Written By Gary Stone
The arrival of ETFs (Exchange-traded funds) on the investing landscape, their increasing popularity and their ongoing expansion to cover more and more sectors, specific industries, commodities and market segments continues to open up an increasing number of opportunities for investors in being their own fund manager.
The main benefits of ETFs include: –
- Ease of trading and flexibility
- Available access from the same trading account using your broker
- Low costs
- The ability to reduce volatility within your portfolio
As active private investors we can make use of these characteristics to run our portfolio similar to a managed fund but without the costs or hassles associated with buying a small amount of a large number of stocks or other instruments in an attempt to replicate an index or industry sector. Instead, we can use ETFs in a number of ways to achieve investment goals and achieve what we all want, i.e., better growth and performance of our capital than we otherwise would have achieved by not being our own fund manager. There are a number of ways ETFs can be used when managing your own investment capital.
Single ETF strategy
Prior to the emergence of ETFs, the only real way to ‘follow’ an Index, such as the S&P500 or ASX200, was to invest in a mutual fund or managed fund that tracked the index through a basket of stocks that replicated that index. This meant paying fees and charges to a fund manager for managing your money, which, for index funds, was a less than active fund manager fee.
The investment process for both index and active funds required completing a prospectus and sending a cheque to buy, completing a redemption form to sell, or completing a switching form to switch between funds.
The other alternatives were to invest in Listed Investment Companies (LICs) or to attempt to replicate the index yourself by buying the shares that constitute that index proportional to the cash you have available. This obviously has drawbacks for many in terms of the time involved, brokerage costs, volatility and stock selection!
Now, if your desire is to achieve a return that is consistent with the return of a major Index, such as the S&P500 or the NASDAQ, then you can simply buy an ETF that tracks that index – for example, SPY in the case of the S&P500, QQQ for the NASDAQ and STW in the case of the ASX200. ETFs are available over a large number of stock market indices, so the index return you hope to match is limited only by the availability of an ETF over that Index. This strategy is not dissimilar to a ‘buy and hold’ strategy, as it uses no timing techniques for entry and exit. It does however allow for collection of dividends as and when they are paid and removes volatility that would occur from individual stock movements and different position sizes in individual stocks.
According to research conducted by S&P Dow Jones Indices SPIVA© Scorecard, this strategy over the long term can outperform over 75% of active fund managers in the USA and Australia. There is further research by Vanguard, which shows that over 25 years from 1980 to 2005, the average active mutual fund, including dividends, in the United States matched the S&P500, excluding dividends. (Source: “The Little Book of Common Sense Investing” by John Bogle, page 44).
This single ETF strategy can also be applied to a sector index if you have faith in it for the long term, such as the NASDAQ Pharmaceuticals index or a Healthcare sector index. As an active investor with a strategy or trading plan that involves the use of technical analysis, the potential exists to outperform the chosen index through the timing of entries and exits based on a researched trading methodology.
Single ETF Strategy – with timing
As active investors and traders with an understanding of technical analysis tools, we can further enhance the potential returns available through the single ETF strategy. Through the use of some timing techniques to enter and exit the market, the aim is to be fully invested in the market during uptrends or bull markets, and waiting in cash on the sidelines during prolonged downturns or bear markets.
In this way, we can take full advantage of market conditions to improve our returns over and above the ‘buy and hold’ method. The use of timing techniques allows us to avoid large bear markets, such as the one experienced in 2008, following the GFC, and to compound our overall returns by re-investing profits from previous closed positions. The table below displays the results of using the combination of two simple technical analysis timing techniques to enter and exit the STW ETF, as opposed to a simple buy and hold strategy, namely a
customised ATR Trailing Stop and Swing peaks and troughs based on period (not percentage) swings.
Both strategies include any dividend payments that were made during the period when trades were open. You can see that by timing our entry and exit from the STW as opposed to simply buying and holding for this 13.5 year period from Oct 2001 when the STW was first listed, would in theory, have increased our return by over $78,835, for an annualized gain of almost 10.61% compared to 8.76% for the buy and hold approach.
This immediately puts the DIY investor into the lofty realms of outperforming more than 75% of the world’s so-called professionals, the active managers of mutual and managed funds. The timing strategy outperformed the spot ASX200 index by 6.4% compounded per annum. Of particular importance is that we would also have suffered a significantly smaller maximum drawdown. By timing our exit from the market we would have preserved our capital and suffered much less emotional and psychological turmoil than the “buy and hold” investor.
In the chart below the solid blue area represents the performance of our method using timing to enter and exit the STW ETF. The orange area displays the performance of the STW ETF without timing over the same
period, both excluding dividends. Note: Over 13.5 years, just 30 trades were executed, or only 2.2 per annum! Hardly an active strategy. The benefits of using ETFs as a foundation to one’s investment strategies are becoming clearer and clearer to DIY investors. Their low volatility, focus on a small list of instruments, asset class diversification and removal of single stock shocks allow for simple investing strategies to be deployed in the market. Add some basic timing to your arsenal and the advantages over the buy and hold strategy, investing in managed funds or managing large stock portfolios is clearly evident.
