PEJ ETF: Don’t Count On A Fun Week (NYSEARCA:PEJ)

Investment Thesis

The Invesco Dynamic Leisure and Entertainment ETF (NYSEARCA:PEJ) is a risky way of betting on the resurgence of U.S. consumer spending since it targets 30 stocks in industries like Movies & Entertainment, Hotels & Resorts, and Casinos & Gaming. However, it’s too much like visiting the casino right now. Preliminary figures from the University of Michigan indicate consumer sentiment is at its lowest levels since 2011. With official numbers due this Friday and the unknowns surrounding the impact of higher interest rates, PEJ is one game of roulette I’m happy to sit out.

ETF Overview

Strategy

PEJ tracks the Dynamic Leisure & Entertainment Intellidex Index, comprised of 30 U.S. companies in the leisure and entertainment industries. Examples include hotels, restaurants, and entertainment companies involved in radio and television programming. The eligible stock universe is the largest 2,000 stocks by size on the NYSE, NYSE American, and NASDAQ exchanges, and the Indexes are fundamentally weighted using size and model scores as an input into a modified equal-weighted schema. Intellidex Indexes are created by evaluating factors across five broad categories:

1. Price Momentum
2. Earnings Momentum
3. Quality
4. Management Action
5. Value

Intellidex Indexes are rules-based and very active due to their quarterly rebalancings, scheduled in February, May, August, and November. It’s common for portfolio turnover rates to exceed 100%. PEJ’s 2021 turnover rate was 126% and reached as high as 207% in 2019. That means that investors must have faith in the strategy rather than its current holdings at any point in time. For that reason, I’ll be spending a large portion of this article discussing PEJ’s performance under various conditions.

Industry Exposures and Top Holdings

PEJ is currently an equal mix of Consumer Discretionary and Communication Services stocks, plus Sysco (SYY), which falls in the Consumer Staples sector. Below are industry allocations according to the latest fact sheet as of March 31, 2022. Today’s allocations are similar, and I will be using the most up-to-date weightings in my fundamental analysis later.

The following graph provides the top five holdings in each GICS industry. These 25 companies account for 86.64% of the ETF, with McDonald’s (MCD), Sysco, and Marriott International (MAR) as the top holdings.

Additional Information

Here is a list of additional statistics you may find interesting:

• Current Price: $40.09
• Assets Under Management: $1.30 billion
• Expense Ratio: 0.55%
• Launch Date: June 23, 2005
• Trailing Dividend Yield: 0.53%
• Five-Year Dividend CAGR: -3.90%
• Ten-Year Dividend CAGR: 5.33%
• Dividend Frequency: Quarterly
• Five-Year Beta: 1.37
• Number of Securities: 30
• Portfolio Turnover: 126%
• Assets in Top Ten: 45.11%
• 30-Day Median Bid-Ask Spread: 0.07%
• Tracked Index: Dynamic Leisure & Entertainment Intellidex Index
• Short-Term Capital Gains Tax Rate: 40%
• Long-Term Capital Gains Tax Rate: 20%
• Tax Form: 1099

The 0.55% expense ratio is probably too high to make PEJ a decent core holding, but it’s historically very volatile. While conservative investors see that as a negative, more aggressive investors with long time horizons could view its five-year 1.37 beta positively. Either way, it’s appropriate to view PEJ as a short-term investment. If the fundamentals and market environment line up, adding PEJ to your portfolio for 3-6 months at a time makes sense.

Performance Analysis

Assessing Intellidex Indexes

I want to begin by analyzing the historical performance of most other Intellidex Indexes listed in the latest annual report. I don’t usually do this, as I believe each portfolio should stand on its own. However, with turnover so high and the slight chance that today’s portfolio will be similar to the one next year, I want to know if the overall strategy works. For simplicity, I’ve assigned one or more passive ETFs to serve as benchmarks as follows:

All benchmarks except IBB and XSW follow a market-cap-weighted scheme, so these are pretty straightforward alternatives. Let’s see how the Invesco ETFs based on the Intellidex Indexes performed historically, with positive figures indicating relative annualized outperformance.

Over the entire measurement period, Intellidex Indexes underperformed in five cases, outperformed in two, and were flat in one. However, over the last three-, five-, and ten-year periods, only one Intellidex Index outperformed. In my view, this isn’t a great track record. However, relative performance was better through the Great Financial Crisis. It’s not unusual for factor-based approaches to perform well in bear markets. Still, I’d expect much better results for the amount of risk these Indexes expose investors. It solidifies my opinion that these are only appropriate for short-term investors.

