We get many inquires about how we manage our client portfolios using exchange traded funds (ETFs).  Recently we wrote a piece for Index Universe describing our process.  With the growing list of available ETFs and ever-changing trends, we are convinced more than ever that a disciplined investment strategy is required to enhance portfolio returns, diversify and reduce downside risk.

Screening the ETF world
by Tom Lydon
Apr 12, 2007

When our advisory switched over to all- ETF portfolios in 2000, we developed various screening processes to determine which ETFs to include in client portfolios. The first, and perhaps most important, is the 200-day moving average of each ETF. Trend lines are a key technical indicator for us, and, as a result, we’re only invested in ETFs that are above their 200-day moving averages. If an ETF falls below it, or if it drops 8% off its high without going below its 200-day average, it’s sold. The sell discipline is rigorous, and is applied to all asset classes, sectors, and global regions where there is ETF representation.

The other important screen in buying ETFs is determining which ones are significant. In our universe, significant ETFs are those with some track record and, more importantly, volume and liquidity. Every week new ETFs enter the market, and these products at launch attract little investor interest. Anything under about $75 million is automatically kicked out of our database. But, we do monitor all ETFs as they grow, and if an ETF reaches a size that makes it a useful addition to client portfolios, we add it to our list. With over 400 ETFs trading in the US, our investable universe includes around 130. Those 130 are monitored daily, and specific ETFs are chosen based on their individual merits, a combination of technical and fundamental factors.

Trend lines: Positive and negative
We look for uptrends, and then examine those trends using fundamental analysis. Once a position is entered, we stay in the investment until the trend turns negative, declining below its trend line. In some cases, where trends have moved steeply to the upside, the corresponding ETF may be more than 10% above its moving average. In those cases, we impose an 8% stop-loss. Mathematically it works.

Below is a chart of the S&P 500 (SPY) with its 200-day moving average. You can see when we’re in the market (when the S&P is above the trend line) and when we’re out (when the S&P is below the trend line)


How often we pull the trigger on building or unwinding a position all depends on the ETF and where that ETF lies in relationship to its own moving average. As mentioned above, if an ETF moves far above its trend line and then drops 8% off its high, that move will trigger a sell signal. Looking at the iShares FTSE/Xinhua 25 (FXI) chart, for example, for the 12 months ending February 2007, FXI was almost always above its trend line. In early January, it began softening, dropping 8% off its high. We sold it at that point, even though we didn’t anticipate the further and steeper decline in March. By following our sell discipline, we were able to protect more of the gain and avoid greater losses.