ETF Update: Time to Diversify?

Successful sector investing requires concentrated investments.  A fully diversified portfolio will match the market.  The sector investor seeks to beat the market by finding opportunities with strong potential.  This requires less diversification and more short-term risk.

The right amount of diversification depends upon your time horizon and trading frequency.  It is also helpful to have a method that helps in gauging relative sector strengths.  In our own trading, we select from a universe of 277 ETF's.  The ratings are based upon technical criteria reflecting Trends and Cycles.  Since our approach adds a bit of Anticipation, we call it the TCA-ETF method.  (For new readers, there is a more complete description of our methods at the end of the article.)

In this article we will consider a completely un-diversified approach, describe how to achieve some level of diversification, and apply the results to the current market.

The Gil Blake Approach

Legendary mutual fund timer Gil Blake was the winner of the United States Trading Championship for five consecutive years and a subject of the Jack D. Schwager book, The New Market Wizards,   He had a strong opinion about diversification.  No!  In response to a question, Blake responded as follows:

I'm not a big fan of diversification.  My answer to that question is that you can diversify very well by just making enough trades per year.  If the odds are 70% in your favor and you make fifty trades, it's very difficult to have a down year.

Gil Blake famously invested his entire portfolio in a single Fidelity sector fund each day. Later, he used hourly trade data to take similar actions.

Blake's approach rejected diversification in favor of a short time frame and many trades.  In a system that really works, you can reach the "long run" fairly quickly.  (We wrote more on this topic here.)

Finding a Balance

For most of us, it is impractical and expensive to turn over our entire portfolio every day.  ETF investors may find our approach an interesting contrast to Blake's.  We use a thirty-day time horizon, but review our ratings twice each day.  While we have an expected holding period, we adjust more frequently and trade more often if circumstances warrant.

We also get as much diversification as possible.  Here are the guidelines:

• At least six positions
• No more than 1/3 of all positions in the same specific sector (e.g. banking, Asian nations, chip stocks)
• No more than 1/2 of all positions in the same super-sector
• Sacrifice a small ratings difference for more diversification

The Current Market

Despite these guidelines it can be difficult to find diversification without sacrificing performance.  For many weeks the top sectors were all related to finance and real estate.  Last year's rapid market decline sent sector correlations nearly to 1.0.  This year's rapid rebound has done the same.

A more measured advance, and even a trading range, provides a great opportunity for the diversified sector investor.

As you can see from the list below, it is possible to include some European country funds (EWO and EWD), European REIT's (IFEU), insurance (KIE, IAK), banks  and financials (KBE, IYF), and health care (IHF) while sticking to the top portion of the list and solidly positive ratings.  (We further diversified on Friday).

This is a much broader range of opportunities than we have seen in recent weeks.  Perhaps other ETF investors will offer some comments on their own approach to the question of diversification.

Weekly TCA-ETF Rankings

57% (versus 29% last week) of all sectors are now in the penalty box, having violated certain technical criteria.  The index package (near the bottom of the table) shows that the longs are beating the shorts by a wider margin than last week.

We were up about 1.5% on the week, beating the S&P 500 by more than one percent.

Based upon continued, but moderating, strength in the model signals, we continued our bullish position in the Ticker Sense Blogger Sentiment poll.

Here are the top sectors from our expanded universe of 277 ETF's.  The list also includes the values for the broad market ETF's and their inverses.

Note for New Readers

Our weekly ETF Update is designed to assist both investors and traders interested in ETF's and Sector Rotation.  Before turning to the current rankings, let us undertake a review for readers new to this series.

Our Method.  In this past article, we described our basic methodology and why we believe the rankings are useful for fundamental traders and technical traders alike.  While we urge readers to check out the entire article, the key point is that ETF's pose challenges and opportunities different from investment in individual stocks.  The fundamentals may be more difficult to assess.  Even with a good grasp on fundamental trends, there is a lot of technically-based trading in ETF's.  This means that those trading with a fundamental approach (and we do this as well) want to monitor the "hot money" moves.  Here is an article on that point.

The system synopsis. We look at Trending sectors, Cyclical Sectors, and build in an element of Anticipation for both entry and exit -- thus the name of the model, TCA-ETF.  While we do not reveal the exact methodology for spotting trends and cycles, the system is not a "black box."  The basic elements are used by many, and widely reported.  We even discuss the need for human analysis as opposed to black box trading.

We report the rankings each week, now on the weekend with a one-day delay, using the Thursday output from the model.  We monitor and trade this daily, and offer a free report (request via the email address on the top left of the site) for those interested in our weekly trading program.