IMPLEMENTING THE “DOGS OF THE WORLD” STRATEGY USING ETFs Cantor Fitzgerald Center for Institutional ETF and Indexing Research David Smith, Ph.D Albert Neubert Denise Shelley, Ph.D Research Brief 2.0 November 2014 [email protected] 212 359 8700 R In association with The unpredictability of global equity markets is clearly a challenge for investors that are seeking stable, positive, risk-adjusted returns. Yet certain trends have shown themselves to be rather reliable. As noted in the Cantor Research Brief 1.0, short-term momentum for individual stocks and for markets is an important factor that has even been indexed and in turn, productized in the form of new ETFs. Longer term, however, momentum that may currently be producing superior risk-adjusted returns tends to shift in the opposite direction. This feature of markets is known as return reversal, and is often attributed to investors’ overreaction to information. (The well-known phenomenon of reversion to the mean is one example of return reversal.) How can investors take advantage of likely return reversals across international markets? The so-called “Dogs of the World” strategy is an attractive option. In simplified form, the strategy involves buying single-country ETFs associated with last year’s worst-performing international markets (the “Dogs”) and holding them for 1-5 years – the time period during which such markets generally bounce back. Research by Smith and Pantilei (2014), soon to appear in the Journal of Investing, demonstrates the benefits of applying the Dogs strategy over the long run. BACKGROUND For almost 30 years, research has documented return reversal as a powerful force for individual stocks, industries, and international markets. The most influential study of international markets to date is provided by Balvers, Wu, and Gilliland (2000). They follow 18 international markets over a 27-year period and document that return reversals are a regular feature of the investment landscape. They also conclude that reversal strategies require patience, as they often play out over many months. Most readers will recognize a return-reversal strategy as one form of contrarian approach. Contrarian approaches involve going against the market’s consensus sentiment. Notwithstanding its rather sour name, a “contrarian” way of thinking can pay off for several reasons. The world’s worst-performing markets in a given year have generally internalized and priced-in negative economic news. In fact, markets may experience overselling in response to bad news and then continue to move downward reflexively in response to later news that in sunnier times would be considered merely ambiguous. It is at just such a time – when the economy is stumbling along and policymakers appear to be unable to get anything right – when the market often takes its initial steps toward a powerful reversal. And it is much easier to rebound with high-percent returns off the low base left by the previous year’s declines. 1 Return reversals for individual stocks have been documented by Fama and French (1988), De Bondt and Thaler (1985), Kim, Nelson, and Startz (1991), and Bali, Demirtas, and Levy (2008). 2 See Gropp (2004) for evidence showing return reversals for industry sectors. 1 DOGS OF THE WORLD Many investors are familiar with the Dogs of the Dow strategy. Michael O’Higgins developed that approach as well as the Dogs of the World idea (O’Higgins, 2014), which is part of a four-pronged approach presented as the Michael O’Higgins Absolute Return Strategy (MOAR). The four portfolio components as seen in Exhibit 1 include investing 25% each in long-term and intermediate-term U.S. Treasuries, 25% in platinum, and 25% in Dogs of the World. All elements of the MOAR can be implemented using low-cost ETFs. However, for the purpose of this Brief, we will focus ONLY on the Dogs of the World component of O’Higgins’ MOAR strategy. Exhibit 1. Components of the Michael O’Higgins Absolute Return (MOAR) Strategy Component Weight Representative ETF Ticker Symbol Long-term US Treasuries 25% TLT Intermediate-term US Treasuries 25% IEF Platinum 25% PPLT Dogs of the World 25% Five single-country ETFs Source: O’Higgins (2014) In O’Higgins’ version of Dogs of the World, single-country ETFs for last year’s five worst-performing markets are bought at the beginning of the current year. They are then liquidated after one year and the next year’s five “Dogs” replace them as portfolio holdings. How does the Dogs of the World portion of the strategy perform? We will assume all returns are in US dollars. Exhibit 2 provides anecdotal evidence, based purely on market index performance, of the return-reversal