A Look Inside ETF Rebalancing

A lot of investors may not realize it, but even passively managed ETFs rebalance. Some do so on a quarterly basis, while other funds rebalance semi-annually. Regardless of frequency, an ETF's rebalancing act is an important event for investors to be aware for the simple reason that the fund's new composition has a direct impact on the most important factor of all: Returns. Rebalancing can also have a significant impact on multi-country ETFs. For example, some traders and ETF industry observers have said the Vanguard MSCI Emerging Markets ETF

and the iShares MSCI Emerging Markets Index Fund

, the two largest emerging markets ETFs by assets, should reduce exposure to South Korea and Taiwan. The argument being that those two countries

and the heavy weights to those nations offered by EEM and VWO tempers the impact of emerging markets growth on the funds' returns. WisdomTree

is one ETF sponsor that goes beyond traditional market-cap weighting methodology when it comes to rebalancing its funds. In June, the firm rebalanced the WisdomTree Emerging Markets Equity Income Index ((WTEMHY), the index tracked by the popular WisdomTree Emerging Markets Equity Income Fund

. The top 10 additions to the WTEMHY had an average price-to-earnings (P/E) ratio of about 5x while the top 10 deletions had average P/E ratio of over 15x, WisdomTree said in a research note. "The top 10 deletions had positive price performance averaging about 4% from May 31, 2011, through May 31, 2012, but displayed negative trailing 12-month dividend-per-share growth growth over that same period. These stocks outperformed the MSCI Emerging Markets Index, which returned -20.32% over this period, by nearly 25 percentage points. This fact, combined with their declining dividends, is why we deleted them,"

. Prior to the June rebalance, DEM "was significantly under-weighting the equities of China and Russia because their share prices were high relative to their trailing 12-month dividends," WisdomTree said. With valuations in those countries compelling and dividends up, the index's exposure to those nations was increase. As of August 14, China and Russia combined for 28 percent of DEM's weight. "I believe emerging markets will continue to provide the bulk of global economic growth in the coming years," said Jeremy Schwartz, WisdomTree director of research in the note. "And I know that weighting an equity portfolio by a measure of fundamental value such as dividends helps manage valuation risk – which is critical in emerging markets. That's why it's so important to rebalance indexes—and portfolios—every year." At the end of May, China and Russia combine for less than 23 percent of DEM's weight. Taiwan is DEM's largest country exposure at almost 21 percent while Brazil is just ahead of Russia at 13.8 percent of DEM's weight. In the case of DEM, an argument can be made in favor WisdomTree's rebalancing methodology. Over the past year and five years, the ETF has handily outperformed VWO and EEM and DEM's current dividend yield of 5.22 percent is far superior to that of its larger rivals. Investors are taking note. In February, WisdomTree touted the fact that

. That number has since jumped to $4.1 billion. For more on ETFs, click

.