Will Quant Strategy ETFs Suffer From Returns Decay?

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 |  Includes: DWAQ, PWC
by: IndexUniverse

Your blog about chasing returns got me thinking, Jim: Will all these new quantitative strategies suffer from returns decay?

By returns decay, I mean a fading of outperformance over time. In other words, will these new quantitative strategies outperform during their first stretch on the market, only to lag over the long haul?

It's easy to imagine why this might happen. These strategies are designed in the rearview mirror, using historical data to create an investment screen that would have beaten the market in the past. By capturing whatever trends exist in the market, you might guess that these funds would ride on inertia and continue to outperform immediately post-launch. But as market forces shift, will the funds keep up? In the active-quantitative world, people are always monkeying with their formulae trying to keep their models au courant. But these new quantitative ETFs are "set it and forget it," as far as I know.

Unfortunately, there isn't enough data on most ETFs to answer this question; most of the new quant-active ETFs have only a few months' worth of data, or one year at most.

My hypothesis does find some anecdotal support in the two longest-standing quant-driven ETFs, however: the PowerShares Dynamic Market Portfolio (NYSEARCA:PWC) and the PowerShares Dynamic OTC Portfolio (PWO). Both funds launched in May of 2003, and quickly put up some impressive performance numbers. Since then, however, returns have ebbed.

The table below compares the performances of PWC, the S&P 500 and the Russell 2000 over various time frames. I've included both the S&P 500 and the Russell 2000 because people disagree on the appropriate benchmark for this fund.

The data is from Yahoo! Finance and covers October 7, 2003, through September 4, 2007, which is all the information that they have available. The first column shows the net performance since October 7, 2003, while the other columns show the annual performances.

PowerShares Dynamic Market Portfolio (October 7, 2003September 4, 2007)

10/7/03 9/4/07

2003

2004

2005

2006

2007

PWC

55.6%

7.5%

17.6%

12.4%

11.1%

-1.3%

S&P 500

49.0%

6.9%

17.3%

3.1%

17.0%

-1.5%

Russell 2000

39.8%

7.0%

9.1%

2.9%

13.6%

2.5%

Click to enlarge


The results are interesting. PWC delivered its best performances from inception through 2005. In 2006 and 2007 [YTD], however, it has substantially trailed both the S&P 500 and the Russell 2000.

The table below looks at PWO and the Nasdaq.

PowerShares Dynamic OTC Portfolio (October 7, 2003September 7, 2007)

Since October 7, 2003

2003

2004

2005

2006

2007

PWO

42.1%

5.4%

12.4%

9.6%

6.0%

3.3%

NASDAQ

34.5%

5.0%

8.7%

1.2%

9.5%

6.2%

Click to enlarge


Again, PWO beats its benchmark in 2003, 2004 and 2005, as well as over the long haul. But again, it trails in 2006 and 2007.

What To Make Of This?

What do we make of this? I'm not sure. But a few things are clear.

First, these PowerShares funds have so far delivered on their promise of long-haul outperformance. Both funds have easily outpaced their relevant benchmarks since inception. And we're not talking theoretical results, either: these are real-time results that you could have bought into with your brokerage account.

Second, that outperformance has reversed course over the past 19 months, and both funds have lagged the market.

Is this returns decay coming home to roost? Is the market switching from a value-focused market to a growth-focused market, and these funds can't keep up? It's probably too early to say.

Still, one thing is for sure: It is not a coincidence that all these alternatively weighted strategies are being launched following a period of strong value outperformance. And now that the tide is shifting, it pays to be on guard.

Written by Matthew Hougan