CDC - CDC: Ineffective Momentum Strategy No Reason To Buy

2023-12-30 00:37:42 ET

Summary

• CDC generally invests in U.S. equities with above-average yields and below-average volatility.
• It sometimes shifts to cash, depending on market conditions.
• These shifts are sometimes ill-timed, leading to losses and underperformance, as has been the case YTD.
• A look at CDC, and at its strategy, follows.

I last covered the VictoryShares US EQ Income Enhanced Volatility Wtd ETF ( CDC ) in late 2022. In that article, I expressed concern about CDC's market timing strategy, as these are rarely successful. Since then, the fund has significantly underperformed the S&P 500, due to an ill-timed shift to cash.

CDC's market timing strategy remains the same, and so the fund remains a sub-par investment opportunity.

CDC - Basics

• Investment Manager: Victory Capital
• Underlying Index: Nasdaq Victory US Large Cap High Dividend 100 Long/Cash Volatility Weighted Index
• Dividend Yield: 4.24%
• Expense Ratio: 0.38%
• Total Returns CAGR 5Y: 7.12%

CDC - Overview and Strategy Analysis

CDC is an equity index ETF investing in U.S. equities, sometimes holding cash. The fund tracks the Nasdaq Victory US Large Cap High Dividend 100 Long/Cash Volatility Weighted Index , a relatively complicated index.

The index first selects applicable stocks based a basic set of criteria, including size, liquidity, and profitability: only companies with positive TTM earnings are included in the index. The index then selects the highest-yielding 100 stocks from applicable securities. Weights are determined by volatility, with lower volatility stocks having greater weights, and vice versa. There are industry caps meant to ensure diversification.

The index is generally fully invested in equities, but sometimes holds cash. Asset allocations are based on market conditions, with the index and fund attempting to time the market. The strategy is somewhat complicated, but can be summarized thus.

• The index is generally fully invested in equities
• The index switches to equities and cash once its underlying equities are down at least 8%
• The index goes back to being fully invested in equities once its underlying equities are down less than 8%, or another 8% down
• Rebalances are done at the end of the month

Note that the returns of the fund and its underlying equities might differ a bit, as the fund also holds cash, and switches between the two.

Nasdaq provides investors with an infographic explaining in more detail the above. In bold, the rules for CDC's underlying index (there are several others).

Right now, the fund is 75% cash and 25% equities.

If you go back to the table with index rules, you will find that CDC goes 75% cash when its underlying equities are down between 8% and 16%. Detailed information about the returns of the fund's underlying equities is not readily available, but most of the larger dividend ETFs have seen losses of somewhere around that range, 10.6% on average.

In my opinion, the fund's current holdings are in-line with expectations and index rules. CDC is meant to hold 75% cash and 25% equities when its underlying equities are down between 8% and 16%, and dividend equities are mostly down somewhere between that range. Go back to the index rules table, and you will see that the fund will return to full equity exposure once losses go below 8%, or above 16%.

In my opinion, CDC's underlying index has many significant negatives and shortcomings, making a buy rating all but impossible.

For starters, the fund is quite complex. I think I have a decent grasp of how it works, but explaining and summarizing it was tough. In a sense I don't think you even can summarize the fund: index rules are very specific and finicky. Complexity means risk, and means that performance might significantly differ from what is expected. Buying a more straightforward dividend ETF is simpler, and safer.

In my experience, combining dividend yield and volatility measures in the same fund, as CDC does, sometimes leads to moderate, but permanent, capital losses for shareholders. I've explained these issues in more depth here , but the situation can be summarized as follows.

Focusing on stocks with above-average yields leads to concentrated portfolios with above-average risk. Focusing on stocks with below-average volatility means, in practice, selling stocks when they are down, as volatility tends to spike when stocks are down. So the fund is investing in relatively risky stocks, due to focusing on those with higher yields, selling them when they go down, due to focusing on those with lower volatility, effectively locking-in any gains. In my experience, although this does not always happen, it is a significant risk to funds like CDC. Avoiding these risks seems best.

CDC's strategy is very sensitive to market conditions, so could oscillate widely depending on very small market movements. If equities are down 7.9%, then the fund does nothing. If equities are down 8.1%, then the fund sells 75% of its equity portfolio. The fund experiences very big movements based on very small market price changes, increasing risk, volatility, and making it difficult to understand what the fund is going to do at any given moment.

Finally, and most importantly, I am wary of the fund's market timing strategy. In my opinion and experience, market timing rarely works, at least when done mechanistically and rigidly like CDC does. Successful strategies are (mostly) developed by nimbler quant firms and hedge funds, rarely by constrained index funds. Successful strategies are generally copied until alpha is exhausted, doubly so for index strategies, which can be easily front-run.

In my opinion and experience, market timing strategies are generally unsuccessful, and CDC will be no exception. Importantly, I argued the same last time I wrote about CDC, and have been (mostly) proven right, with the fund significantly underperforming since:

Notwithstanding the above, and in the interest of full disclosure, I think it is important to mention the fact that the fund's strategy does sometime work. As an example, it seems that the fund sold a portion of its equity investments during March 2020, and went back to a full equity exposure sometime during April 2020. Although the fund's timing was not even close to perfect, it managed to sell in time to avoid some losses, and bought in time to experience most gains. CDC significantly outperformed comparable dividend ETFs during 1H2020, but matched the performance of the S&P 500 due to being underweight tech.

CDC's strategy sometimes works, sometimes doesn't. Playing it safe by avoiding the fund seems best.

For what it's worth, the fund has very slightly underperformed most dividend ETFs since inception, moderately underperformed the S&P 500.

Which brings me to my next point.

Strategy First, Past Performance Second

In general terms, CDC's performance track-record is reasonable enough. Although the fund has underperformed the S&P 500 since inception, that was mostly due to value underperforming in the past. Most other dividend and value ETFs underperformed too, as can be seen above. I don't think this is a deal-breaker, especially considering the fact that value has performed quite a bit better since the pandemic, especially in 2022.

What I do think is a deal-breaker is the fund's market timing strategy. I have serious misgivings about the strategy, including its risks, recent losses, and the fact that these are rarely successful. In my opinion, these issues are much more important that the fund's performance track-record, and I would say the same even if the performance were much stronger. I did, in fact, say the same in my last article on CDC, and the fund's performance had been much stronger at the time. CDC had outperformed most other dividend ETFs, and matched the performance of the S&P 500:

Notwithstanding the fund's reasonable performance, I argued that its strategy was too risky, and could prove ineffective. I have been right so far, with CDC significantly underperforming since:

Point being, focusing on strategy is more important than on past returns, and generally leads to better investment decisions. In my opinion at least.

Conclusion

CDC's market timing strategy is risky and not terribly effective. As such, I would not invest in the fund.

For further details see: