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By Mike Moody

Strategy indexing is hot, according to John Prestbo of Dow Jones. In a recent interview carried in Index Universe, he discussed what he meant by strategy index:

[Index Universe editor Olivier] Ludwig: What are we talking about here? Things like what Rob Arnott’s up to, or to those smart-beta indexes that have proliferated in the last 12 months?

Prestbo: That’s exactly what I’m talking about. I group them all together into a broad category called “strategy indexes,” where the index is not tracking a traditional segment of the market so much as it’s tracking a way of approaching the market. A lot of people want to get the best return they can, and they are willing to put in the time and effort to be flexible and manipulate their portfolio among various offerings. They combine the benefits of semi-active investing with the lower costs that come with it. The cost may be higher than the plain-vanilla indexes, but they are lower than an active manager.

I added the italics. The Technical Leaders indexes must have been far ahead of the wave, since Powershares launched PDP more than five years ago, not in the last 12 months! Academic factor models, like Carhart’s four-factor model suggest that there is a return premium (above inflation) available from:

  • the market itself
  • small-cap stocks
  • value stocks
  • momentum stocks (relative strength)

There are hundreds of ETFs that can give you market exposure, and many more focusing on small-cap and value stocks. If you look hard enough, you can probably find even ETFs for small-cap value stocks in almost every market.

To my knowledge, for many years, only the Technical Leaders ETF family focused on relative strength. PDP was launched in March 2007. Developed (NYSEARCA:PIZ) and emerging markets (NYSEARCA:PIE) were added later, in December 2007. Russell now has a couple of momentum indexes out, although they are less than 12 months old.

Here’s a quiz for you: Of Carhart’s four factors, which has the largest return premium? Maybe the graphic below will help you answer the question.

(Click to expand)

Which factor has the largest return premium?

Source: Mercer Advisors

The best returns belong to the return factor that has been most neglected: relative strength. It is a source of continuing amazement to everyone in our office that PDP has $500 million in assets, rather than billions like some of its competitors, especially given its performance. Perhaps value investing sounds more sophisticated and small-cap investing is racier, but historically it’s been relative strength that has provided the biggest raw returns.

Good investing requires education, so maybe PDP is just ahead of the curve. We’re hoping that, over time, there will be more discussion of relative strength as a return factor and that it will get a more prominent (and well-deserved) place within investor portfolios.

Source: PDP: Leading The Strategy Indexing Revolution?