Letting Winners Run

Great interview with Tammy DeRosier in IBD:

Tammy DeRosier enjoys baking peach cobblers and biscuits with her young daughter. As president of Dorsey Wright & Associates (DWA), she cooks up strategies to empower investors.

The firm’s specialty is technical analysis based on relative price strength — a method of evaluating the performance of investment choices against one another. It underlies both the “momentum” ETF suite from PowerShares and a best-performing ETF in 2015, a First Trust fund of funds.

DeRosier, 45, recently talked to IBD about Dorsey Wright’s philosophy and pipeline, as well as its recent acquisition by Nasdaq.

IBD: How is the DWA investment philosophy translated in the PowerShares DWA Momentum ETFs?

Tammy DeRosier: The wonderful thing about momentum, or relative strength investing, is that it is a systematic and rules-based system that fits perfectly in the ETF structure.

Every quarter, a universe of approximately 1,000 stocks is ranked from strongest to weakest, and the PowerShares DWA Momentum Portfolio’s (ARCA:PDP) underlying index is reconstituted to include the strongest 100. This allows strong stocks like Apple (NASDAQ:AAPL) to get into the portfolio, and more importantly, forces it to stay in as long as it is strong, so you can enjoy the ride.

At the same time, if a stock cannot perform, the strategy will rotate it out of the portfolio. In other words, we let the winners run and sell the laggards, which is oftentimes psychologically hard to do. So putting that strategy into an ETF forces an investor to stay within the rule set.

IBD: Do momentum-based strategies underperform in volatile or bear markets? When do they lag?

DeRosier: It’s always important for investors to know what a strategy’s Achilles heel is; and every strategy has one. For relative strength or momentum investing, the two periods when you can experience a lag in performance is during a choppy or trendless market or during leadership changes.

Think about your car — if you want to shift from first to second gear, you have to let off the gas (and) push in the clutch, and you actually lose some speed just before you shift into that next gear. Relative strength is much the same, as the new leadership is rotating into the portfolio and old leadership is falling out.

These times don’t necessarily come during volatile or bear markets, though. Sometimes you could be having a bear market in a couple of sectors and a bull market in other sectors, and a relative strength or momentum portfolio will excel during that period.

This year is a perfect example of how the energy space in general has struggled, while the health care and technology sectors have done well.

IBD: Isn’t capturing momentum tricky — part of the moves may be beyond grasp by the time they are identified?

DeRosier: We never try and catch the exact bottom of any market, sector or stock trend. Instead, we aim to let that stock hit the bottom and begin to move up. That shows some potential sustainability to the trend. If we can capture the majority of the up move, that is all you need in order to produce positive portfolio performance.

What’s actually most interesting about PDP is the fact that it provides a vehicle for investors to hold the “high fliers” as a portfolio. On its own, any one of these stocks might be too volatile, but as a portfolio, it can work very well. The systematic approach forces investors to stay with the winners and sell the losers.

IBD: You believe the relative strength methodology can beat the market. Yet PDP has performed roughly in line with the Russell Mid-Cap Growth benchmark over one-, three- and five-year periods. Why?

DeRosier: On a five-year trailing total return basis, PDP ranks in the top 1% — or, said another way, PDP has outperformed 99% of the funds in its category according to Morningstar, so we are quite proud of how the ETF has performed. High relative strength stocks have moved higher in fits and starts over the last five years or so. We are currently slightly ahead of the Mid-Cap Growth Index over the periods you mentioned, and we have a bigger spread over the much broader S&P 500 Index.

Conditions for momentum stocks have been much more favorable recently, so we are very happy with where we are sitting. The performance spread between leading and lagging stocks has started to move upward again after a long period of sideways movement. Whenever the spread moves higher, our strategies have greater potential to outperform.

If this trend can continue, we would expect our strategies to continue to perform well vs. the broad market.

IBD: How can smart beta ETFs be combined in a portfolio?

DeRosier: Investors can mix and match philosophies together by actually looking at the basis of the strategy. For instance, momentum and low volatility, or value, pair together well. Typically when one is zigging, the other is zagging. That gives the overall portfolio a smoother ride.

IBD: First Trust Dorsey Wright Focus 5 (NASDAQ:FV) has racked up assets of $3.96 billion in under two years. Why did Focus 5 resonate with ETF investors? What’s unique about how the DWA relative strength ranking system is applied in FV?

DeRosier: The relative strength rules are the same for all the indices we construct, including the index that underlies FV. The index or model includes the strongest from the inventory, and the weakest from the inventory sit on the bench. Much like a pitcher in baseball, if he starts to walk some batters or they get hits off him, the manager will go to the bullpen and call in another pitcher. Our rules work the same way. A member of the index can have a walk or two, but a consistent pattern of weakness means the next strongest will come in while that sector or stock goes to the bench.

I think the appeal of FV, much like all of the ETFs following DWA indexes, is the transparency of the rules and the underlying strategy being based in the irrefutable laws of supply and demand.

(Editor’s note: FV tracks an index that analyzes the relative price strength of all First Trust sector- and industry-based ETFs, and selects the top five with the highest price momentum.)

IBD: What does the acquisition by Nasdaq mean for your company?

DeRosier: Nasdaq offers us the resources to grow our business into a truly global platform that goes far beyond the core businesses we have developed in the last 25 years.

IBD: What’s in the pipeline for ETFs and mutual funds?

DeRosier: We always have interesting strategies that we publish on our research website. One that we have incubating is a combination of factors such as low volatility and the strongest relative strength of those names.

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