PEJ Historical Performance

The following graph highlights PEJ’s performance against the Consumer Discretionary Select Sector SPDR ETF (XLY) and the Vanguard Telecom Services ETF (VOX) since its inception. I’ve also simulated a portfolio split between the two sector ETFs, reflecting PEJ’s current composition.

PEJ underperformed XLY by an annualized 3.47% but outperformed VOX by 0.51%. Against the blended portfolio, PEJ underperformed by 1.68%, with about 30% more volatility and a worse drawdown from June 2007 to November 2008. As a result, risk-adjusted returns (Sharpe and Sortino Ratios) were worse against all portfolios.

Despite these poor results, traders had opportunities. For example, PEJ outperformed the blended portfolio by 15.36% and 16.05% in 2010 and 2013. Also, from April 2020 to March 2021, PEJ gained 90.36% compared to 72.69% for the blended portfolio. It’s reflected in the table below, which highlights various roll period performances for each of the four portfolios.

PEJ appears to perform best after a crash, typical of most high beta and high P/E funds. Before investing, there should be a clear sign that sentiment is positive, and for that, we can use the University of Michigan Consumer Sentiment Index as a guide for predicting consumer spending.

Consumer Sentiment And The Fed

The University of Michigan’s Index of Consumer Sentiment is derived from these five questions:

Used as a leading indicator of households’ future consumption and spending, the Index is at its lowest level since August 2011. The reading was 59.4 in March and 65.2 in April, and preliminary results for May show a decline to 59.1. Final results are expected Friday.

In several instances, a sharp decline in the Index preceded a recession. For example, the Index reached a high of 112.0 in January 2000 and, after several smaller ups and downs, ultimately bottomed at 55.3 in November 2008. Many market observers refer to the 2000s as the “lost decade of investing,” and declining sentiment likely played a factor. In contrast, the next decade trended upward, with only a few short-lived corrections like in 2013. Positive Index readings were supported by unprecedented stimulus as the Federal Reserve did everything it could to keep the economy (and stock market) humming along. The graph below highlighting the Fed’s balance sheet growth in the last 20 years shows an increase of approximately $1.1 trillion in 2013, though that was nothing compared to the $3 trillion pandemic response.

However, with quantitative easing on hold, investors should prepare for the strong possibility that a recession will occur either this year or next. Federal Reserve Chairman has stated that interest rates will continue to rise until there is “clear and convincing evidence that inflation is in retreat,” adding there will be some pain involved in the form of increased unemployment. My interpretation is that the Fed isn’t going to save the market this time. A brief recession is needed, and only after that occurs will a high-beta consumer spending ETF like PEJ be an appropriate investment.

Fundamental Analysis

PEJ’s fundamentals are challenging to interpret, given how many entertainment stocks have high valuations and high expected growth levels. However, the overall growth and valuation picture is positive after controlling for outliers. PEJ’s constituents are expected to grow revenue and earnings at 23.22% and 27.70%, respectively, in line with XLY. However, its forward price-earnings ratio of 24.52 is nine points less than XLY and three points higher than VOX.

This growth come despite a poor five-year historical track record on sales. I believe that companies are racing to take as much of the consumer spending pie as possible before the effects of higher interest rates. A busy summer travel season is crucial for leisure and entertainment companies, so a poor sentiment reading on Friday could be devastating for PEJ.

Investment Recommendation

Holding PEJ this week is too risky, and I think you should sell before the Index of Consumer Sentiment figures for May are released on Friday. The trend has been sharply down the last few months, and unlike in the 2010s, the Federal Reserve appears unwilling to rescue markets until inflation is controlled. A recession, albeit a brief one, is a strong probability, and history shows that the best time to buy PEJ is after that occurs. You don’t want to be holding a highly-volatile ETF if markets fall further, and that’s what PEJ is today.

Intellidex Indexes don’t have a great long-term track record, and since portfolio turnover rates generally exceed 100%, it will be difficult for the average investor to keep up with. Therefore, if you decide to roll the dice with PEJ, treat it only as a short-term tactical play. Otherwise, combinations of sector ETFs like XLY and VOX are preferred. Thank you for reading, and I look forward to discussing this further in the comments section.