The debate over fundamentally weighted indexes has become a common topic of discussion in indexing circles. Detractors of the theory argue that it results in indexes with a small-cap value tilt, and as of December 31, they can now point to 2007 as proof. In the year that large-cap and growth outperformed small-cap and value, fundamentally weighted indexes did not fare so well in comparison with cap-weighted indexes. In particular, dividend-weighted strategies seem to have been hit the hardest on the domestic front; the Dow Jones U.S. Select Dividend Index, for example, was down 5.16% in 2007, while the S&P 500 was up 5.49%. That’s a difference in performance of nearly 1,000 basis points.

In this comparison, we examine large-cap and small-cap domestic ETFs as well as international ones from WisdomTree (WSDT.PK) and PowerShares in comparison with other cap-weighted ETFs.

Amongst large-cap funds in 2007, the SPDRS (NYSEARCA:SPY ) and the iShares S&P 500 Index Fund (NYSEARCA:IVV ) were up 5.40% and 5.44%, respectively. Meanwhile the Vanguard Large-Cap ETF (NYSEARCA:VV ), which tracks the MSCI U.S. Prime Market 750 Index, was up an even higher 6.44%, with ETFs based on other major cap-weighted indexes in between. However, the PowerShares RAFI U.S. 1000 Portfolio (NYSEARCA:PRF ) was up just 4.25%, while the WisdomTree LargeCap Dividend Fund (NYSEARCA:DLN ) was up 2.99%. The group was trailed by the WisdomTree High-Yielding Equity Fund (NYSEARCA:DHS ), which actually declined 4.42%.

Name Ticker 2007 Return (%)

Vanguard Large Cap VV 6.44

SPDR DJ Large Cap ELR 6.19

iShares S&P 100 OEF 5.93

iShares Russell 1000 IWB 5.68

iShares S&P 500 IVV 5.44

SPDRs (S&P 500) SPY 5.4

PowerShares FTSE RAFI 1000 PRF 4.25

WisdomTree LargeCap Div DLN 2.99

WisdomTree Total Dividend DTD 1.33

WisdomTree Div Top 100 DTN 0.11

WisdomTree High-Yld Eqty DHS -4.42

Fundamental indexing also fared poorly in the small-cap domestic segment. Small-cap stocks did poorly, so it’s no surprise that the best-performing fund, the SPDR Dow Jones Wilshire Small Cap ETF (DSC), was up just 1.67% for the year. At the other end of the spectrum of cap-weighted funds, the iShares Russell 2000 Index Fund (NYSEARCA:IWM ) was down 1.47%. In between that range fell the PowerShares FTSE RAFI U.S. 1500 Small-Mid Portfolio (NASDAQ:PRFZ ), which was down 0.11%; it also outperformed the iShares S&P SmallCap 600 Index Fund (NYSEARCA:IJR ), which was down 0.44%. The WisdomTree SmallCap Dividend Fund (NYSEARCA:DES ), however, showed a rather stunning 12.05% decline.

Name Ticker 2007 Return (%)

SPDR DJ Small Cap DSC 1.67

Vanguard Small Cap VB 1.27

PowerShares FTSE RAFI1500 PRFZ -0.11

iShares S&P 600 Small IJR -0.44

iShares Russell 2000 IWM -1.47

WisdomTree SmallCap Div DES -12.5

The WisdomTree MidCap Dividend Fund (NYSEARCA:DON ) showed similarly poor performance in relation to other mid-cap funds, falling 5.49% while the MidCap SPDRs (NYSEARCA:MDY ) were up 8.25% and iShares S&P MidCap 400 Value Fund (NYSEARCA:IJJ ) was up 2.42%. There is no similar PowerShares ETF that has a trading history for all of 2007.

It’s been what we call a perfect storm against value stocks concentrated in the financial arena, says WisdomTree President & Chief Operating Officer Bruce Lavine. Large-cap in particular was a very difficult environment, with large-caps outperforming small-caps and technology stocks—which are less likely to pay dividends—outperforming financial stocks, he adds. From that perspective, DLN underperformed only by a small margin—just a couple hundred basis points.

Lavine chalks much of the U.S. underperformance up to the subprime crisis and its aftereffects, with companies that had strong fundamentals often being hit the hardest. There are some unique characteristics about the U.S. market that have just been tough this year. That had to do with getting let down by companies that had solid fundamentals on paper.

The situation changes a little when you look at international; on the surface, the iShares MSCI EAFE Index Fund (NYSEARCA:EFA ) did nicely with a 10.97% gain. The PowerShares FTSE RAFI Developed Markets ex-U.S. Portfolio (NYSEARCA:PXF ) has only been around since June 2007, so there’s no data to compare, but WisdomTree’s comparable funds trounced EFA. The WisdomTree DEFA Fund was up 15.06%, and the WisdomTree International LargeCap Fund (NYSEARCA:DOL ) was up 15.46%. The WisdomTree DEFA High-Yielding Equity Fund (NYSEARCA:DTH ) rose 11.37%.

Name Ticker 2007 Return (%)

WisdomTree Intl LgCap Div DOL 15.46

WisdomTree DEFA DWM 15.06

WisdomTree Intl Div Top 100 DOO 14.05

iShares MSCI EAFE EFA 10.97

WisdomTree DEFA HiYld Eq DTH 11.37

When you go international, you don’t have the same concentrations in the financials or the REITs that you see in the U.S., Lavine says. He also points out that international companies are far more likely to pay dividends, with 90% of the components of the MSCI EAFE paying dividends.

So what does this all mean? Well, not a heck of a lot, really. It’s one year’s worth of performance. It is telling that the year that domestic small-cap and value stocks were dominated by large-cap and growth stocks, domestic fundamental ETFs also did poorly—but then growth also beat value at the international level, with the iShares MSCI EAFE Growth Fund (NYSEARCA:EFG ) up 16.11% and the iShares MSCI EAFE Value Fund (NYSEARCA:EFV ) up just 7.17%. The dividend-weighted WisdomTree ETFs, of course, outperformed at the international level, once again raising the question of how much can be blamed upon the subprime mortgage mess and whether the underperformance of alternatively weighted ETFs in 2007 was an anomaly.

Over a long period of time the strategy has borne itself out. Generally if you own the dividend-paying segment of the market, historically that has been a very strong place to be, Lavine says.

Written by Heather Bell