The use of leverage is also open to the DIY active investor. Running the same simulations over the STW including leverage would boost returns further.
Multiple ETF strategy
A simple multiple ETF strategy builds on the single ‘buy and hold’ ETF strategy. Instead of holding just one ETF, typically an Index tracking ETF, this strategy involves spreading capital over 5 – 10 different ETFs. The aim of this strategy is to hold a basket of different ETFs to create a diversified portfolio. Like all buy and hold strategies, no technical analysis or timing tools would be used. It is purely a ‘buy and hold’ approach that will do well when the chosen markets are performing well, and it will underperform when the chosen markets are performing poorly.
Unlike a ‘buy and hold’ stock portfolio however, this ETF portfolio has the potential to achieve a much higher level of diversification, thereby further reducing volatility. An ETF investor adopting this buy and hold approach, could, for example, hold a portfolio of 5 Index tracking ETFs, 3 sector tracking ETFs, and 2 commodity tracking ETFs, such as gold and crude oil.
The ETFs considered for inclusion in this ‘buy and hold’ approach would be influenced by the investor’s personal choices, chosen markets, and personal biases and preferences. An investor with a view on the direction of grain prices could hold an agricultural ETF, just as an investor with a view on the price direction of base metals could hold an ETF that tracks metal prices.
The Index tracking ETFs within the portfolio could include those that track major, developed equity indexes such as the S&P500 or the S&PASX200, or those that track emerging and developing markets, such as the Brazilian equity index, or a combination and mix of both. The alternatives and ability to include a wide variety of markets are limited only by the investor’s personal choices, available ETFs, and market liquidity.
We have run a historical simulation of the ETFs of the following equities indices: Mexican Bolsa, German DAX, NASDAQ 100, S&P600 Small Cap and NASDAQ Biotechnology Sector Index since October 2001 when the most recent ETF for any of these indices was listed, being the IBB for the NASDAQ Biotech Sector, to mid-February 2015. The respective ETFs are EWW, EWG, QQQ, IJR and IBB, all listed in
the United States. The simulation uses an equal weighting of 1/5th of capital per ETF. This is a very simple position sizing approach, which could become a little more sophisticated by adjusting the weighting according to volatility. This would be more difficult to achieve for a buy and hold approach, but a timing approach would lend itself to adjusting the weighting each time a new position is opened in a particular ETF
This equity curve is in U.S. dollars and excludes any exchange rate variation against the U.S. dollar. The buy and hold approach of these 5 x ETFs achieved an annualised compounded growth of 9.28%, excluding any dividends or leverage and would have grown $100,000 to $329,000. Compared to this, the S&P500 – the red line in the chart above – achieved an annualised compounded growth of 5.27%, excluding any dividends, and would have grown $100,000 to $200,000.
This outcome shows how the S&P500 index, the world’s equities market benchmark, can be outperformed by gaining exposure to and diversifying across indices and sectors that can do better than the S&P500 through the simple use of ETFs.
However there is one major problem that a lot of investors would have had with this approach and that is, the risk taken along the way. In March 2009 this portfolio would have suffered a -57% drawdown of portfolio equity. Most investors battle to live through such an experience without panicking or making investment mistakes.
Multiple ETF strategy – with timing
The next logical step in our ETF journey is to introduce some simple timing techniques. The 5 ETFs included in this basket are the Mexican Bolsa, German DAX, NASDAQ 100, S&P600 Small Cap and NASDAQ Biotechnology Sector. (ETF codes are EWW, EWG, QQQ, IJR and IBB). Running this ‘timing’ strategy across these same 5 ETFs (with no leverage), achieved an annualised compounded growth rate of 12.26% (excluding dividends) and would have grown our $100,000 capital to over $461,000. This is a big improvement on the buy and hold strategy on the same 5 ETFs shown above, which would have grown our capital from $100,000 to $329,000 over the same period.
Importantly, as well as improving our overall compounded annual return from 9.28% to 12.26%, we have also managed to reduce the severity of the drawdown from -53% to -17% by ‘going to cash’ when any sell signals were generated for any of the ETFs.
This simple, yet highly effective approach has made a significant, positive impact on our overall net worth, not to mention our mental and psychological state, as we have been able to exit the market and sit on the sidelines during severe price retracements. We can then re-enter the market when any new buy signal is generated, taking advantage of the next upward price move. With just a little effort of doing 9 trades a year over the 13.5 years, we’ve been able to massively improve performance while taking much less risk during big market downturns compared to the buy and hold.
Very few managed funds would have achieved this sort of performance and even if they did, it is unlikely that an investor would have found them in advance.
Gary Stone has more than two decades of experience and is founder of Share Wealth Systems, a leading provider of share market trading strategies.