Readers of IndexUniverse.com know that this publication is skeptical of technical analysis and other attempts to beat the market. But “relative strength” – which selects stocks that are outperforming their peers – has a major following, and there are a lot of people who believe that it works.
Unfortunately for PowerShares, however, the timing on the fund launch couldn’t be worse. the launch came two days after a major market panic hit Wall Street, with the Dow dropping over 400 points in a single session. In early trading today, it’s down a further 72 points, and volatility in the market is surging.
That’s a tough situation for any ETF launch: investors aren’t looking to put new money to work when the market’s crashing. But it’s particularly tough for a relative strength ETF. Relative strength strategies capitalize on trends – the idea that a market or group of stocks moving in one direction will keep moving in that direction. The strategy does well when trends stay in place. But when market leadership shifts, everything falls apart.
“[W]e will struggle … when there is a major change in leadership,” Dorsey, Wright says in its literature.
In fact, that’s what happened in 2006, as large-cap and growth stocks retook leadership from small/value. According to PowerShares’ literature, the Dorsey Wright Technical Leaders Index trailed the S&P 500 last year by more than 4 percent. (Over the long-term, PowerShares says the index has performed well on a backtested basis, delivering 13.08 percent annualized returns over the past five years versus 4.32 percent of the index.)
If the recent market turmoil creates another change in market leadership – and that’s definitely still an “if” - the newly launched ETF could suffer.The Fund
The fund tracks an index of 100 stocks chosen for their “relative strength” compared to their peers. The index is said to have a “modified equal-weighting,” although in practice, some stocks are weighted up to 5 percent if they show strong performance. The index is rebalanced quarterly.
Currently, the index is dominated by large cap names, representing over 70 percent of the fund. It is also diversified across multiple sectors, with the largest exposure to Financials (20 percent), Information Technology (16 percent), Consumer Discretionary (14 percent) and Health Care (13 percent)