A Strategy For Investing In Exchange Traded Funds

01/05/05 03:56:05 PM

by Koos van der Merwe

Because exchange traded funds are traded rather than redeemed, they are more tax efficient than mutual funds. Here is a strategy you can play with to invest in them.

Security: I-Units, I-Shares
Position: N/A

Exchange traded funds (ETFs) are a portfolio of securities that trades on the stock exchange. They offer the broad diversification of mutual funds but at a fraction of the cost, and because they are traded rather than redeemed, they are more tax efficient than mutual funds. Here's a strategy you can play with them. First of all, you must find a data source that will supply you with end-of-day data for all the ETFs. At the moment, there is a considerable list, ranging from ETFs of indexes of various countries around the world, to the indexes put out by stock exchanges and even brokerage houses. There is a book titled THE NEW INVESTMENT FRONTIER by Howard J Atkinson with Donna Green that attempts a complete list of ETFs available, but as new ones are created almost monthly, the list is nowhere near complete.

The first step is to create a datafile that holds all the ETFs in which you are interested. After that, the next step is to create a strategy to analyze them, and choose those you should invest in. The program I use is TechniFilter Plus.

Figure 1: A portfolio of i-Units traded on the Toronto Stock Exchange.

Graphic provided by: Excel.

I decided I wanted to be continually invested in the top five performing ETFs, and that every week I would switch the worst performer for the best. If, however, the top five ETFs were already in the portfolio, I would not make a switch. When I refer to a switch, I mean a buy and a sell. This does create a commission payment, but if the portfolio is traded through a discount brokerage house, commission costs can be low.

I also include a stop-loss of 8% in the strategy. If the ETF should drop 8% from the newest high price made, I sell during the week if necessary, but I will only purchase the top-performing fund after I run the analysis at the end of the week.

Figure 1 is a portfolio of i-Units I traded on the Toronto Stock Exchange (TSE) for 2004 following this strategy. There are only four i-Units in the portfolio because only 11 i-Units are listed on the TSE.

However, at last count there are 81 ETFs on the US markets, allowing us to create a larger portfolio. Below is the one I created on December 4, 2004.

Figure 2: I-Units, Toronto Stock Exchange

The prices in both portfolios are the prices as of December 31, 2004.

The Technifilter Plus formula I use is as follows:

[1] Symbol
[2] Name
[3] Close
[4] Move Close of today - close of yesterday.
[5] Performance 100 * (Close - close of 104 days ago) / (close of 104 days ago)

I have chosen 104 days to determine the performance because a period of 104 days is close to six months of trading days. There are five trading days in a week, and on average four weeks in one month. (4 x 5 = 20 x 6 = 120.) Deducting public holidays and days when the market has low volume or open only half days gives me a figure of 104 days. This figure is a personal preference, and you can adjust it to suit your trading style. I run the program, and then rank it according to the top performer.

Is the strategy successful? So far, yes. Profits for the year as shown in the i-Unit portfolio are not the 20%-plus we strive for, but at 11% it is better than nothing. In 2001, the i-Unit portfolio gave a 11.81% return; 22.52% in 2002; 16.05% in 2003; and 11.83% in 2004. Note there was not a loss in one year. This speaks for itself.

Koos van der Merwe

Has been a technical analyst since 1969, and has worked as a futures and options trader with First Financial Futures in Johannesburg, South Africa.