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ETFs Combine the Best Features of Stocks and Mutual Funds While Avoiding Some of Their Problems

By Ken Long

I started trading Exchange Traded Funds (ETFs) in earnest in 2001, as mutual fund families began clamping down on frequent trading, and quickly discovered their utility as trading vehicles as well as other nice features for traders.  To oversimplify, ETFs are baskets of shares that trade on an exchange like a regular stock, but combine the best features of individual stocks and index mutual funds.  They are growing in popularity and capitalization every year, and are clearly a trend in the investment world that is here to stay.  They are well-suited to help you achieve your financial objectives whether you are a long term investor or a frequent trader, or some combination of both.  I have found ways to employ ETFs for every time period and trading strategy in my kit bag and am excited for future developments.

We started the ETF workshop at IITM in 2003 because Exchange Traded Funds were popping up on the radar more and more.  The early workshops felt very much like the pioneer days of the Old West, but without the scalping.  On second thought, it is fair to say that scalping is never far from a trader�s or investor�s mind.  In this article I want to recap where we have been over the last few years and look ahead to where the business of trading and investing in ETFs may be going.

The proliferation in the past 2 years of books, articles and strategies for ETF trading is remarkable.  There is clearly a strong market demand for information and ideas. A simple Amazon search on �ETF Trading� returns 177 hits without refinement.  I am glad to see that my favorite ETF book comes in at the top of the list. The ETF Book: All You Need to Know about Exchange Traded Funds by Richard Ferri is an excellent, comprehensive primer, and you could do a lot worse than start there.

As I have taught trading techniques for ETFs over the past years I've seen traders' understanding of basic ETF knowledge morph over time. For the most part I no longer need to explain what ETFs are, what they can be used for, or how they are similar to and how they differ from stocks and mutual funds.  This tells me that ETFs as a concept and a practice are now well-established in the public consciousness.  When Suze Orman speaks regularly about them, you find them creeping into 401(k) plans, and see financial advisors who offer ETF portfolios exclusively, then it is safe to conclude that they are here to stay.

It remains true that ETFs have some of the advantages of both mutual funds and individual stocks, while avoiding some of the problems.  Compared to mutual funds, ETFs are just as easy to understand, and are very competitive on cost, administrative fees, and in tax treatment.  They offer the same diversification as mutual funds but have added flexibility and power. 

Flexibility comes from the ability to trade intraday in both directions and to use some position sizing math to fine tune your risks and protect more quickly against changes in market direction. There�s also flexibility in portfolio construction deriving from the number of new and precisely defined market segments they cover, which allows you to fine tune your asset allocations.

Power comes from the ability to buy and sell leveraged products or use options that are aligned with both broad and narrow market segments, for those who have opinions or expectations on short term market or sector direction and volatility.

ETFs offer the advantages of flexibility and power when compared to individual stocks as well.  The flexibility comes from the built in diversification, which allows you to stand aside from researching at the individual company level and play broader based trends.  They allow for easily implemented market and sector neutral trading strategies as well as pairs trading.  There is a trade off in volatility between ETFs and stocks that allows for some powerful trading ideas.  Generally you will see that ETFs offer less volatility and more regularity than individual stocks, but retain enough smooth, short term movement to allow for shorter term timing strategies.

In this table you can see that ETFs are much less volatile than their large cap stock counterparts in the large US indices:

(Note: ATR% is a measure of recent volatility calculated by dividing ATR by Price.  This allows for a fair comparison of current volatility between stocks/ETFs and for assessing a stock�s/ETF�s change in volatility over time.)

By their nature and construction, you just don�t see the extraordinary moves overnight in ETFs that you see in individual stocks, which can be moved by surprise news events.  This tradeoff allows for some interesting possibilities for short term traders.

Following the news of new ETF releases should be enough to convince you that ETFs are here to stay. It seems like some of the newer ETFs are products in search of a customer, but that is to be expected in a rapidly expanding market that is hungry for new concepts. When you see news of an ETF that focuses exclusively on bio-fuel grains, you know that true market segmentation is here.

It is also clear that the true pioneer days are over and that the ETF market is entering a new, more mature phase as some offerings that were slow to arrive simply could not get traction to compete against first movers in their segment. Claymore recently closed 11 of their undersubscribed, low volume ETFs.  It is worth paying attention to avoid getting blindsided by low volume troubles of this sort.

For all the advances in size and capitalization that ETFs have experienced recently, they remain a small but growing fraction of the world equity market, and so I expect to continue to see innovation and aggressive marketing in the competition for dollars to manage.  More is on the way for sure.

