The Art of Streetplay

Tuesday, June 20, 2006

WisdomTree Update, June 20th 2006

Needless to say, a lot has happened since my last post, and since I first started writing about WisdomTree in April 2005. The 20 ETF's have officially launched. All trade on the NYSE under a variety of tickers- DTN, DLN, ..., all of which are listed on the up and running website they now have. One of the commenters on this blog completely nailed the launch date. They have brought on board yet another BGI veteran, Bruce Lavine.

Rather than spell out everything that is easily available to the public, it might be of value to analyze what is going on one level deeper.

(1) WSDT is leveraging its star power and university environment very effectively. It has done this in 3 ways- 1) it has obtained ETF's licenses much more quickly than I thought would be possible, 2) it has gotten discount or free advertising all over the WSJ, CNBC, on the floor of the NYSE, and elsewhere, and 3) it has gotten heavily discounted research and development aid from students at the University of Pennsylvania and Wharton, through a class offered called the Wharton Field Challenge.

This cost structure really doesn't need much capex at all to fuel itself. The management team is also most likely compensating itself in a call option-type fashion than anything else. We will look at the economics later.

(2) The Expense Ratios seem low to me. The expense ratios range from 28 to 58 bps, but the "bread and butter" fund, in my opinion, seems to be the Total Dividend Fund which charges 28, and DIEFA, which charges 48. The rest are probably better looking on the backtests (as weighting to small caps increases, and as they squeeze for more yield), but I am unsure about their merits relative to what is currently in the marketplace. As Luciano, their head of research said himself, what is lacking in the marketplace today are indices which are broader, more representative indices which fill larger asset allocation needs. What is not lacking are "one-off" products that may be seen as tricky, clever attempts to game the system... but a Small Cap Dividend Fund may fall into that category itself. We will factor this into the economics later.

(3) They are 100% playing the "fundamental indexation" theme, which has been beaten to death on this blog. Siegel mentioned it in his piece in the WSJ, and it has been mentioned many other times since. As such, they are essentially piggy-backing off of a wave which really truly originated with Bob Arnott, off of which 2 companies have already put out ETF's. My hypothesis is that they started with a Dividend index, and not one of the other perhaps more "expected" fundamental metrics, because Siegel, their Director of Research, has already done quite a lot of work on dividends, which means there may be cost factors involved. In a prior post on this blog, I mentioned a study that he had done a while back, but concluded that the dividend space was too crowded for this to be a likely ETF candidate (oops). My bet is they either won't have to pay a licensing fee, or the licensing fee is greatly reduced, because Siegel can claim that this is all simply an extension of prior work that he has done, which gives him a claim on said work. If this is true, then he gets all the advertising and education benefits of the "fundamental indexation" wave-- which I am sure that he, Arnott, Steinhardt, and others in the pseudo-active ETF space now intend to drive into the heads of common investors around the globe-- without having to pay for it. If it works, maybe he can release other indices based on other fundamental metrics later.


The Economics of an Investment in WSDT

I talked about the probable cost structure for WSDT in prior posts. Most specific talk of it is in the oldest post-- basically their revenue model is the expense ratio. Barclays charges something like 70 bps on a whole bunch of its indices, while the Spiders goes down to like 12 basis points. WSDT seems to be in the middle.

So you'd make an assumption on what WSDT's weighted average expense ratio is (if the split is 50/50 domestic international flagship ETF's, that would imply 38 bps). They typically get paid Monday through Friday if PowerShares was any indication, so the cash flow is a very slow and steady function of the assets under management. They may or may not have to pay a license fee (variable cost), then they pay for listing on the NYSE (fixed and variable cost), and they pay for the traders who construct the indices which most likely track computer-generated output of what it is the portfolio should look like with say a 5% leeway. They pay transaction costs (variable cost). They will also pay for a sales force (pseudo-variable cost), through which they intend to open themselves up to new investment channels. Other than that the biggest costs are for the management team. If you look at the pedigree of their management team (many guys who were heavily involved with the launch of the BGI suite), there is no way they are getting much in cash- they are probably accepting a call option-type compensation package-- variable cost. Research is probably not expensive at all because of student help, and marketing is probably much cheaper because of their star management. Main other costs I would imagine are consumer education, maintaining a website and logistical and administrative expenses.

They are "competing" against a handful of other ETF's which already have fundamental indexation products on the market-- I've talked about many of them on my blog, but they include 2 that were put out and are paying licensing fees to Arnott as well as the products put out by Powershares, now a sub of Amvescap. I know that WSDT intends to release a bunch of other non-dividend products (isn't focusing on being a dividend ETF co.), but I would be surprised if they were to sway too far from the fundamental indexation theme (aka piggybacking Arnott).

The key swing factors from my point of view are as follows:
  1. How much of mutual fund and hedge fund assets will end up in the hands of ETF products, synthetically or directly, when ETFs represent ~$420bn in assets, mutual funds ~$8T, and hedge funds ~$1.25T?
  2. Will Wisdom Tree win out over the host of other ETF products attacking the same market?
The driving force behind (1) is the sad fact that 80% of mutual funds underperform the market. And by market I mean the S&P.

More broadly speaking, the driving force behind (1) is the sad fact that it is very difficult to beat the "market", period. It takes a lot of work. And when you throw hedge funds into the equation, most of the hedge funds that do consistently outperform are either lucky or are not open to new investment. Of the hedge funds that are open to new investment, a good proportion of them are probably receiving compensation that is not in line with their ability to generate risk adjusted returns. Niederhoffer's Matador fell 30+% in the month of May alone. I am sure they are suffering from redemption issues. There were a slew of other funds which have closed after the recent market weakness. And I am sure there are many other investors who are looking at these funds closing, looking at their own investments and scratching their heads at why they are paying so much themselves (200 basis points and 20% of profits) when their hedge fund investments, which were supposed to be resilient on the downside, have fallen far more than the market has.

