Posted on 03/05/2012
On Friday, we took a look the PowerShares DWA Technical Leaders Index (PDP) as it reached its 5th year anniversary since it was launched. As we showed in the article, PDP outperformed the S&P 500 index on a 1-year, 2-year, 3-year, 4-year, and 5-year basis. The performance is what it is, and there is no denying that, yet there are still some of you that face a bit of opposition when talking about the benefits of PDP because they are just unwilling to pull the trigger for some preconceived notion of risk or cost or any number of other thoughts. So, let's take a look at some of the most frequently expressed oppositions to such a tactical equity approach to the market.
The cost of PDP is substantially higher than, say, the SPY. I don't want to pay more than I have to.
The first thing that comes to mind here is, "You get what you pay for." The first part of the statement is undeniably true, the expense ratio for PDP is 0.70% while the expense ratio for SPY is just 0.10%. This means $10,000 invested in the PDP would cost $70 per year while an investor only pays $10 per year in the SPDR S&P 500 ETF (SPY) for the same $10,000 investment. This is a mental block for some investors; however, as we have seen the PDP has outperformed the S&P 500 consistently over time, enough to more than cover the higher price tag. As a matter of fact, a $10,000 investment that was purchased in PDP on March 1st 2007 has cost the investor a total of $350 over the past five years in expenses. For that $350 the PDP investor has seen a gain of 10.04%, or in real dollar terms the PDP's investors portfolio has grown to $11,004 for a gain of $1,004 (net of the $350 paid in expenses). On March 1st, 2007 if you instead opted for the cheaper option of the SPY, for the same $10,000 investment you would have only paid $50 total over the course of the past five years based on the expense ratio; however, are you better off for it? While you only paid $50 ($10 per year) a $10,000 investment in SPY back on March 1st, 2007 is only worth $9,752. So even after factoring in the cost of each investment, those opting for PDP have been rewarded despite the higher fee.
It is also worth noting that for ETFs the expense ratio is spread out over the course of the year, and results in a daily reduction in the NAV of the fund. So, that $70 cost in our $10,000 PDP investment is spread out over 365 days, it is not a one-time payment. Therefore, when you view performance of ETFs the return numbers that you see already take into account the expense ratio.
I know that PDP has outperformed in pure returns, but what about dividends. The S&P 500 surely pays a higher dividend then PDP and would cause the S&P 500 to outperform, right?
There is no doubt that dividends can be tremendously beneficial to the overall returns of a portfolio, but are they enough to pick up the slack of notable underperformance? Let's go back to our $10,000 investment in the PDP and the SPY and see how the numbers bear it out. In the table below you will see the growth of $10,000 in both the PDP and SPY including accounting for dividend payments. The dividend payments were assumed to be held in cash and not reinvested. At the end of the day the dividend payments certainly help the SPY more than it helped the PDP; however, over the five year period it is still the PDP outperforming by a margin of 11% versus 6% for the SPY.
What about the volatility. I am willing to accept a little more volatility than the market for potential outperformance, but I don't want to take a massive amount of risk.
According to the PDP fact sheet the volatility of the DWA Technical Leaders Index (PDP) is actually slightly higher than the S&P 500. The 3-Year Volatility (%) number for PDP is 19.98 compared to 18.97. We should note that the volatility numbers published on the PDP fact sheet includes 3 year numbers ending 12/31/2011. The 3 Year performance (ending 12/31/2011) for PDP is 62.77% compared to 39.23%. So, does the PDP tend to have higher volatility than the SPX. Yes. The next question I would ask is 23.54% in outperformance over a 3 year period (an average of 7.84% per year) worth 1% higher volatility? That is not a question that we can answer for you and/or your clients; however, it is useful to have all of the information.
Another way to address the slightly higher volatility in the PDP is to combine it with something that can help dampen volatility, but not take away from the excess returns PDP has provided over the year. One way to accomplish this is a combination of PDP and PowerShares S&P 500 Low Volatility ETF (SPLV). Since March 1st, 2007 SPLV has outperformed the S&P 500 +5.44% versus -2.67%. However, what is perhaps more interesting is the combination of the PDP and SPLV is the best performing of the three in the chart below. In other words, a 50/50 portfolio split between the PDP and SPLV not only has dampened the volatility over the past five years, but it has actually enhanced the returns of the just the PDP or just the SPLV.