ETF Update: Making the Most of Opportunity

No wonder it seems confusing.  From the bulls....

The market makes a new 52-week high, and it is still lower than pre-Lehman levels.  The major Wall Street firms (check out The Bespoke Investment Group for a great table) are increasing their year-end targets for the S&P 500.  Corporate profits are growing at a remarkable pace -- more than anyone expected.  Forward earnings estimates are continually revised upward.

and from the bears....

None of this can last, since it is all a result of government stimulus.  When the stimulus ends, there will be no organic economic growth.  The Obama Administration is anti-business, anti-market, and anti-capital.  Newly emboldened from the health care victory, we can expect more socialistic policies and regulation stifling financial markets in the next few months.  Under these circumstances, no one would consider starting a new business, so there will be no job creation.  And by the way, we will have either deflation, inflation, or stagflation, depending upon which mistake Ben Bernanke makes next.  (Check out yesterday's "week ahead" article for links to thirty bearish arguments you should know about.)

Since either viewpoint might be correct, what should an ETF investor do?

(For new readers, there is more information about our specific approach at the end of the article.  We also have a weekly email update for interested readers, along with some helpful reports about how to interpret the model output.  Send an email to etf at newarc dot com).

Using ETFs to Balance Risk and Reward

A systemic approach to ETFs and Sector Investing can help us to find the best opportunities.  It can also help when things go wrong.  Done correctly, a trading system should match the objectives of the user.

Only with confidence in the system can the investor shrug off the inevitable bad periods and enjoy the victories.

You must know when to expect success.  You need to understand the system.  In our shop we think of a trading system as a wise advisor.  It is not a black box, since we monitor the output and use human discretion when needed.  (I wrote about this process here.)  The advice should be matched to the needs of the investor.

Two Clients, Two Systems

For some time we have been observing the results from two different models.  To illustrate the difference, let us imagine that we went to Vince, our system guru, and described two different clients:

• Oscar believes in the long-term strength of the economy and the stock market.  He has a lovable and irrepressible enthusiasm.  When things go wrong, he steps back for a bit, but soon tries again.  He expects to do better than others during good times.  Oscar understands that this approach involves more risk.  Oscar is opportunistic.

• Felix also has a positive long-term outlook, but he is something of a fussbudget.  He is much more cautious, with an emphasis on capital preservation.  He is perfectly willing to step aside from the market when there are signs of danger.  He knows that he will miss some moves, but that is OK.  He scores big gains when the market moves lower and he escapes the loss.

There is a little bit of Oscar, and a little of Felix, in all of us.  That is why the Neil Simon play, the movie, and the television show were so successful.  Thinking about your own approach to risk and reward is the first step to successful investing.

This Week's Ratings

This is the first week for which we are publishing the ratings for both TCA-Felix (in use for the last several months) and TCA-Oscar.  As usual the ratings are from Thursday's close.

I expect to have more scope for my weekly column on ETFs by using the Oscar and Felix approach.  There will be more candidates to write about and some interesting comparisons.  I invite reader suggestions about how to display, highlight, and discuss the results.  I also expect the articles to be more fun -- both for me to write and for you to read.

This week I am not doing my normal sector highlight, but readers can see some interesting differences in the two sets of ratings.  You can also see how the two approaches fit with your current investments.

TCA-Felix

TCA - Oscar

For New Readers

When I started writing about ETF selection 2 1/2 years ago, it was a little deceptive.  My company has emphasized sector investing for over ten years.  ETF's are just the latest incarnation.  It is time to re-emphasize some points I made in the initial launch of this series.

This report is aimed at two different groups:

1. Individual investors.  But not for the reason that one might think.  We are NOT making a trading recommendation for individual investors.  Each investor is different -- in goals, risk tolerance, life situation, tax issues,  and other special circumstances.  The individual investor must consider all of these factors and should consult a professional advisor.  On their own, individual investors significantly lag the overall market averages.  Investors should read this series not for recommendations, but to see how difficult  it is to design and implement a trading system.  It is not as easy as the TV ads, where the online brokerages make money by persuading you to trade frequently.
2. Traders.  We invite comparisons to other systems and rankings.  We invite comment.  While we have a strong method, we always seek to improve what we do.  Our readership includes many astute market observers and professionals, and we welcome reactions.

The Model

Most developers of systems -- both individuals and professionals -- make a crucial mistake.  They take a big chunk of recent data and find a system that would have worked during that time period.  This is back-fitting of the model.  Even those who hold out a subset of data may find that their models are not really predictive.  When a model developer repeatedly uses the same out-of-sample data, it gradually becomes "contaminated" -- almost as if the test data were part of the development data.  It is the most common mistake.  Any developer who is not constantly on guard for this has probably become a victim.

A first-echelon modeler (like Vince, known well to those on WealthLab) has strong methods for avoiding this problem.  These are described in various books, but beyond our scope here.  Our method introduces even one more check.  We took Vince's work and applied it to a universe of sectors that he had not even thought about when developing the model -- and we used a different time period for the test.  We did not do this dozens of times, we did it once.  When the model showed good results, we had the nearest thing to real-time testing that one could achieve.  This sort of rigorous back-testing is much better than simply trading the model, since one gets plenty of variation in the simulation.  If the methods result in excessive drawdown or risk, that becomes clear from the simulation.

The biggest problem for the system trader is to maintain confidence when things seem to be going wrong.  Unless you  have complete confidence in the development process, you will bail out on your system the first time you see losses.

Comments

[chetan.gariki@gmail.com]

Is there a list somewhere of the most diversified but liquid ETFs (i consider most stock ETFs more or less tightly correlated) that are least correlated with each other. The list i currently have is:

SPY
EEM (quite correlated to SPY; but ok i guess)
AGG
DBC
UUP