Barking up the wrong tree: a spotty record for Dow’s dogs

THERE is no such thing as the Holy Grail of investing or trading; there is no strategy that guarantees you an endless stream of profits. But if you are looking for an approach which doesn’t require you to be a mathematical or technical genius, then there are some medium-term strategies that have enjoyed some degree of success.

The Dogs of the Dow is a famous investment strategy that was the brainchild of American money manager Michael O’Higgins in the early 1990s. His theory involves buying – usually on the first day of the year – an equal share in the 10 highest-yielding stocks of the Dow Jones Industrial Average and then holding these stocks for a year.

The rationale is simple: Dow constituents are large cap, blue-chip stocks so they are unlikely to go bankrupt and are liquid. The highest yielding stocks have fallen out of favour because investors demand a higher-than-average dividend payout to buy the stock. Assuming mean reversion, these shares should, on average, outperform.

But while it is a logical approach, employing the Dogs of the Dow tactic has had only limited success in outperforming either the Dow or the S&P 500 over the past 15 years – see chart. It is also expensive for contracts for difference (CFD) traders to follow the contrarian Dogs of the Dow because the overnight financing charges quickly mount up if you hold positions for a year, warns City Index’s Joshua Raymond. He adds that it is risky to bet against an outperforming market: “There is a reason why ‘the trend is your friend’ is a well-known saying in the market.”

However, there are alternatives for CFD traders, which are less expensive to finance. One is Croatian investor Tomo Helman’s Dogs of the Seasons strategy, which recommends buying just four stocks in mid-October and then selling them in April or May. This particular strategy capitalises on the seasonality of the US stock market and picks four stocks from the Barron’s 400 index that are fundamentally under-priced. It uses technical analysis to dictate the precise entry and exit points.

Last year, his picks gained 18.72 per cent as opposed to 10.99 per cent for the S&P 500. And in 2008-2009, when stock markets were particularly volatile, his portfolio managed to rise 2.7 per cent compared to a 9.6 per cent drop in the wider index.

Another option open to CFD traders is to go long on the 10 worst-performing stocks in the Dow Jones (or indeed any other index such as the FTSE 100) and sell the 10 best-performing stocks. This strategy assumes that investments revert to the mean, giving the underperformers a boost and knocking back the top flight. This would give you the flexibility to hold the stocks until you think they have reverted to fair value. Nonetheless, there is the risk that they are underperforming or overperforming for good reason and that this trend will continue at your expense.

For this reason, pairs trading is popular among CFD traders. The strategy matches a long position with a short position in two stocks of the same sector, whose prices are usually highly correlated but which have seen a recent divergence. For example, BP suffered a lot more in the wake of the oil well disaster than Royal Dutch Shell. The two stocks are usually highly correlated so in the medium-term the two stocks ought to revert to the existing relationship.

There is certainly no easy or guaranteed way to make money in the markets but all of these strategies have potential. Just don’t be disappointed if the 2010 Dogs have more bark than bite.