Contrarian And Momentum ETFs Head-To-Head: JCO vs. PDP

by on November 23, 2010 | ETFs Mentioned:

The steady rise in the number of exchange-traded products available to U.S. investors over the last several years has been primarily driven not by duplication, but by innovation. The vast majority of recent ETFs to hit the market have been first-to-market products, offering exposure that wasn’t previously available within the ETF wrapper. Investors can now utilize ETFs to access nearly every major world economy, including Vietnam, Ireland, New Zealand, the Philippines, and two different ways to play Indonesia. Those seeking exposure to commodities can make a pure play on everything from cotton to tin. And increased sector granularity is evidenced by new funds focusing on uranium production, companies involved in rare earth metals, and copper miners.

Beyond providing options for accessing various asset classes, international markets, and targeted sectors, the rise of the ETF industry has also helped to democratize a variety of investment strategies. There are a multitude of somewhat sophisticated strategies that can now be accessed in a cost-efficient and low-maintenance manner in ETF form, including quant funds, sector and country rotational strategies, as well as long/short ETFs [see all the funds in the Quantitative Methodology ETFdb Category].

While many of the most popular ETFs are linked to “plain vanilla” cap-weighted indexes, there are dozens of funds linked to enhanced benchmarks that utilize various screens and quantitative analyses to determine holdings and individual allocations. Historically, executing these investment strategies required significant time and research capabilities–meaning that many investors interested in these strategies ended up forking over hefty fees to active managers. But the development of enhanced indexes and increased popularity of ETFs has democratized many of these strategies, allowing all types of investors access to tactics previously reserved for only the most sophisticated.

Two popular investment strategies take very different approaches to stock selection: momentum investing involves buying companies with strong recent performance, while contrarians focus on quality stocks that for one reason or another have fallen out of favor with investors. Both of these strategies are available through ETFs, presenting alternatives for exposure to large cap domestic equity exposure beyond SPY or IWM.

Contrarian Vs. Momentum: ETF Options

Both contrarian and momentum strategies are popular among investors, and both have their share of success stories. Legendary investor Warren Buffet has never been afraid to go against popular opinion, making billions of dollars off of his mantra that calls for investors to “be greedy when others are fearful, and be fearful when others are greedy.” Likewise, countless investors have racked up huge profits by identifying hot stocks or asset classes early and riding the rally higher as more and more money chases returns [see Weighting Methodologies: An ETF Report Card].

Contrarian investment strategies are build around stocks that have fallen out of favor with Wall Street, posting recent returns that lag significantly behind the market. But successful contrarian strategies don’t simply stockpile losers; identifying underperformers that have plunged despite strong fundamentals has the potential to deliver impressive results. Momentum investing, on the other hand, is based around the premise that past results are indicative of future returns–or at least that the very recent past may give an indication of performance in the very near future.

Of course neither strategy is a slam dunk, and both carry risks. Investors who think they’ve found a bargain may actually be buying in long before a security actually bottoms out. And those who chase returns risk arriving on the scene too late, establishing a position just in time for a reversal or closing out just before a turning point.

ETF Options

The Contrarian Opportunities Index Fund (JCO) is an intriguing option for investors looking to employ a strategy that bets on stocks that have performed poorly, but whose dismal returns aren’t justified by their fundamentals. In the other corner is the PowerShares DWA Technical Leaders Portfolio (PDP), which offers investors a way to establish exposure to companies with powerful relative strength characteristics without having to comb through financial statements and spreadsheets. Below, we profile both of these funds, including their methodologies, performance, and expenses.

