure the equity market performance of developed and emerging markets excluding companies based in the United States. MSCI USA Index: A broad-based measure of free float-adjusted market capitalization-weighted equity market performance within the United States. MSCI USA Value Index: Measure of the performance of companies within the United States, weighted by free floatadjusted market capitalization, that have lower prices relative to their fundamentals, like dividends or book value. MSCI USA Index: Measure of the performance of companies within the United States that have exhibited profitability, earnings stability and low debt to equity. Russell 2000 Index: Measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 is a subset of the Russell 3000 Index, representing approximately 10% of the total market capitalization of that index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership. MSCI EAFE Index: Measure of the performance of companies from within the MSCI EAFE Index that have exhibited profitability, earnings stability and low debt to equity. MSCI Emerging Markets Index: Measure of the performance of companies from within the MSCI Emerging Markets Index that have exhibited profitability, earnings stability and low debt to equity. MSCI Europe Index: Measure of the performance of companies from within the MSCI Europe Index that have exhibited profitability, earnings stability and low debt to equity. MSCI Japan Index: Measure of the performance of companies from within the MSCI Japan Index that have exhibited profitability, earnings stability and low debt to equity. MSCI ACWI ex-us Index: Measure of the performance of companies from within the MSCI ACWI ex-us Index that have exhibited profitability, earnings stability and low debt to equity. Jeremy Schwartz & Christopher Gannatti are registered representatives of Foreside Fund Services, LLC WisdomTree Investments, Inc. WisdomTree is a registered mark of WisdomTree Investments, Inc. WTGM WISE (9473)