With over 600 ETFs now available, it is easier than ever to find a way to express specific trading and investing ideas that span the range from passive asset allocation to intraday opportunity trading and all points in between using these powerful, flexible instruments. The ETF workshop has become a highly regarded, high payoff event to get exposed to a number of time tested, practical strategies along with some inventive new ideas for finding and exploiting an edge in the market.

We recently started up a chatroom for ETF swing traders who have been to the ETF workshop and were looking for a way to maintain contact with their network, refine their techniques and develop ideas in a controlled, productive and positive environment.  It combines the power of blogging with the deliberate discussions of discussion boards, fully supported with search and filter capability as well as the ability to share images and files in real time with the group. Although it�s only a couple weeks old, it is already adding value to the participants. 

Contact me at ken@tortoisecapital.com if you are interested in what�s going on in there.

About the Author: Ken Long, a retired Lieutenant Colonel in the U.S. Army with a Master's Degree in System Development, is currently a professor of tactics and logistics at the Army's Command and General Staff College. He has developed the Tortoise Method of mutual fund switching, a trading system that takes about five minutes each week with a goal of outperforming the S&P 500 Index. 

Ken is the instructor of our upcoming  ETF 101 Techniques Workshop, our new ETF 202 Techniques Workshop and a co-presenter with Van at our Blueprint for Trading Success Workshop. Ken is founder of Tortoise Capital Management, www.tortoisecapital.com.

He is a trader and writes a daily and weekly market assessment for mutual funds and exchange traded funds. He is a proud husband, dad, and 
ju jitsu practitioner. 

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Trading Tip

The Dirty Little Secret about MACD

by D.R. Barton, Jr.

�A single advantage is worth a thousand sorceries.�
--Turkish proverb

Today we�re taking a break from our series on uncertainty to look  at a useful technical tool that many of the traders that I work with use.  We�ll resume the uncertainty discussion in two weeks.

General information can be worse than no information at all.

I was shopping for home theater equipment for our newly finished basement.  I wanted to know what worked best for the price range I was willing to pay.

I started my research in the �old school� way.  I went down to the local newsstand and bought a few magazines that were �buyer�s guides� for home theater equipment.  What a disappointment.

These rags were more than willing to tell me who made the equipment, the manufacturer's specs, and even where to buy them.  But not one of them told me how well the systems performed relative to one another.

I had paid for a lot of additional, but useless information.  Endless lists of model numbers and prices.  I guess I could have used a dart or closed my eyes and pick one.  But that�s not my style.

I needed a resource that would listen to the systems, compare them, and tell me which one in my price range sounded better.  After a long and frustrating search, I finally found an online site that was helpful (more on that below).

I find that lots of traders and investors are equally frustrated with technical analysis.  There are lists of technical indicators that you can use.  But which ones are useful?

One of the most widely used indicators is the Moving Average Convergence-Divergence indicator or MACD.  However, there are two distinct ways to use it.  The real question is �How do you use this thing and is either method any good?�  Today we�ll answer that question.

The Technical Analyst�s Super-Value Meal � The Big MAC - D

One of the main technical tools that I use when evaluating technical patterns like double tops and bottoms is the Moving Average Convergence-Divergence (MACD).  Most analysts call it the �Mac � D�.  Today, I�d like to take a more in-depth look at this very useful indicator.

The MACD was developed by Gerald Appel and is based on exponential moving averages (EMA). But since it uses the difference in the moving averages, these traditionally lagging indicators become a momentum oscillator.

For our math minded friends out there, if you want the exact math you can find it on Investopedia.com or stockcharts.com.  But for now, all we need to know is that there are three components to the MACD that are shown in this oil chart below:

I

The numbers below refer to the circled numbers in the chart.

1.      The MACD fast line � black thick line

2.      The MACD signal line � blue thin line

3.      The MACD-Histogram, which is just a bar chart that shows the difference between the MACD fast line and signal line.

How to Apply MACD:  Popular vs. Useful

There are the two ways to use the MACD that are widely discussed in the trading analysis.

MACD Crossover.  The most commonly discussed way to use the MACD is to buy the instrument being charted when the fast line crosses above the signal line (bullish crossover) and sell or short it when the fast line crosses below the signal line (bearish crossover).  From our previous crude oil chart, these signals look very appealing!

These crossovers look great!  But hindsight is always 20/20!   There are two things to note about using MACD crossovers:

1.      They work well in trending markets.  Just like any garden-variety moving average crossover. (And the crude oil prices in our chart have certainly trended well in the past year!) 

2.      The �Achilles heel� of this crossover system is that you get a lot of false (i.e. losing) signals in choppy markets.  For example, even in our nicely trending oil chart, look at how many false signals are generated (as designated by the red arrows):

What No One Is Telling You

Here�s the amazing thing that no one will come out and say in their articles and books:  traditional MACD crossovers don�t work very well.  The one exception to this �non-disclosure� oversight is my good friend Chuck LeBeau who talks about his testing of MACD crossovers in his excellent book, Computer Analysis of the Futures Market.  Chuck will be teaching the Systems course with me in April.

Mechanically trading MACD crossovers in the traditional way is really tough sledding, especially in choppy or sideways markets.  MACD crossovers can be useful when combined with other tools, but here�s a telling (if anecdotal) indication:  of all the traders that I�ve been fortunate enough to study and work with, not one uses MACD crossovers!

But there�s good news � as I�ve mentioned above, MACD is very useful when used in its convergence-divergence role.  Next week we�ll dig into the application of MACD for helping us identify market turning points.  Until then --

Great Trading!

D. R.

P.S. Oh yeah, I promised a site for home theater reviews � I use two for most electronic products � www.cnet.com  and www.consumersearch.com.  The second is a summary of reviews and is usually quite useful, while Cnet gives more in-depth research.

About D.R. Barton:  A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena.  He is a regularly featured guest on both Report on Business TV,  and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio.  His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at  �drbarton� at �iitm.com�. 

 

Melita's Inspirational Corner

Seriously, Can�t We Laugh About This

by Melita Hunt

A few mornings ago I was chatting to my step-father about friends of ours who love one another very much, but are currently experiencing some problems in their marriage. They just can�t seem to agree with one another at the moment, and both of them think that their side of the argument is the right one.

So he explained the situation to me for purposes of discussion and to hear my point of view. Yet, as he told me the story, I couldn�t help but hear the distinct agreement with the man�s side of the story and the complete misunderstanding as to the women�s side of the story. I won�t bore you with details, but suffice to say, it is probably a standard argument out there among young married couples over mothers working. I of course, took the side of the woman and tried to explain what she was thinking, feeling and talking about. This led to further discussion until we agreed that men really are from Mars and women are probably from Venus, or at least somewhere that �Martian� isn�t taught. The problem isn�t the people, nor is it the situation, it can easily be resolved if they were both speaking the same language to one another. The key was effective communication or lack thereof.

The woman in question is very similar to me, she talks a LOT. And the guy, well let�s just say he works a long day and then likes to go into cave man territory for a few hours. This scenario is familiar the world over, so you would think we would have worked it out by now. But it seems to rear its head, in each new generation or partnership.

We all know that men and women are very different, but my step-dad (who is in his late 70s) still hasn�t worked women out and often scratches his head at the behavior of Mum and I.  So helping out with a viable solution for his friends, wasn�t exactly on the cards. He could only give the man�s side of the story.

It brought me back to a wonderfully funny set of books by Allan and Barbara Pease. They have been aptly titled:  Why Men Don�t Listen and Women Can�t Read Maps, Why Men Can Only Do One Thing at a Time and Women Never Stop Talking, Why Men Don�t Have a Clue and Women Always Need More Shoes.

If you are looking for a serious read, without generalization and stereotyping, then I am giving you ample warning, please don�t even consider looking at these books. Some Amazon reviewers have given them a real hiding (perhaps those people should stick to stuffy literature), but for a few laughs and some downright fun, they are a hoot. Needless to say, I went up to the local bookstore and bought one for my step-dad today to illustrate some of the man/woman differences and to give him a laugh. The howls of laughter from both he and my mother from the lounge room this evening confirmed that it was a worthwhile purchase.

I think that they recognized themselves and each other in some of the case studies, such as women having to tell a � hour story rather than just getting to the point, and women�s preference for zig-zagging and spending time in the supermarket rather than just taking a straight line and getting what they need, not to mention asking for all of the details of the phone call that the man just finished having.  

And more importantly, reading this book together tonight had us all in tears (of joy that is) as a family. We were rolled over laughing, and it brought up other serious family subjects that we could discuss without tension because we were in a lighthearted mood. 

In life we often take everything too seriously, and it�s nice to have a break and a laugh at ourselves sometimes, and it is especially useful if it helps with a subject that is causing friction and problems in a marriage.

Hopefully the  book, or sections of it, will be passed on to his friends in the hope that they recognize that part of the communication breakdown is the fact that one of them is a man, and one of them is a woman � which is also what brought them together and why they love one another! And perhaps with a little more understanding of the ways of the significant other, things will start to lighten up. And that�s worth smiling about.

Melita Hunt is the CEO of the Van Tharp Institute. If you would like to keep up with Melita�s progress regarding her recently diagnosed lung cancer (she is a never-smoker). Please feel free to read her blog at www.myleftlung.com.

You can contact Melita at mel@iitm.com

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