|
Invest In The Best, Not The Bargain
Relative strength investing with ETFs
By
Steven W. Poser
At first
blush, the idea of buying only the strongest stocks and selling the
weakest seems like a simple plan to implement. However, in trying
to execute this strategy many investors foil their own efforts by
attempting to get the strongest stocks at the lowest price. But
there’s no bargain bin at a bourse. It is a virtually
insurmountable challenge for an investor to find quality stocks at a
bargain price.
Savvy
portfolio managers, on the other hand, do not waste their time
searching for a diamond in the rough but would rather find the best
of the best. One way to do that is through relative strength
investing. According to the relative strength method, CANSLIM, you
should buy the strongest stocks (the leaders) and jettison the
laggards. However, many people do not have the time and/or expertise
to tackle the task of relative strength investing with individual
stocks, bond or funds.
The good
news is, not only does relative strength investing work for
individual stocks, bonds or funds, but it also works for exchange
traded funds (ETFs). In the past, allocating investment dollars
across industries and asset classes was incredibly difficult. There
was no cheap way to buy and sell gold or bonds, for example. Also,
an investor had to choose individual stocks or mutual funds to
achieve any semblance of balance. With more than 190 ETFs and
HOLDRs trading in the United States, investors can now slice and
dice their portfolios in almost every imaginable way. And by
following these basic steps to create a relative strength trading
system using exchange-traded funds (ETFs), you can intelligently
invest in these instruments.
BEATING A BENCHMARK
One of
the simplest ways to compute relative strength is by comparing an
individual stock or group of stocks to a benchmark, such as the
Standard and Poor’s 500 Index. If you divide the price of a stock by
the S&P 500 and the line is rising, the stock is rising faster than
the S&P. Unfortunately, this shortcut leaves out two important
pieces of information:
-
A comparison between the stock
under consideration and other stocks.
-
Dividends and other cash flows
from the stock or the S&P 500.
When you
buy a stock, there are two parts to its return: price change and
dividends. Dividing the stock price by the S&P 500 ignores
dividends. You cannot possibly know the total value of your
investment without dividends. In addition, it is more direct to
look at actual returns when trying to compare various stocks or
assets, as opposed to dividing by a benchmark index.
A more
comprehensive way to compute an asset's relative strength is to
determine its total return for a given period of time. First, the
total return is calculated as (current price – starting price + cash
flows) / starting price. For example, if you purchased the Energy
SPDR (XLE) on September 1, 2005 at $52.00 per share and sold it on
September 27 at $53.00, you also would have received a $0.14761
dividend per share. Your total return is ($53.00 -
$52.00+$0.14761)/$52.00 or 2.21 percent.
Next,
calculate the total return of all assets during a given time period.
You can compare relative rankings over time by converting the
rankings into percentiles. A stock's percentile ranking is defined
as the percent of stocks with lower returns. The stock with the
highest total return is in the 90th percentile. If you
have a list of 10 stocks and two issues have higher returns, your
stock is in the 70th percentile; the worst stock would be
in the zero percentile.
SELECTION PROCESS
The most
straightforward method would be to rank all ETFs for total return.
Unfortunately, many ETFs have substantial overlaps. There are
industry-based offerings on S&P and Dow Jones indexes, as well as a
few specialized products focusing on REITS. Powershares also
manages quantitatively-based, industry-centric products.
In
addition, try to avoid ETFs that have very high weightings in one
or two stocks. If you look at many of the top-performing stocks
during the past 12 months, you would probably notice that many of
them are in the energy sector. Depending on how you create a
relative strength portfolio, you could find yourself dangerously
overweight in this one area. Of course, your returns during the
past year or so would have been nothing short of spectacular, as the
chart of the Oil Services HOLDRS (OIH) and Special Sector SPDR-Energy
(XLE) illustrates (see Figure 1). However, keeping
all your eggs in one industry can be a risky proposition. The
volatility of your returns may be very high.
By
dispersing your portfolio across many industries and even asset
classes, you may still be able to achieve the goals of relative
strength investing without putting too much hard-earned money into
one basket. To avoid being overweight in one industry, select only
one fund from a given industry or sector. You can choose which ETF
to include from a given sector based on one of many characteristics,
but liquidity should be the first characteristic to consider.
Buying and selling an ETF with greater liquidity will probably
result in less slippage, which can easily overwhelm small
performance variations between similar ETFs and harm your returns.
Portfolio managers advise against putting large orders in at the
open for the less liquid portfolios. They also note that routing to
the listed exchanges can result in less slippage for funds with
lower daily volumes.
PORTFOLIO SETUP
The
portfolio should hold five ETFs/HOLDRs or four funds plus a
20-percent weighting in cash. (My preferred methodology includes one
fund from each industry/sector plus the streetTRACKS Gold Trust (GLD),
a bond fund and cash. GLD is not included in the portfolio example
because 12 months of data for the ETF was not available at this
writing.) The initial selection ranks the included funds by total
return. To capture short-term, medium-term and long-term trends,
compute a three-month, six-month and 12-month total return ranking,
giving both the six-month and 12-month rankings double weightings.
Then choose the best five ETFs whose ranking is in the top 50
percent of your list of funds and whose momentum is positive. In
other words, do not initially choose the second-ranked fund if it
has dropped from a ranking of first in the prior week. Calculations
are based on Friday’s close with trades executed at the open on
Monday.
HOLDING PATTERN
A good
general rule is to hold any fund in the portfolio for at least three
weeks. Doing so will limit number of transactions and thus,
transaction charges. Furthermore, only remove an ETF when it falls
below the 50th percentile, even if other funds move above
it in the rankings. This means that you will not always hold the
top five ETFs with positive momentum, but you will always hold funds
that rank at or above the 50th percentile in our ranking
scheme, once the fund has been in the portfolio for three weeks.
 |
Table 1 presents a list of possible ETFs based
on the individual industry/sector ETFs with the highest
average volume for its type of funds. The three-month,
six-month, 12-month and weighted returns are calculated for
two consecutive time periods. (See Tables 2
and 3.)
A FLEXIBLE SYSTEM
Of course, you can use this outline as a basis for other
relative strength systems and adjust it to suit your
investment style. For example, you could allocate among
different asset classes, allow short and long positions, or
change the trading and evaluation time frames to fit the
frequency with which you adjust your portfolio. Other
possible improvements might include preventing the selection
of ETFs that rally too far in too short a time.
Regardless of the method you choose, the expansive choice of
ETFs available today gives you an inexpensive and efficient
way to create a relative strength-based investing or trading
program.
Steven W. Poser, educational consultant to
www.TradingEducation.com, is an accomplished analyst and
market Technician. He is also the author of Applying
Elliott Wave Theory Profitably (Wiley, 2003). |
Reprinted from SFO Magazine
Copyright © 2005 SFO Magazine
PO Box 849, Cedar Falls, IA 50613, ph. 319.268.0441 |
