Alternative Beta

July 22, 2013

…has been discovered by the Wall Street Journal. Recently, they wrote an article about better ways to index—alternative beta—and referenced a study by Cass Business School. (We wrote about this study here in April.)

Here’s the WSJ’s take on the Cass Business School study:

The Cass Business School researchers examined how 13 alternative index methodologies would have performed for the 1,000 largest U.S. stocks from 1968 to 2011.

All 13 of the alternative indexes produced higher returns than a theoretical market-cap index the researchers created. While the market-cap index generated a 9.4% annualized return over the full period, the other indexes delivered between 9.8% and 11.4%. The market-cap-weighted index was the weakest performer in every decade except the 1990s.

The most interesting part of the article, to me, was the discussion of the growing acceptance of alternative beta. This is truly exciting.

Indeed, a bevy of funds tracking alternative indexes have been launched in recent years. And their popularity is soaring: 43% of inflows into U.S.-listed equity exchange-traded products in the first five months of 2013 went to products that aren’t weighted by market capitalization, up from 20% for all of last year, according to asset manager BlackRock Inc.

And then there was one mystifying thing: although one of the best-performing alternative beta measures is relative strength (“momentum” to academics), relative strength was not mentioned in the WSJ article at all!

Instead there was significant championing of fundamental indexes. Fundamental indexes are obviously a valid form of alternative beta, but I am always amazed how relative strength flies under the radar. (See The #1 Investment Return Factor No One Wants to Talk About.) Indeed, as you can see from the graphic below, the returns of two representative ETFs, PRF and PDP are virtually indistinguishable. One can only hope that relative strength will eventually gets its due.

PDPvPRF zps323d99f1 Alternative Beta

The performance numbers above are pure price returns, based on the applicable index not inclusive of dividends, fees, commissions, or other expenses. Past performance not indicative of future results. Potential for profits accompanied by possibility of loss. See www.powershares.com for more information.

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Fun With Backtesting

September 4, 2012

This just in from Institutional Investor: many backtests fail in real life. They write:

Makers of indexes often fill in the blanks with historic data on the components to produce hypothetical index performance. But a recent Vanguard study found that a large percentage of these hypothetical, back-filled indexes that had outperformed the U.S. stock market didn’t keep up after they went live as the index returns subsequently fell. What may be happening, says senior Vanguard ETF strategist Joel Dickson, is that indexes are being developed by “rearview mirror investing,” that is, through selection bias of what worked well in the past. The result can mean a nasty surprise for investors.

Duh.

Pretty much anyone can do data mining with the computing power available on a desktop computer. And index providers will continue to do data mining as long as investors ram money into products with lousy backtests.

Back-filled index funds attract on average twice the cash flow in the initial launch phase than funds with new indexes that don’t have such data, indicating that the availability of a track record makes the fund more attractive — even if it probably won’t last.

Good backtesting can be very useful and can give investors a good idea of what to expect in the future. But how can an investor tell if the backtest is any good or not?

One thing to examine is how robust the index methodology is. For example, when we built our Systematic Relative Strength products, we subjected them to Monte Carlo testing for robustness. That made it apparent that the systematic investment method itself was sound, even though the range of outcomes on a quarterly or annual basis can be significant.

With the proliferation of indexes for ETFs, it’s becoming important to be able to evaluate how robust the backtesting was. Probably partly because of a robust backtesting process, our Technical Leaders Index has outperformed the market since inception. I’m sure many other indexes are thoughtfully constructed—but I’m just as sure that there are some that are not.

Do your homework before you put client money at risk.

See www.powershares.com for more information. Past performance is no guarantee of future returns. A list of all holding for the previous 12 months is available upon request.

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Checking In On PDP

August 30, 2012

So far, 2012 has been an excellent year for the PowerShares DWA Technical Leaders Index (PDP). Year-to-date, PDP is +14.94%, while the S&P 500 is +12.16%. PDP, which began trading on March 1, 2007, is a big source of pride for our firm as it has outperformed its benchmark in every year since its inception except for one. For those unfamiliar with the strategy, the index is comprised of 100 high relative strength stocks and is reconstituted on a quarterly basis.

In every quarterly reconstitution there are stocks that come and stocks that go. Those that retain their strong relative strength stay, and those that have deteriorated are replaced. Interestingly, there are a number of stocks that have remained in the index since its inception over five years ago, including Apple Computer.

As shown above, the S&P 500 (red line) has gone nowhere, while Apple Computer (blue line) has powered higher. Apple is currently the biggest weight in the index:

Obviously, not all of our holdings work out as well as Apple. However, capturing a few of these big winners can make a big difference.

As we announced just a short time ago, our Technical Leaders Index family was recently expanded to include DWAS, the PowerShares DWA Small-Cap Technical Leaders Index. Now, it is a family of four: PDP, PIE, PIZ, and DWAS.

See www.powershares.com for more information. Past performance is no guarantee of future returns. A list of all holdings for the last 12 months is available upon request.

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The Problem With Seeing The Forest For The Trees

August 14, 2012

The proverbial wisdom is that it is a character flaw to be unable to view “the forest for the trees.” However, from an investor’s perspective, sometimes granularity can be a virtue. There are any number of data points that reveal that investor sentiment is sub-par, including our own bi-weekly survey. Retail investors continue to pull money out of domestic equity funds and put it into fixed income. Consumer confidence is low. The economy both here and in many developed economies is stagnant.

