Getting Technical With New ETF (PDP)

By Matthew McCall | April 26, 2007 AAA

There are basically two approaches investors can take when analyzing the stock market: fundamental analysis and technical analysis.

Making an investment decision based on past performance of a stock, or volume, or a moving average all fall under technical analysis, and the big Wall Street firms will all tell you this is "voodoo". What they fail to mention is that they all have technical-analysis departments of their own.

I believe a mix of fundamental and technical analysis is the best approach for the average investor. Using fundamental analysis to find solid companies and then charts to determine when to buy and sell. However, there are plenty of investors that rely on pure technical analysis when making their decisions.

First ETF Based on Technical Analysis
Until now, the world of exchange-traded funds (ETF) and technical analysis did not co-exist. In March, PowerShares, an ETF company, and Dorsey Wright & Associates, an investment advisor and research firm, launched the PowerShares DWA Technical Leaders Portfolio ETF (NYSE: PDP).

The product is a pioneer in its field because it is the first ETF to be based solely on technical analysis.

The ETF is based on the Dorsey Wright Technical Leaders Index, which is comprised of approximately 100 stocks. When choosing the 100 stocks for the index, DWA begins with a universe of the 3000 largest U.S.-listed stocks and compares them against the major indices as well as sectors and sub-sectors. This is done quarterly and the results are put into a proprietary algorithm to determine the 100 stocks and their weightings.

The goal of the index, and thus the ETF, is to identify a stocks that demonstrate high relative strength versus its peers. Stocks with high relative-strength readings are often outperforming the market and have strong charts. This type of investment strategy goes well with the "follow the trend" theory of investing. According to Mike Moody, a senior portfolio manager at Dorsey Wright, "This is a portfolio that isn't very highly correlated to the S&P 500." For investors looking to further diversify their portfolio PDP offers that due to the low correlation to the market.

As long as the market leadership remains constant, PDP should be able to easily outperform the market. If the leadership begins to rotate, it could see the leaders of the past drop quickly and PDP will likely take a hit during the rotation. The good news for investors is that the portfolio is rebalanced and reconstituted quarterly. According to PowerShares the annual expense ratio will be capped at 0.6%, a reasonable number for a unique product.

Breakdown of PDP
As of March 31 over three-quarters of the ETF fell into the mid-cap asset class (53% in the mid-cap growth and 23% in mid-cap value). The mid-cap stocks have been able to outpace the overall market for years, and that is the reason for the large allocation. While the ETF is heavy in the mid-cap stocks, the sector breakdown is quite diverse. Not one sector makes up more than 17% of the allocation and only four are 10% or more. The financials and industrials lead the way with 17% each, followed by materials and consumer discretionary at 15% and 13%, respectively. As long as the trend continues, the ETF will continue to allocate with the best performing areas such as materials and industrials.

With 100 stocks composing the ETF it does not allow one stock to become over weighted. The current top five consists of Holly Corp (NYSE: HOC), Titanium Metals Corp (NYSE: TIE), NII Holdings (Nasdaq: NIHD), American Tower Corp (NYSE: AMT) and Allegheny Technologies (NYSE:ATI). HOC and TIE are the only two stocks with a weighting over 5%, indicating diversification is in the allocation.

Does Past Performance Equal Future Performance?
All of the top five except AMT are up a minimum of 20% year-to-date, well above the gain of 4% in the S&P 500. Because PDP only went public in March 2007, it's impossible to do a long-term comparison of the ETF versus the market. However, PowerShares backdated the index and over the last ten years the index more than doubled the S&P 500.

1878-PDPchart.gif

Past performance is never a guarantee of future performance, but trend-following and relative strength has increased in popularity in the last few years. As long as the trend continues and PDP is able to determine the leadership in the market, it could be in line for continued success.

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