Moats That Matter
WisdomTree Investments, Inc. (NASDAQ:WETF) has the ability to create certain indexes and related ETFs more rapidly than its competitors who license indexes from third party index providers, as it benefits from a regulatory exemptive relief that enables it to use its own indexes in ETFs. Apart from its product development capabilities, this regulatory exemptive relief enabled WisdomTree to enjoy the first mover advantage in a number of asset classes. These include among others, the industry’s first emerging markets small cap equity ETF, the first actively managed currency ETFs, one of the first international local currency denominated fixed income ETFs and the first managed futures ETF. In 2008, the SEC proposed a rule that, if adopted, would eliminate the need for ETF sponsors to obtain exemptive relief. In March 2010, the SEC announced it would defer approval of applications for exemptive relief for ETFs that make significant use of derivatives pending a review by the SEC. If and when this moratorium is lifted, the barriers to entry for the ETF industry will be substantially lowered and WisdomTree may be forced to compete increasingly on the basis of price with new competitors entering the market.
WisdomTree differentiates from its competitors by creating its own indexes that weight companies in its equity ETFs by its own measure of fundamental value. In contrast, traditional indexes are typically market capitalization weighted and tend to track the momentum of the market. WisdomTree Investments, Inc. (NASDAQ:WETF) disclosed in its 2012 fourth quarter results release that certain broad based market capitalization weighted index ETFs sponsored by Charles Schwab Corp (NYSE:SCHW) and Vanguard have been subject to significant price competition. A possible reason for the price competition is the lack of differentiation for market capitalization weighted indexes vis-a-vis that of WisdomTree’s proprietary indexes. Moreover, 68%, or 23 of its 34 equity ETFs, outperformed their capitalization-weighted or competitive benchmarks since their respective inception through Dec. 31, 2012. However, this is a double-edged sword. If WisdomTree’s equity ETFs underperform either due to market conditions or possible flaws in its own measure of fundamental value going foward, investors might switch to traditional market capitalization weighted ETFs offered by WisdomTree’s competitors.
Valuation and Financial Analysis
WisdomTree currently trades at a forward P/E ratio of 29.1, based on Reuters data. Its gross margin and pre-tax proforma operating margin increased from 61% and 6% in 2011 to 66% and 18% in 2012 respectively. WisdomTree is expected to benefit in the form of improved gross margins, with the signing of a new fee arrangement with BNY
Mellon effective from Jan. 1, 2013, where BNY Mellon will continue to serve as portfolio manager to certain ETFs under more traditional sub-advisory economic terms. Prior to this, WisdomTree shared all third-party costs and profits and losses equally in developing currency and fixed income ETFs together under the WisdomTree Trust. In addition, WisdomTree still has net operating loss carry forwards from the significant losses it incurred and it has recognized a deferred tax asset for such carry forwards. WisdomTree’s revenues grew by 30% from $65.2 million in 2011 to $84.8 million in 2012, while operating expenses as a percentage of revenues fell from 94% in the fourth quarter of 2011 to 78% in the last quarter of 2012.
Peer Comparison
WisdomTree’s asset management peers include Charles Schwab Corp (NYSE:SCHW), TD Ameritrade Holding Corp. (NYSE:AMTD), T. Rowe Price Group, Inc. (NASDAQ:TROW) and Waddell & Reed Financial, Inc. (NYSE:WDR). Charles Schwab engages in securities brokerage, banking, and related financial services. Ameritrade provides securities brokerage services and technology-based financial services to retail investors through the Internet. T. Rowe Price Group, Inc. (NASDAQ:TROW) offers investment management services to individual and institutional investors through separately
managed accounts, sub-advised funds, and other sponsored investment funds. Waddell & Reed is engaged in providing investment management, investment product underwriting and distribution services. Among them, WisdomTree is the only one that focuses exclusively on ETFs. Based on Reuters data, Wisdom Tree, valued at 29.1 times forward P/E, trades at a premium to the rest of the asset managers which trade at a range of 17-23 times forward P/E. This is largely due to WisdomTree’s organic growth outpacing that of its competitors and asset management peers. Based on data from Strategic Insights, a mutual fund industry research company, WisdomTree Investments, Inc. (NASDAQ:WETF) led a group of traditional publicly traded asset managers (excluding money market funds) with a growth rate of 39% in 2012 based on net flows for the period over BoP AUM.
Company-Specific Risks
The WisdomTree ETFs have a limited historical track record with only 22 out of 47 ETFs having a track record exceeding five years, and approximately 68% of its ETF AUM was concentrated in ten of its WisdomTree ETFs as at Dec. 31, 2011. A limited track record and a lack of diversification are critical risk factors for both investments and investment managers.
In December 2011, Research Affiliates, LLC filed a suit against WisdomTree in the United States District Court for the Central District of California, alleging that the fundamentally weighted investment methodology infringed three of plaintiff’s patents. In November 2012, Research Affiliates announced that it will withdraw its patent infringement lawsuit and acknowledged that WisdomTree’s fundamentally-weighted indexes and strategies were developed by WisdomTree independently of Research
Affiliates. There is no guarantee that WisdomTree will not be subject to claims of infringement of third-party intellectual property rights in the future. This is important as WisdomTree’s fundamentally-weighted indexes and strategies are important differentiating factors.
Conclusion
WisdomTree’s premium valuations over peers embed huge growth expectations from the market, and it is ‘easier’ for WisdomTree to disappoint than exceed such market expectations. The lifting of the moratorium for approval of applications for exemptive relief for ETFs that make significant use of derivatives and/or any underperformance of equity ETFs based on its own fundamentally weighted index methodology relative to competitive benchmarks are two of the biggest risks that investors need to pay attention to.
The article Should You Buy WisdomTree’s Shares Or Its ETFs? originally appeared on Fool.com and is written by Mark Lin.
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