Investors often make the mistake of evaluating the economy and financial markets in a monolithic fashion. However, it is significantly more complicated than that. Even in a lukewarm economy, there are micro-bull markets taking place right under our nose. One way of observing this reality is to look at the YTD performance of the 100 stocks that currently comprise the PowerShares DWA Technical Leaders Index. PDP is the ticker of the ETF that tracks this index.

Within this index, there are currently 27 stocks up more than 30% YTD (some up as much as 70-80% YTD) and the median YTD performance of stocks in the index is +18%. Through 8/13/12, PDP is up 12.30% YTD, outperforming the S&P 500. In fact, PDP has performed favorably compared to the S&P 500 in this bull market and and since inception.

So, where are some of the micro-bull markets taking place? Consider the business of the Skyworks Solutions (SWKS)-the index constituent that currently has the best YTD performance:

Skyworks Solutions, Inc., together with its subsidiaries, offers analog and mixed signal semiconductors worldwide. The company provides power amplifiers and front-end solutions for cellular handsets from entry level to multimedia platforms, as well as smart phones.

Source: The Street

In full disclosure, not all of the constituents of the PowerShares DWA Technical Leaders Index are performing well. This index is re-constituted quarterly with high relative strength stocks. Sometimes, strong stocks are added to the index and they perform abysmally. Sometimes the index as a whole underperforms. The point of this article is not to say that relative strength is a panacea. That said, there is solid research that shows that relative strength has been an effective way to beat the market over time. Furthermore, the index construction process ensures that the process seeks to identify individual winners regardless of the macro environment.

Not all trees in a forest are the same.

Image source: Confused Capitalist

See www.powershares.com for more information. Dorsey Wright also currently owns SWKS in our separately managed accounts. Past performance is no guarantee of future returns. A list of all holding for the previous 12 months is available upon request.

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PDP in the News

June 26, 2012

Bloomberg has an article today entitled “ETFs Passive No More.” It’s an article about the rise of intelligent indexation. Here’s their thesis:

Exchange-traded funds are posing a new threat to the $7.8 trillion market for active mutual funds by challenging the notion ETFs are only good for tracking benchmarks.

Here’s their blurb about PDP:

The PowerShares DWA fund, which invests in U.S.-listed companies, uses an index that selects them based on “relative strength,” a proprietary screening methodology developed by Richmond, Virginia-based Dorsey, Wright & Associates Inc. The fund has advanced at an annual rate of 2 percent since its inception in March 2007, compared with the 1.2 percent gain for the Standard & Poor’s 500 Index over the same period, and the 3.8 percent increase in the Russell 3000 Growth Index.

Their offerings may further erode the market share of active mutual funds, sold by traditional money managers such as Fidelity Investments, Capital Group Cos. and Franklin Resources Inc. The companies tout the ability of their managers to beat benchmarks mostly through individual security selection.

“Historically, active managers held a unique appeal to prospective investors,” said Steven Bloom, who helped develop the first ETF in the 1980s and is now an assistant professor of economics at the U.S. Military Academy at West Point, New York.“Now, ETFs are infringing on that territory by holding out the prospect of alpha.”

The article points out that by using a rules-based investment process within an ETF, you can shoot for alpha, while getting the tax benefits of the ETF structure. Rules-based ETFs are going to continue to blur the line with active mutual funds over time. It’s also going to be interesting to see how many of the rules-based processes are robust and how many have been optimized. Curve-fitted performance will tend to degrade over time, while a truly adaptive model should be more consistent.

We think the trend toward intelligent indexes will continue and we’re excited to be one of the pioneers.

See www.powershares.com for more information about PDP. Past performance is no guarantee of future returns. A list of all holdings for the trailing 12 months is available upon request.

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PDP vs. Ken French High Relative Strength

June 12, 2012

In past posts (“Relative Strength vs. Value-Performance over Time” and “Relative Strength, Decade by Decade”), I’ve used the Ken French database’s relative strength portfolio. While this is useful in concept, what solidifies the findings in my previous posts is the similarity between Ken French’s High RS data and one of our ETFs, PDP.

PDP is a PowerShares ETF based on the Dorsey Wright Technical Leaders Index. It has its own proprietary calculation method, which is different than that of the Ken French database. Yet, over the past five years, both have performed very similarly.

Table 1:

HighRSPDPSP500 PDP vs. Ken French High Relative Strength

PDP has only been on the market since March of 2007. Yet, over those five years, the two indexes have performed almost exactly the same…no small feat considering the stock market over the last few years. Imagine, then, using the Ken French data as a “loose proxy” for PDP going back decades. We’re not saying the two will always perform the same—we’re just pointing out that it’s clear both indexes are exploiting the same factor (RS) in a practical way.

Currently, relative strength growth rates (10-year rolling returns) are at some of the lowest levels since the 1930s; and historically we can see that growth rates often increase once they hit rock bottom. That may bode well for relative strength returns going forward.

Chart 1:

HighRS10YearGrowthRatesBar PDP vs. Ken French High Relative Strength

See www.powershares.com for more information about PDP. Past performance is no guarantee of future returns. A list of all holdings for the trailing 12 months is available upon request.

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