DWAS: Excessively Risky SMID Strategy With Dismal Returns (NASDAQ:DWAS)

Invesco Dorsey Wright SmallCap Momentum ETF (NASDAQ:DWAS) provides easy quality interpretation of lively small- and mid-cap stocks. Despite the fact that it looks promising at first glance, I think this is a rather poor strategy that does not bring profits that would compensate for its excessive risks.

In my previous note presented in February of this year, I explained that DWAS has two major problems, namely software quality and rather questionable performance. There are two factors that influenced my decision to write a sequel to the name today. First, the ETF has significantly underperformed the S&P 500. Second, its portfolio has been deeply recalibrated following two reconstitutions, and I’m pleased to provide my readers with a review that should reinforce the point that despite the being reshuffled frequently, the exposure to the quality factor of the ETF does not become much larger (enough to qualify for Shopping List) and that, most of the time, it cannot sufficiently capture the edge of the market. But before discussing all these details, I think it is worth recapitulating the essential elements of his strategy.

How does DWAS select strong small-cap stocks?

The DWAS website provides a succinct overview of the key aspects of its strategy. It explains that the Dorsey Wright SmallCap Technical Leaders Index is its basis. Its reconstitution as well as rebalancing have a quarterly schedule. Regarding the methodology, it is said that:

The Index includes securities in accordance with a Dorsey, Wright & Associates, LLC proprietary selection methodology that is designed to identify companies that demonstrate strong relative strength characteristics based on that company’s market performance. Approximately 200 companies are selected for inclusion in the NASDAQ US Benchmark Index.

The prospectus gives a little more detail about this. For example, it clarifies that the selection process includes the calculation of the impulse score.

The momentum score for each security included in the underlying index is based on the medium- and long-term upward price movements of the security compared to a representative benchmark.

DWAS returns: underperformance persists

Is DWAS able to identify winners? There’s no denying that he is, but the bigger problem is that he can’t adequately benefit from this ability. A good example here is that the weighted average YTD price return of its portfolio is nearly 68.8%, according to my calculations, with the key contributors being the healthcare sector in general and biotech companies in particular (the sector’s YTD average price return is 55 .4%). But how much did the fund return during that time? About 10.6%, at the time of this writing. The iShares Core S&P 500 ETF ( IVV ) returned about 18%. Also, since the previous note, DWAS has significantly underperformed the S&P 500 Index.

Longer-term returns offer little in defense of his strategy, as almost nothing has changed since my note in February. To illustrate this, we compiled the following data:

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Data from Portfolio Visualizer. The period is August 2012 – July 2024

It is clear that while the task of matching the pace of the market (which I procure with IVV regularly) was failed by DWAS, it outperformed the iShares Core S&P Small-Cap ETF (IJR), but only by a few bps. I see two problems with this.

• First, this is not a commendable achievement for an ETF that has a massive 181% turnover, as it removes stocks it considers losers and adds winners quarterly, mirroring the rebuilding process of the underlying index. Meanwhile, IJR’s turnover was just 25% in the last fiscal year.
• Second, because DWAS is highly volatile, which is no surprise for a momentum-centric vehicle, its risk-adjusted returns (namely the Sortino and Sharpe ratios in the table above) are much weaker in comparison with those of the IJR.

Mix of DWAS factors: persistent quality issues

Compromises on quality are not what I am prepared for. I assume that most of my readers take this factor seriously. And DWAS does not provide results in this regard.

As of February 22, approximately 60.5% of DWAS holdings have been disposed of as the underlying index has been reconstituted in March and June. Something has changed in terms of sector allocations, as illustrated in the table below. For example, utilities are now not represented, while the fund’s allocation to industry has become even larger.

However, little has changed in terms of exposure to the quality factor, which is a perennial concern. To corroborate, on August 26, out of 200 companies in the portfolio, 53 (representing 23.8% of net assets; weights on August 23) were unprofitable. This is not necessarily a problem as the losses may be the consequence of large R&D expenditure which is necessary to ensure robust growth rates and therefore there should be an improvement in quality plus the potential for capital appreciation in the future . This is partly evident from the fact that EBITDA margins are rather compressed or negative, with a weighted average of only 10.1%, which means that there were operating expenses (including, but of course not limited to research and development ) and not interest, taxes, or depreciation and amortization that had the most significant impact on the bottom line. Just for context, the WA EBITDA margin of the IVV portfolio is around 32%. Indeed, the DWAS portfolio has quite strong weighted average growth rates, according to my calculations.

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Calculated using data from Seeking Alpha and ETF

However, I see no reason why quality should be sacrificed to gain exposure at this level of growth. It is true that the income growth rate is higher than that of the S&P 500 ETF; however, their EPS growth rates are nearly on par.

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Calculated using data from Seeking Alpha and ETF

And there is one more problem that is not immediately apparent. In fact, EPS growth rates are not available for 30% of the DWAS portfolio (the main reason being that these companies are currently loss-making or expected to remain loss-making). In IVV, such stocks are less than 5% by weight. This affects the accuracy of the results.

Next, their quality features are simply incompatible. DWAS has only a 50.2% allocation to companies with a B-Quant Profitability rating or higher, compared to nearly 95% for IVV. There is also a massive difference in the capital efficiency metric.

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Calculated using data from Seeking Alpha and ETF

Some consideration should also be given to value. Its weighted average earnings yield is not very informative because negative numbers make it unusable. But with the appropriate adjustments made (negative numbers replaced by zero), we arrive at an EY of 4%, which is not particularly indicative of a skewed value by SMID standards. And it is higher than that of IVV by only 30 bps. Also, only 27.9% of its net assets are allocated to stocks with a B-Quant Valuation grade or higher.

In terms of the size factor, DWAS’s weighted average market cap rose from the previous note to $3.74 billion (as of August 26) from $2.95 billion. Small caps and microcaps make up about 32% of the portfolio.

As for the volatility and momentum features, I would have to say that it offers considerable exposure to the latter factor.

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Calculated using data from Seeking Alpha and ETF

The upside is high beta, which remains well above 1, in line with the numbers seen in February.

Conclusion

In conclusion, the risk of the DWAS strategy has not translated into significant performance in the past. I see no argument as to how this can change in the future. One of the reasons here is that the quality characteristics of his portfolio leave a lot to be desired, and in my opinion, this is a problem that cannot be solved by a portfolio reconstruction, because it is embedded in the selection universe.

Overall, I admit that investors could play the volatility game with this vehicle and that it is quite capable at times, as since its inception in 2012, it has had eight months with a return of over 10%, the most recent being December. 2023 (11.5%). For context, IVV only had two such months, the due remark here being that those came in April and November of the extremely volatile and pandemic-torn year 2020. IJR was closer to that result, with seven such months in the books. However, DWAS is anything but an option for long-term investors, as volatility will affect risk-adjusted returns. The burdensome 60bps expense ratio is another issue. The Hold rating is thus maintained.