ETF Update: Inverse ETFs And The Investor Toolbox

What role should ETFs play in the investor toolbox?  Tadas Viskanta did a pretty thorough job of answering this question in a survey article last week.  Anyone interested in ETF investing should read the entire piece carefully.  It is very valuable.  (We are delighted to see this new dimension in articles from Abnormal Returns, one of our favorite sites).

The main arguments are that some ETFs are poorly designed.  Others (especially the leveraged long and leveraged short choices) are geared to short-term trading and do not deliver when evaluated over a long time.  The compounding of daily returns is not matched, because the fund rebalances to deliver short-term trading results.  Most investors do not understand this.

Many ETF investors do far worse than a buy-and-hold strategy.  Essentially, the ETF facilitates all of the worst psychological traits of the individual investor.

ETF investors need to understand these points.

We wish that Tadas has also covered the concept of intermediate term sector rotation  - our own strategy, and also that of others.  Here are the key concepts:

1. Have a genuine system, not just market feel and hunches.
2. Test the system, because otherwise you will have no confidence.
3. Maintain discipline.  Accept short-term losses but control risk.

Our Approach

Our own approach meets all three of the key objectives.  We have a time frame of about one month.  This is not geared to day traders, and it also limits the trading costs of investors who want something more powerful than “buy and hold.”  We consider Trends, Cyclical behavior, and we add a dash of Anticipation.  Since we do this with a universe of ETFs, we call it the TCA-ETF method.  We tested it on a universe of sectors not used by the developer.  We also reached into a different time frame.  This is the kind of testing that allows you to have some confidence in ultimate performance, so you are not second-guessing yourself every week.  (The complete current rankings are at the end of the article, along with an explanation of our methodology).

This Week’s Spotlight

Each week we highlight the major moves in our rankings.  Most dramatically, we see the ascendancy of the index shorts.  While these short positions are partly covered by long sectors, the longs are not what we call “market” sectors.  They march to a different drummer.

The rankings for the inverse ETFs on the broad market - SH, PSQ, and DOG - reflect a negative outlook.  Our ranking list shows the rapid moves in these sectors.

Weekly TCA-ETF Rankings

Our weekly ratings go from Thursday to Thursday.  The performance (from Friday to Friday) lost about 3% as we transitioned to short positions.  The market had volatile and mixed trading, with rapid shifts from day to day.  This is the worst short-term combination for our system, and we lost ground to the S&P 500 which was down only slightly on the week.

We note the rise in health care sectors, and expect some mid-week buying in these groups.

Here is the chart for the most recent trades and current ratings as of Thursday’s close:

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