Indexes & Holdings

JCO tracks the Dow Jones U.S. Contrarian Opportunities Index, which follows a rules-based methodology to select stocks in a manner that would be considered consistent with a contrarian investment strategy. Stocks are chosen from a broad market universe screened to identify securities ranked lowest by three-year trailing total return performance. But as mentioned above, poor recent performance isn’t the only criteria for inclusion. From the pool of laggards, stocks are selected according to rankings by ten qualitative factors, including long-term expected profit growth, P/E ratio, price/cash flow ratio to five year median, and current quarter EPS revisions. That step results in about 125 securities, which are given equal weightings in the index. JCO focuses on U.S. assets, spreading exposure across small, mid, and large cap stocks. Currently, the highest sector allocations are made to consumer services, health care, and business services [see also A Closer Look At The Contrarian ETF].

PDP is linked to the Dorsey Wright Technical Leaders Index, which includes approximately 100 U.S.-listed companies that demonstrate powerful relative strength characteristics. Relative strength is a metric that measures how a stock is performing relative to other stocks in the same industry, or how well an industry is performing relative to other industries. The calculation for relative strength is pretty straightforward–it’s simply the performance of a security during a specified time period divided by the performance of a benchmark index over the same period [see Under The Microscope: Technical Analysis ETF].

Similar to benchmark underlying JCO, the construction process for PDP’s index involves multiple analyses. In addition to considering the relative performance of different sectors of the economy, the index provider (Dorsey Wright) analyzes the relative strength of each of the 3,000 largest U.S.-listed companies. The 100 stocks that receive the highest scores from the proprietary analysis are included in the index, and weighted using a modified equal weighting methodology (basically those with the higher relative strength characteristics get a higher weighting).

Most equity ETFs exhibit low turnover, as the composition of the underlying index generally remains static. But the index to which PDP is linked results in a high turnover strategy, as shifts in relative strength–which may lead to certain securities falling out of the index–can occur relatively quickly. That isn’t necessarily a bad thing; the nuances of the ETF structure can actually lead to tax advantages. But when relative strength rankings change considerably, PDP’s performance may lag. Like all trend following strategies, relative strength investing may struggle when trends change. On the other hand, when definable trends exist in the market, PDP should generally perform pretty well.

Currently, PDP’s biggest sector allocations are to the consumer discretionary (26%) and industrials (22%) sectors, reflecting the strong recent performance from these corners of the economy. Among the largest individual holdings are Apple (3.6%) and American Tower Corporation (3.4%) [see also Four Alpha-Seeking ETFs Crushing SPY].

Performance & Fees

Since its inception in 2007, PDP’s performance has justified consideration as an option to investors looking for broad-based exposure to U.S. equity markets; the PowerShares fund has beaten the iShares Russell 3000 Index Fund (IWV) by about 200 basis points since its launch. But as shown below, PDP has been also exhibited higher volatility–partially the result of the lower number of holdings (just 100) compared to the broad-based Russell 3000. PDP especially struggled in 2008, when many stocks and sector that had been flying high (such as financials) suddenly fell off a cliff. But during the impressive rally that began after markets bottomed out in early 2009, PDP delivered some impressive results:

JCO is a relatively new addition to the ETF lineup–having launched in April 2010–so the performance data for the contrarian ETF is limited. But the early results are certainly compelling, as JCO has beaten IWV by about 300 basis points during its first seven months of operation. Moreover, backtested data for the underlying index (it was created by Dow Jones in late 2008) suggests that the methodology would have performed quite well historically [also read The Ten Commandments Of ETF Investing].

As far as expenses are concerned, these ETFs only differ by two basis points; JCO charges 0.58% and PDP charges 0.60%. These fees are considerably higher than traditional ETFs offering domestic equity exposure; the average for the All Cap Equities ETFdb Category comes in at just 0.35%, and the Schwab U.S. Broad Market ETF (SCHB) charges just six basis points. But the fees for the contrarian and relative strength ETFs are considerably lower than most actively managed mutual funds, and certainly still offer a cost-efficient way to implement detailed and somewhat complex investment strategies.

[For more analysis of ETFs sign up for our free ETF newsletter.]

Disclosure: Photo courtesy of Bart Hiddink. No positions at time of writing.