Traditionally, Growth indexes give you exposure to “U.S. companies whose earnings are expected to grow at an above-average rate relative to the market” and Value indexes give you exposure to “U.S. companies that are thought to be undervalued by the market relative to comparable companies.” So which is better? Depends on the time frame. Markets can go through long stretches of favoring one over the other. Here is how the last 15 years have looked:
Source: Dorsey Wright, Price returns only, not inclusive of dividends or all transaction costs, IWF used for Russell 1000 Growth and IWD used for Russell 1000 Value
Part of the appeal of a momentum strategy is that it sidesteps the unnecessary restrictions of the style box. Take the PowerShares DWA Momentum ETF (PDP). This ETF is based on a momentum index constructed by taking a universe of about 1,000 U.S. Mid and Large Cap stocks and identifying the 100 with the best momentum characteristics (according to our rankings). PDP is rebalanced on a quarterly basis.
The relative strength ranking process used to construct the index used for PDP pays no attention to whether or not a stock is a “Growth” stock or a “Value” stock. Rather, a stock simply has to be relatively strong. As shown in the chart below, the correlation of Momentum (PDP) to Growth (IWF) and Value (IWD) over time changes.
Source: Yahoo! Finance. Returns used for this were total returns, inclusive of dividends, but not all transaction costs.
Notice how in recent years the correlation of Momentum to Value has been lower than it was in the first couple years of PDP’s history. Why is that? Because Growth stocks have generally been performing better than Value stocks in recent years so our relative strength ranking process leads us to those stocks.
What does this mean for an investor? I think it could mean that an investment in a Momentum Index is likely to be more adaptive than an investment in a style-specific index. Ultimately, I think the ability to adapt to different market environments is key for investment success over time.
The relative strength strategy is NOT a guarantee. There may be times where all investments and strategies are unfavorable and depreciate in value. Dorsey Wright is the index provider for PDP and a suite of other Momentum ETFs at PowerShares. See www.powershares.com for more information.
