Second, our research shows that when you weight directly by the earnings stream, you end up owning companies in proportion to their contribution to the U.S. earnings stream, which was about $900 billion last year. Historically, that approach led to outperforming the capitalization-weighted indexes by anywhere from 100 to 300 basis points a year.

For example, Exxon Mobil, our largest holding, generated $40 billion in earnings in 2006. That $40 billion is about 4.5% of the $900 billion income stream in the U.S., so their weight in our index was 4.5%.

In general, the stock market represents the investors’ estimate of future profits and their growth, and we believe that investors pay too much for growth. The market is efficient in the long term, but in the short run, stocks aren’t always efficiently priced as they are subject to speculative bubbles. We use the opportunity to move away from capitalization weights and that strategy is especially useful for avoiding the bubbles, such as the one in 2000, or the bubble in Japan. Eventually, the market reverts back to the income stream, We believe you’re better off just owning the income stream.

Q: You mentioned the reconstitution of the indexes. How often do you do it?

A: We reconstitute the indexes once a year. We do it in December for our domestic indexes, and in June for the international ones. In that process, we both select the companies and re-weight them. If a company has been profitable for the previous four quarters on a cumulative basis, it is included in the index. If it hasn’t, it is deleted from the earnings index. If a company cancels a dividend during the year, it is removed from the dividend index. Overall, we have very few rules and we apply them once a year. In that way we limit the turnover on the indexes.

Q: How do you handle the timing issue of the reconstitution, or the fact that the fiscal year of some companies may end at a different month, or that their earnings may not be published at the time?

A: The approach we use with S&P is to look back at the most recent four fiscal quarters. So the fiscal year of the companies doesn’t really matter. Regarding the dividends, our weights are based on the most recently declared dividend per share. If a company has declared a dividend per share before November 30, and has regularly paid dividends in the past, then it is eligible for the index. We use the most recent dividend per share data available and we annualize it for our domestic dividend indexes.

Q: When calculating the dividends of domestic companies, do you use the dividend per share only, or you include the diluted options as well?

A: We look at the dividend per share and we multiply it by the common shares outstanding. In effect, the result is an index that is scaled to the size of the company, meaning that the larger companies have larger weights because the number of the shares outstanding is one of the factors. But instead of multiplying the shares by the stock price, which is a multiple of earnings and dividends, we multiply it directly by the dividends per share. So a company like GE, which pays dividends of $10 billion annually, will represent about 4% of our index because the amount of dividends in the U.S. is about $260 billion.

Ultimately, our methods tend to shift the weight in the index towards stocks with higher dividends and lower P/Es. There’s a lot of research that shows that, over time, stocks with higher dividend yields and low P/Es have outperformed the market.

Q: What is the correlation between the domestic ETFs and the domestic indexes?

A: An ETF is designed to provide the return of the index. Some of the funds replicate the index, meaning that they hold all the securities in exactly same proportions, while others hold a sample of the index. So the funds that mirror broad indexes may hold 600 securities. Since the goal of the ETFs is to provide the total return of the index, they usually track the indexes closely.

Regarding the correlation, right now in our domestic funds it is at least 95%. There are some funds that are deviating by only 0.20%. For example, the WisdomTree Total Dividend Index tracks approximately 1,500 securities. Over the last year, the index returned 23.36%, while the fund was up 23.5%. The Bank of New York is actually running the portfolios that track the WisdomTree Indexes, and they have a lot of experience with ETFs over the last 10 years.

Q: I suppose that many of the underlying stocks in international ETFs trade when the U.S. markets are closed. How do you reconcile that issue?

A: That’s correct; we use the local shares which trade on markets opened at different hours. The result is that the ETF trading in the U.S. to a secondary market, sometimes serves as a future. It is like a tracking basket that is updated every 15 seconds and is based on the previous night’s closing prices of stocks, adjusted for the currency, and developments in the market when overseas markets are closed.

In that sense, the ETF actually gives an idea about the future. It can start trading away from the index, and that’s an interesting feature, because investors actually use the ETF overnight to get a sense of how to handle markets that change quickly.

Q: So it is good that you don’t have ETFs that carry the volatility of the Shanghai market, which can fluctuate by 6% or 8% a day.

A: Well, many people would actually be attracted to it, simply because there might be a way to profit or hedge against a loss.