In February 2007, WisdomTree launched the WisdomTree U.S. MidCap Earnings Index, and the WisdomTree U.S. MidCap Earnings Fund (EZM) to track it. With an almost 11-year live track record for reflection, we review why WisdomTree chose to weight this Index by earnings and how this decision has helped the exchange-traded fund (ETF) achieve returns at the top of its Morningstar Category of active and passive peers.

How Valuation Has Been Important

Over a variety of long-term periods, work by Professor Jeremy Siegel in his book The Future for Investorshas indicated that the after-inflation returns of equities have held a very close relationship to their earnings yield—the reciprocal of the price-to-earnings (P/E) ratio. In short:

If, for instance, we’re looking at the S&P MidCap 400 Index with a trailing 12-month P/E ratio of 26.1x as of January 31, 2018, that is associated with a 3.8% earnings yield, and it becomes more challenging to see real after-inflation returns to U.S. equities that are too different from this 3.8% level—at least if history is any guide.¹

Where WisdomTree’s U.S. MidCap Earnings Strategy Can Help

The WisdomTree U.S. MidCap Earnings Index follows two big-picture steps at its annual rebalance, screened on November 30 of each year:

This process has tended to raise earnings yields (same thing said a different way: lower P/E ratios) compared with market capitalization-weighted universes of similar stocks. Below, we focus on the WisdomTree U.S. MidCap Earnings Index P/E relative to the S&P MidCap 400 Index historically.

The WisdomTree U.S. MidCap Earnings Index Has Had a 26.5% Average P/E Ratio Discount Compared with the S&P MidCap 400 Index over Its Live History