A Closer Look At The Contrarian ETF (JCO)

by on July 30, 2010 | ETFs Mentioned:

The last few years have seen no shortage of innovations in the ETF space. Opportunistic issuers have capitalized on a shift in investor mentality by rolling out ETFs offering never-before-seen levels of granularity in emerging markets. IndexIQ introduced hedge fund replication ETFs, a line of products that initially drew skepticism but has now been embraced by investors looking to add non-correlated assets to their portfolios. Geary Advisors rolled out the first state-specific ETFs, two products that have turned in rather impressive performances.

One of the most intriguing products to hit the market so far this year is an ETF that has largely flown under the radar of investors. Javelin rolled out its Contrarian Opportunities Index Fund (JCO) at the start of the second quarter, introducing an ETF that seeks to use a formalized methodology to implement a strategy investors have been using for centuries.

Warren Buffett once offered up the advice to “be fearful when others are greedy and greedy when others are fearful.” In a sense, JCO employs quantitative analysis to implement this strategy, taking advantage of market conditions to buy into quality stocks at an attractive entry point. JCO tracks the performance of the Dow Jones U.S. Contrarian Opportunities Index, a benchmark that follows a rules-based methodology to select stocks in a manner that would be considered consistent with a contrarian investment strategy.

Most investors are familiar with the concept of contrarian investing, a strategy that includes establishing positions in stocks that have a recent history of less-than-impressive performances and have fallen out of favor with Wall Street (BP serves as an excellent and timely example of a contrarian investment play). In order to be included in the index underlying JCO, stocks must have underperformed the broad market in recent years; specifically, stocks are chosen semiannually from a broad market universe (the Dow Jones U.S. Broad Stock Market Index) and are screened to identify securities ranked lowest by three-year trailing total return performance.

But JCO doesn’t simply invest in stocks that have performed poorly during the previous three years. It’s important to note that component companies in the underlying index must also demonstrate strong fundamentals relative to other companies. Once the selection pool has been formed by running the performance screen, potential constituents are ranked based off of a 10 factor model incorporating price, earnings, valuation, quality, and momentum screens. These qualitative factors include long-term expected profit growth, P/E ratio, price/cash flow ratio to five year median, and current quarter EPS revisions [see all of the criteria on the index methodology description].

Based on the results of that screen, 125 individual stocks are selected for inclusion in the index, with each receiving an equal weighting. The index is reconstituted semiannually, creating an opportunity for laggards that have seen a reversal of fortunes to work their way out of the benchmark. It’s also worth noting that there is a 30% cap on any individual sector, a key restraint considering that entire industries can occasionally fall out of favor with investors despite relatively sound fundamentals [also see the Buy And Hold Hall Of Fame].

Under The Hood

Through the end of June, JCO had its biggest weightings in consumer services (28%), followed by health care (22%) and industrials (15%). While the fund maintains some exposure to mega and large cap equities, the equal-weighted structure of the related index ensures that stocks across the market cap spectrum are represented; JCO has significant weights in mid cap, small cap, and even micro cap stocks [see a breakdown of JCO holdings]. That makes the Contrarian ETF a possible choice as a core equity holding in a portfolio for buy and hold investors who are not concerned by the fund’s low trading volumes [see all ETFs in the All Cap Equities ETFdb Category].

JCO is a relatively new product, so it’s tough to tell just how well the strategy has played out for investors (Dow Jones launched the underlying index in late 2008). There is a substantial amount of backtested data suggesting that the Contrarian index has consistently outperformed more broad-based benchmarks such as the Russell 2000 over the last 15+ years. For those who like the idea of bargain hunting, JCO might be worth a closer look; this fund offers a way to inject a disciplined, analytical approach into the “buy low, sell high” strategy that many investors swear by [also see Long Live Buy And Hold: Three Reasons You Shouldn't Try To Time The Market].

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Disclosure: No positions at time of writing.