There is nothing new in the fact that mutual funds underperform. Academic studies have been done, etc etc. It boils down to one real question-- if 80% of mutual funds underperform the market and mutual funds charge 150 basis points, and there are ETF's which have shown an ability to outperform the market over time which also have deep capacity for investment and charge a 80% less than mutual funds, the current aggregate allocation of funds may consider changing!

So there are reasonable arguments for individuals in both camps to perhaps consider ETF's in some shape or form.

I will sound crazy for proposing the numbers below, but remember that I am looking at this from a 5 year perspective. In 5 years, either the paradigm shifts, or this company is probabilistically dead. I factor in probabilistic death into the upside through a setting, at the end, of the probability that paradigm shift does not occur. Adjust the market size, costs, margins as you wish... but I would hope that the underlying model is more or less representative.

The basic calculus-- if 25% of assets in funds right now are paying excessive, tax inefficient fees with inefficient portfolio construction, and come to the realization that they are doing so over the next 5 years, and if, in that period of time, (1) companies can release the education necessary to educate the market and (2) companies can create the platforms which can provide investors easy, tax efficient access to these products, and (3) WSDT is able to get 20% of those assets, it will have around $500bn in assets under management. At 38 bps, its top line is $1.83bn. With the SPY as a guide, transaction costs are probably around 12 bps for WSDT. Licensing fees is a wildcard. Sales commission and management expenses may be another 5 bps (or $242mm, split between ~10 hotshot (greedy) managers and a salesforce of maybe 30 highly successful guys), just to throw out a number. The other costs will probably become more variable-- research maybe $1mm, listing probably cost them $200k per ETF initially plus maybe 1bp of ongoing costs, website + non-exec admin + consumer education maybe another $80mm. Because IXDP emerged from a dead company, there may be some tax benefits, so perhaps slap on a 20% tax rate. This implies recurring net profit in the upside case of around $700mm. That profit will be a bit cyclical but in general pretty high quality so lets say slap a 15 multiple on it-- market cap of $10.5bn. Its market cap right now is $314mm, implying an annualized return of 100% for 5 years.

So what is the likelihood of this happening? Assume, for a moment, that the outcome of this company is binary (probably not too far from the truth). If the probability that they meet this admittedly extremely lofty scenario is 10%. That implies the expected value of the future market cap is $1.1bn, imply an expected annualized return of 27% from here... with some serious volatility.

Any thoughts would be appreciated.

4 Comments:

  • That's a hell of an analysis. I liked most of it, but I've responded about where I disagree. It'll be interesting, either way.

    By Blogger Byrne Hobart, at 8:53 AM  

  • great analysis ... however, instead of focusing just on the average investor - which is important -- I think where WSDT will really make waves is with the institutional investors - such as state pension plans, endowments, etc.

    Powershares never had a shot at these types of players in thier first couple of years, they were relying on indy investors and advisors.

    WSDT has the connections with their management teams and board members.... (connections to education community, american express, dain, etc) I beleive they actually have a Wealth Management Services division as part of the company -- which I assume will be the ones to work directly with the institutional clientele.

    There was a very interesting article in Pension & Investment magazine in November2005(Pensions & Investments: WisdomTree sprouting dividend-based indexes
    November 14, 2005)

    This article discussed WSDT's pension advisory services... the article talked more about how WSDT will offer pension avisory services AND offer ETF's to the public.... it sounded like two seperate items...

    ALSO, take a look at the volume on the ETF's being traded.... the Japan Small cap DFJ -- has an average volume of 763,000 ... it looks like some very large block trades came in on the first few days of trading -- could this be the institutional money??

    Again, the institutional side of things is what I find interesting... I am interested in your thoughts on this aspect,,,

    MFU

    By Anonymous Anonymous, at 10:38 AM  

  • Theory is missing from the data-driven analysis of fundamental indexation. The fatal problems with dividends and certain other so-called fundamental metrics for either selecting stocks or weighting stocks in a portfolio have been analyzed with theory in mind. To avoid excessive repetition here, the full analysis can be found at the following webpage.

    At www.numeraire.com/download.htm there are documents about the fatal fallacy of dividends and other factors: WSJ letter; WSJ article comment; WSJ.com article comment, and blogs comments. The WSJ letter to the editor is a response to the WSJ Op-Ed article, which in turn is a response to the WSJ.com Commentary article. These documents, in turn, are supported by two published articles also available at the numeraire.com webpage: IJEB in June, 2005; and AEF in May, 2006.

    To facilitate fair, open discussion about this matter among interested persons, one of the linked documents (labeled "blogs") at the numeraire.com webpage includes comments by bloggers. I trust this conforms to fair use pursuant to The Chicago Manual of Style, 14/e.

    By Anonymous Robert Coleman, at 9:39 AM  

  • Very thorough analysis, I tend to agree with the exception of compensation for sales/marketing (wholesalers) - comp is prob closer to 10 bps. As a start up, wholesalers may be paid base of 50-70K plus variable comp of 10-15bps and phantom-like equity (the call option-like comp). We could confirm in WSDT's public filings. However, oddly enough, they have not filed Ks or Qs with the SEC although they are public??>

    By Anonymous Anonymous, at 7:43 AM  

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