phenomenon in international markets. The emphasis here is on only the worst-performing market each year, to underscore the effect. Exhibit 2. Subsequent Annual Performance (non-cumulative) of the Worst-Performing Market Worst-Performing Market Subsequent Return Worst-Performing Market Subsequent Return Year Return Market Yr. +1 Yr. +2 Year Return Market Yr. +1 Yr. +2 1988 -59% Turkey 547% -5% 2001 -41% Egypt 2% 92% 1989 -9% Finland -31% -17% 2002 -36% Turkey 126% 42% 1990 -62% Brazil 172% 7% 2003 20% Finland 7% 18% 1991 -45% Indonesia 0% 106% 2004 -1% Thailand 9% 12% 1992 -45% Turkey 220% -50% 2005 -2% Ireland 48% -20% 1993 10% USA 2% 38% 2006 -7% Turkey 75% -62% 1994 -55% Poland -3% 59% 2007 -20% Ireland -72% 13% 1995 -31% India -2% 11% 2008 -74% Russia 105% 19% 1996 -38% Korea -67% 141% 2009 -5% Morocco 15% -15% 1997 -74% Indonesia -32% 93% 2010 -45% Greece -63% 6% 1998 -83% Russia 247% -30% 2011 -63% Greece 6% 53% 1999 -14% Colombia -39% 46% 2012 -11% Morocco -3% 2000 -62% Indonesia -8% 43% 2013 -30% Peru 12%* Notes: All markets’ returns are for the respective MSCI index’s gross return in USD. Shading indicates that the market index outperformed the MSCI All-Country World Index (ACWI) during the year. Also, Peru’s return of 12%* (vs. ACWI 5%) is from January through July 2014. Source: MSCI 2 As Exhibit 2 shows, in the first year after experiencing world-benchmark-trailing performance, about half the time, the local market’s MSCI index beat the MSCI All-Country World Index (ACWI). But what is particularly notable is the magnitude of outperformance: the “Yr. +1” column shows that in six cases, returns have been in the triple digits. The key problem with Exhibit 2 is that most investors would have found it difficult to pursue a Dogs strategy, because of the absence of single-country ETFs for those markets prior to 2001. Since then, the number of markets covered by ETF products has risen to over 40. STRATEGY IMPLEMENTATION USING ETFS Exhibit 3 lists 32 single-country ETFs that have been in existence for a year or more and that have one-way estimated single-day trading costs below 50 basis points for a $20 million trade. In each case, the fund listed has the lowest expense ratio among single-country ETFs for that country. Exhibit 3. Single-Country ETFs Currently Used to Implement the Dogs of the World Strategy Market ETF Ticker Expense Ratio Market ETF Ticker Expense Ratio Australia EWA 0.51% Malaysia EWM 0.51% Austria EWO 0.51% Mexico EWW 0.50% Belgium EWK 0.50% Netherlands EWN 0.50% Brazil EWZ 0.61% Norway ENOR 0.53% Canada EWC 0.51% Russia ERUS 0.61% China MCHI 0.61% Singapore EWS 0.51% Denmark EDEN 0.53% South Africa EZA 0.61% Finland EFNL 0.53% South Korea EWY 0.61% France EWQ 0.51% Spain EWP 0.51% Germany EWG 0.51% Sweden EWD 0.51% Hong Kong EWH 0.51% Switzerland EWL 0.51% India INDA 0.67% Taiwan EWT 0.61% Indonesia EIDO 0.61% Thailand THD 0.61% Israel EIS 0.61% Turkey TUR 0.61% Italy EWI 0.50% UK EWU 0.51% Japan EWJ 0.50% US SPY 0.09% Notes: The ETFs listed above are used in the Dogs of the World strategy. Certain markets in the benchmark MSCI ACWI are excluded from this analysis because a related single-country index ETF does not trade on US exchanges, or because the ETF’s estimated one-way trading costs for $20 million exceed 50 basis points. Annualized expense ratios are reported as of August 2014. Prior to introduction of the lower-expense-ratio ETFs listed above, other ETFs were used to provide exposure to the mar- kets of China (ticker: FXI), India (INDY), and Russia (RSX). Source: Morningstar As stated earlier, implementation of the Dogs of the World strategy would involve buying ETF shares in the five worst- performing markets from the previous year and holding for the subsequent 12 months. The selection of the Dogs is made based on the closing price of each index on the last trading day of the year, and rebalancing occurs the next trading day. All returns are assumed to be reinvested, and the five new entrants into the portfolio are acquired in equal weights. The position for any ETF remaining in the portfolio from the prior year is appropriately resized. 3 HISTORICAL PERFORMANCE How would the Dogs approach have worked in practice? We evaluate the strategy starting in 2001, the first year there was a full-year return history for over 20 single country ETFs. Implementation involved taking equally weighted positions in the prior year’s bottom five markets, as measured by the corresponding MSCI country index. Returns are computed assuming all trading occurs in the first trading day of the subsequent year, and we further assume that we are able to execute at the closing price.