It is truly amazing that in nearly every client meeting we attend a resounding chorus of agreement sounds when discussing the success of high-dividend-yield and low-volatility strategies in 2016. But can their large outperformance continue? The answer will depend on what happens with interest rates. If they move higher, investors may look to parts of the market that have lower valuation multiples but are less interest rate sensitive. We recently described the rebalancing process that results in the WisdomTree Earnings Indexes having lower valuation multiples than the market.

• The WisdomTree MidCap Dividend Index was up 12.99%.
• The WisdomTree SmallCap Dividend Index was up 15.93%.

For those focused on overall portfolio strategies that seek relatively higher dividend-paying stocks, in our view, these strategies will remain great complements to large-cap positions, and it’s also worth noting that these Indexes will undergo their annual rebalance screening on November 30, 2016. Big outperforming constituents may not be able to hold onto their increased weights if they didn’t grow their dividends commensurately.

But a dividend focus is not the only way to consider smart beta approaches to mid- and small-cap stocks.
 
Our Mid- & Small-Cap Earnings Strategies Offer Intriguing Sector Complementarity to Dividends

What if, instead of focusing solely on dividend-paying constituents, an investor were to focus on mid- and small-cap stocks through the lens of profitability? WisdomTree does just that with its mid-cap and small-cap earnings strategies. In 2016:²
 
• The WisdomTree MidCap Earnings Index was up 10.20%.
• The WisdomTree SmallCap Earnings Index was up 12.61%.

These are strong numbers, but not quite as strong as the dividend strategies. Sector exposures shed light as to why.
 
What Sector Bets Are Introduced to Mid-Caps? Dividends vs. Earnings
 
Top 3 Over-Weight and Under-Weight Sectors of WT MidCap Dividend Index vs. S&P MidCap 400 Index, with WT MidCap Earnings Index also shown (as of 10/7/2016)
 

For definitions of terms and indexes in the chart, visit our glossary.

• Utilities: This has been a strong sector in 2016. These stocks may have benefited from being included in the “low-vol/min-vol” phenomenon as well as from having relatively higher dividend yields in—yet another—falling interest rate environment. The WisdomTree MidCap Dividend Index had nearly an 8.0% over-weight to this sector compared to theS&P MidCap 400 Index . On the other hand, the WisdomTree MidCap Earnings Index was close to a market weight in that sector.
 
• Real Estate: This has been another very strong sector in 2016, and, as in the case of Utilities, the income-generating capability of the real estate constituents has found favor in today’s low-rate environment. The WisdomTree MidCap Dividend Index is a 4.1% over-weight, whereas the WisdomTree MidCap Earnings Index is a 4.7% under-weight when measured against the S&P MidCap 400 Index.
 
• Financials: The WisdomTree MidCap Dividend Index is under-weight Financials by 6 percentage points, which has helped during the declining rate environment. The WisdomTree MidCap Earnings Index has a 2% over-weight to Financials, which could be well positioned for a rising rate scenario.
 
What Sector Bets Are Introduced to Small Caps? Dividends vs. Earnings
 
3 Largest WT SmallCap Dividend Index Over/Under-Weight Relative to S&P SmallCap 600 Index, with WT SmallCap Earnings Index shown (as of 10/7/2016)

• Real Estate, Utilities: Like the mid-cap story above, in small caps, the dividend Index tends to be over-weight real estate and Utilities, which benefited during the falling rate environment. The earnings Index is under-weight most sectors, but real estate by more.

• Financials: Again like the mid-cap story above, the WisdomTree SmallCap Dividend Index is under-weight Financials, but the SmallCap Earnings Index is over-weight Financials.
 
Utilities & Real Estate May be Yesterday’s Top-Performing Sectors

It is impossible to know if these sectors can rally again in 2017, but when the U.S. 10-Year Treasury note interest rate rose from 1.36% on July 8, 2016, to more than 1.70% on October 7 ³, it showed us that these sectors are not invincible. They’ve had a great run, and it might be time to consider adding the diversifying potential of WisdomTree’s earnings approach as we look forward to 2017.

¹Source: Bloomberg, for period 12/31/15–10/7/16.
²Source: Bloomberg, for period 12/31/15–10/7/16.
³Source: Bloomberg, as of specified dates.