1/6/08

Dogs of the Dow: Do it yourself vs Mutual Fund vs ETN

There's a somewhat popular simple investing strategy called Dogs of the Dow: at the beginning of the year, one buys, in equal dollar amounts, the ten highest yielding Dow stocks (yield = dividend per share divided by share price). At the beginning of the next year, one replaces these stocks with the ten highest yielding Dow stocks, and on it goes.

This simple strategy of buying and selling once a year has, according to the Dogs of the Dow site, generated a market beating average annual return of 17.7% since 1973.

Now I don't know why the starting year is 1973 (could be because the original study, done by Michael O'Higgins used the period of 1973 - 1989) or what would happen to the average annual returns if the starting year were moved forward or back, but the strategy sounds good in theory for the following reasons. Dividend yields of large companies can be a good measure of the relative worth of their stocks. That is, if a large cap company has a high dividend yield it may indicate that the share price is undervalued. Of course, it may also indicate that the company is in trouble, as is the case currently with Citibank (C). However, taking that into account, it should be noted that companies in the Dow Jones Industrial Average are in the index because they represent the biggest, most solid publicly traded companies in their sector. If a Dow company goes bust, it is replaced by another company in the index. While this may not matter to you if you invest in a Dow company and then see its share price in free fall, investing in Dow companies as a group, and especially in the Dogs, over the long term has shown to be profitable.

Over the years, certain strategies have developed around the Dogs of the Dow, with varying results. For instance, there's one called Small Dogs (the five Dogs with the lowest share prices), and there's one where you invest in only one stock, the one with the second highest yield (the theory being that the one with the highest yield has real problems while the second highest is set for a turnaround). I'll focus on the main Dogs of the Dow strategy here.

If you're interested in the Dogs of the Dow strategy, I know of three different ways of implementing it: doing it yourself, through a mutual fund, or through an exchange traded note (ETN).

Doing it Yourself

This one is fairly obvious. Pick a point in the year, say the first trading day in January, or whenever you wish, and look up the ten highest yielding Dow stocks. There are many ways to do this, one being going to the Dogs of the Dow site. A year later, replace these with the Dogs then.

The advantage of doing this yourself is that it's easy and you avoid mutual fund and ETN fees. Moreover, you get to pick the time of year you commence your investment regimen. Furthermore, if the Dogs drop in any given year, your losses are smaller because you collect dividends four times a year from every stock. Doing it yourself also gives you the flexibility of reinvesting the dividends, should you want to.

The following disadvantages may be relevant. Buying and selling up to ten stocks at a time (up to 20 trades) can put a big dent in your returns if your starting capital is small, because of brokerage commissions. Another disadvantage, particularly if your starting capital is large, is that the ten stocks pay dividends, which are taxed. While dividends can hold up your portfolio in bad times, their tax consequences may hurt during good times.

Minus broker commissions, doing it yourself replicates the strategy most closely.

If you follow this strategy, remember to hold on to the stocks a little longer than a year, so that when you sell them you are taxed at the long term capital gain rate.

Mutual Fund

At the moment, there are two mutual funds that use the Dogs of the Dow strategy. These are the Hennessy Balanced fund and the Hennessy Total Return fund. There was a third, the Payden Growth and Income fund, but it was discontinued.

The advantage of using a mutual fund is that all you have to do is put your money in once. Unlike doing the strategy yourself, the mutual fund manager does all the work for you. Depending on the fund and the method you buy it (through broker or directly from the fund company), as you're only placing one trade instead of up to 20, you're saving on commission fees, particularly if your starting capital is small.

There are a few disadvantages. First, the mutual funds charge you a fee that's taken out of your returns. Hennessy Balanced takes 1.34%, and the Hennessy Total Return takes 1.16%. This may add up to much more than broker commissions if you were to buy the individual stocks yourself. Furthermore, while the mutual funds try to replicate the Dogs of the Dow strategy, they do it imperfectly. This is because it is against mutual fund rules to hold positions in individual stocks that are greater than 5% of the fund's holdings. To compensate, the funds hold treasury bills. Another disadvantage of mutual funds is that you can only sell for the price established at the end of the day. This may be a problem for some people. A further disadvantage is that mutual funds are required to pay out dividends and capital gains at the end of the year. Depending on your starting capital, you may have a big tax bill every year.

ETN

This one is pretty new. The ELEMENTS DJ High Yield Select 10 ETN (DOD) has been introduced at the end of October, 2007.

The advantages are the following. Just like the mutual fund option, you buy once and let the manager do the rest for you. Unlike the mutual fund, the ETN should more closely follow the strategy because its holdings are the ten Dog stocks. Moreover, the ETN is cheaper than the mutual funds, having an expense ratio of .75%. Additionally, all dividends are automatically reinvested without being paid out. This means that you only pay taxes when you sell.

There are a few drawbacks. As this one is really new, it is very thinly traded. As of the previous close the average daily dollar volume was only $111,592.18 (but recently volume has started picking up; the last close had a dollar volume double the average). Moreover, there's no flexibility in keeping the dividends or reinvesting them. While reinvesting dividends is generally a good idea, if a stock keeps falling, your lose money on your reinvested dividends as well, whereas if you kept the dividend your losses would be offset. Another disadvantage of DOD is that it's an Exchange Traded Note, which means that, as unsecured debt, there is issuer risk. Deutsche Bank is the issuer. If it defaults, you lose all your money. If there's a perception among investors that Deutsche Bank is having problems (which isn't very unlikely considering the current credit crisis), there may be a panicked sell off of the ETN that does not reflect the value of the ten Dow stocks it seeks to replicate. As it's already thinly traded, this may add up to a lot of trouble.

Conclusion

So there you have it. In my opinion, the doing it yourself option is most favorable. The ETN option follows in second. I would feel more comfortable with it if the issuer were an institution backed by a rich sovereign. The mutual fund does not seem to be that good a choice.

As with all investing strategies, there are good years and bad years, and those who find a strategy that works most of the time and stick with it tend to do quite well.

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