Fundamental or Technical Analysis: Trading ETF's

Should investors look at ETF's on a fundamental basis or is it better to use technical analysis?

Background

One of the major changes in sector investing in the last several years is the rise of Exchange Traded Funds (ETF's).  These days there is an ETF for almost anything, and new imaginative offerings appear regularly.

It is now attractive for an investor to construct an ETF portfolio instead of buying mutual funds, and there is plenty of advice.  A good place to start is the excellent guide written by David Jackson of Seeking Alpha (full disclosure:  regular readers know we contribute to and support Seeking Alpha).

Our company has specialized in sector trading for nearly ten years.  We have used Fidelity Sector funds, baskets of stocks of our own device, and more recently, iShares.

Trends in Sector Investing

Our experience has encompassed some changes in sector investing, including the following:

• The early period, where large mutual funds gained edge by identifying secular sector moves.  Their problem was the time it took to alter massive portfolios.  Even though they disguised their specific trades, the sectors they were buying always had a strong underlying bid.  Those they were selling had a strong offer above the current market.  Our software detected this and we benefited from multi-month sector trends.
• The outflows from individual investors have reduced this effect from major funds.
• Financial advisors and individual investors now construct their own ETF portfolios.
• Hedge fund managers use ETF's instead of futures.  Those of us schooled in the Chicago tradition of options and  futures trading find this amazing, since futures have some clear advantages.  Nonetheless, those who blog or write trading diaries buy (or sell) SPY or QQQQ to get long  (or short) the market.  When they are bullish about oil, they buy XLE rather than oil  futures.

The Result

Those trying to use fundamental analysis on ETF's do not have their complete tool kit.  Many such investors are trying to time the business cycle or have been encouraged by TV ads to believe that they can have a "feel" for these markets.

The standard metrics -- book value, P/E ratios, cash flow analysis, etc. -- are lacking, at least until some research services come up with cap-weighted metrics for the funds.

Hedge fund traders in ETF's represent "hot money" since the shifts can be quite rapid.

Our Conclusion

For our clients we use both fundamental and technical analysis.  For individual accounts, technical analysis helps us with entries and exits from positions where we have a fundamental position.

ETF's are different.  We find that technical analysis is far superior for ETF trading.  Our technically based TCA-ETF model is the basis for one of our funds, with an average holding period of about thirty trading days.

This approach has worked well on various baskets, but we recently decided to apply it to iShares.  Since the back testing for this new universe (not even contemplated when the model was developed) was very positive on a risk/reward basis, we have embraced these sectors.

Every method has an appropriate time frame.  Each investor has a different time horizon.  For accounts without tax consequences, the more frequent trading suggested by technical analysis has major advantages.

Our Position

In an effort to educate our audience, which includes many who want to have a system, we have been sharing the major calls of the TCA model, including the stumbles as well as the successes.  This is important, since any system trader must have confidence in the  method.  Every system will have losing streaks.  Lacking confidence, the trader will bail out at the wrong time.  Confidence and discipline are the keys -- including strict exit criteria.

The method is designed to get on the right side of major moves and get out before major losses.  Here are the current holdings and results:

The model also recommends about twenty other sectors.  It correctly positioned us for the recent gains.

We will elaborate further on alternative sectors and overall rankings on a weekly basis.  At the moment, this is a "thinking out loud" experiment, where we examine system trading and the best uses of technical analysis.