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.
The available funds from the FXI sale were deployed into the iShares MSCI Malaysia (EWM) and iShares Nasdaq Biotechnology (IBB). In making these buy decisions, we used all the criteria mentioned above plus the short-term momentum for one day, one week, two weeks, three weeks, one month, and so on. When we sold FXI in January, Malaysia was one of the best performers in December momentum, so was biotech.
Malaysia is an example of how human intervention comes into play in our buying strategy. That country isn’t as liquid as China, and it’s more thinly traded. (We sold EWM on 2/27/07.) If we’re selling $5 million or $6 million out of China, we did not want to put the total into EWM. That would have provided too much exposure. As a result, we put in half, and took into account not only the technicals but also the fundamentals. The question we asked was this: If Malaysia is a neighbor of China, and China is declining, why should Malaysia be going up? The answer at the time was that Malaysia has international companies with beach heads in China, but it’s also a country concerned with being too China dependent. The technicals were there, but the liquidity was not. (We sold EWM on February 27, 2007.)
Building and unwinding trades
Our portfolios tend to be more tactical than strategic, which is why we would even consider buying EWM. Based on an advisor’s size and the amount of money invested, it’s a lot easier to buy $1 million than $5 million of an ETF like EWM. Alternatively, if you have $500 million and you’re looking to invest $10 million in a thinly-traded ETF that could be a difficult trade to get through in a short period.
We tend to buy ETFs in small blocks until the desired amount is filled— sometimes it takes hours to work the trade. When the order is complete, equally priced shares are allocated among the various client portfolios. If we’re putting in $5 million into an ETF, and it only trades on average $20 million per day, we know a block for $5 million will not go through easily. It will affect the price.
When fully invested, our client portfolios might appear to be a little aggressive, but we have specific stop/loss points for every position. One of our clients is a 72-year-old widow with a $1.5 million ETF-only portfolio. Until about two weeks ago, we had 50% of her portfolio in domestic ETFs and 50% in global equity. Today it’s 50% domestic, 40% money market, and 10% international. There is no fixed income in it, yet she needs the income. But every month, money is withdrawn from the growth. As opposed to a traditional buy and hold, strategic 50% stock 50% bond portfolio, we’re able to do much better on the return front with a lot less risk. (Our portfolio was up 10.3% net for the 12-month period ending February. In comparison, for the same period, the S&P 500 was up 9.8%.)
The key here is having an investment discipline that includes an exit strategy. It helps protect a portfolio in declining markets, removes much of the emotion from investing, and allows investors to choose from a broader universe of ETFs.
Tom Lydon is CEO of Global Trends Investments, a Newport Beach, CA advisory. GTI was launched in 1996 and today manages some $65 million in assets with an average account size of $850,000. Lydon is also editor or the popular ETF web site, www.ETFtrends.com.