Exchange Traded Funds, more commonly known as ETFs, have been

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1 Trading by Numbers: Scoring Strategies for Every Market By Rick Swope and W. Shawn Howell Copyright 2012 by Rick Swope and W. Shawn Howell APPENDIX B Exchange Traded Funds (ETFs) Exchange Traded Funds, more commonly known as ETFs, have been around since the mid-1990s when the S&P 500 ETF (SPY) was first introduced as a more efficient way to trade the index. The original ETFs were created as a tradable mutual fund, giving investors the ability to enter and exit positions with stock-like execution while still maintaining mutual fund-like diversification. Since then, the ETF market has exploded, with over 1,400 ETFs from which to choose. With so many to choose from, it s imperative that you acquire the knowledge and strategy to better utilize ETFs as both an investment and trading vehicle. Since the ETF is a hybrid product, it shares many advantages of both stocks and mutual funds alike. Fortunately for us, this crossbreeding of a mutual fund and stock has bred out many of the disadvantages of the parents while leaving intact the attributes more valued by a trader. ADVANTAGES Tradable The T in ETF stands for traded, and this is one of the ETF s most significant advantages. An ETF trades just like a stock. This means you can buy or sell an ETF at a moment s notice in the same way you could with a stock transaction. Since the mechanics of buying and selling ETFs mirror those of a stock transaction, stocks and ETFs have the same commission schedule. If, for example, your broker charges a flat rate of $7.99 for a stock trade, the costs to trade a stock or ETF would be the same. 237

2 238 ETFs have become so popular that some brokerages have created their own proprietary ETFs. Many of these can be traded commissionfree. Of course, we all know there s no such thing as a free lunch. The brokerages might not be charging a commission, but that doesn t mean they aren t making money. ETFs come with management fees that are included in the value of each share. These fees can vary greatly with some fees as low as.09 percent per year to over 1 percent. If your broker has a proprietary ETF that you can trade without fee, take a few minutes to research the management fee and compare it to a similar ETF with a commission to determine your true costs. Even with fees, many ETF s are an extraordinary value. Consider the fact that purchasing just one share of the SPY ETF represents ownership in 500 unique companies. The SPY has an annual expense ratio of.09 percent, or $9 per year for every $10,000 invested. Volatility As a result of ETFs usually being comprised of a basket of stocks (or other investments), they tend to be less volatile than individual stocks and, therefore, they have lower gap risk. A gap is simply space between the closing price of one day and the opening price of the next. Gapping goes hand-in-hand with volatility. If the opening price is higher than the previous close, the stock is said to have gapped up. If the opening price is lower, the stock has gapped down. Gaps are most common when information about the company is released after the markets have closed. Information such as an earnings release, an analyst upgrade/downgrade, a product release, litigation, management changes, and much more can have a dramatic impact on the stock s opening price the following day. Since the market is closed when the information is released, the price cannot react until the next session s opening. With buy and sell orders building while the market is closed, the opening gap is often the most dramatic move of the day. Gapping indicates a lack of efficient information dissemination, and, although a gap can work in your favor, taking a trade after a gap has occurred is best left to experienced traders. Order Types As a skilled and disciplined trader, you need to be able to automate your entry and exit orders. ETFs give you the ability to use various order types common to most online brokers, including Market, Limit, Stop, Stop Limit, and Conditional Orders. Diversification ETFs are one of simplest and most cost-effective ways to diversify a portfolio. Suppose you want to fund an Education IRA for your children or grandchildren. With annual contribution limits, you may not have much room in the way of diversification. You can t buy many stocks, and many index mutual funds have minimum purchase requirements. Instead of buying only a few shares of stocks or limited mutual funds, you could utilize ETFs such as SPY (S&P 500),

3 Appendix B: Exchange Traded Funds (ETFs) 239 QQQ (NASDAQ 100), and IWM (Russell 2000) to diversify. In effect, you could add 2,600 different stocks to your portfolio for under $30 in commissions. Technical Analysis Since ETFs trade like stocks, they yield data from every trade throughout the day. You are then able to perform the same type of technical analysis on ETFs that you currently use with stocks. All the rules about support, resistance, price patterns, volume, and so on apply with ETFs. Recognizing that risk management relies heavily on technical analysis, this advantage over mutual funds is key. Non-emotional In all our years as investment educators, we have seldom seen a more dangerous pitfall than becoming emotionally tied to a stock. An emotional attachment creates a biased opinion. That biased opinion blurs and distorts a trader s better judgment, thus yielding bad decisions, resulting in financial loss. Since ETFs are funds, they are comprised of a basket of various stocks and other products. It is unlikely that you would form an emotional bond with this basket, unlike a stock where you might love the company s products (Apple, The Gap), utilize the company s services (UPS, Verizon) or have a family history (my family only buys Ford trucks). Avoiding emotion is difficult when you re a stock picker, but it s fairly easy with ETFs. Changing fundamentals Once upon a time, investing was taught with a simple premise: buy a stock in a company you know, with a product you trust, and have faith in that company for years. That is why so many portfolios ended up with shares of Disney, McDonalds, Wal-Mart, Johnson & Johnson, Citicorp, General Electric, and Standard Oil (now ExxonMobil). That was then, this is now. We invest in an age where CEOs say what they want you to hear, the Street looks for earnings to beat the infamous whisper number, and accountants discover new and creative ways to make losses look like profits and debt look like income. The traditional approach to the fundamental valuation of a stock has mostly vanished. While ETFs are not entirely divorced from fundamental analysis, the focus has shifted from a micro-view of a single company to a macro-view of an industry or sector. No longer are you held hostage to one company s performance and reporting. You should add to your technical analysis a fundamental analysis of the basket represented by the ETF. If you re trading OIH (Oil Services ETF), you would consider fundamental issues such as the price of crude, weather impacts in drilling or refinery locations and the value of the US dollar. But if XYZ Company in the OIH ETF turns out to be cooking their books, it likely won t be a catastrophic event for your portfolio. Always a trade somewhere For your average stock and mutual fund investor, there is only one profitable market and that is the bull

4 240 market. As we all know, the market is not in a constant state of going up. In fact, the market spends more time either moving sideways or down. There are numerous ETFs that are designed for bear market strategies and many of those also have option contracts associated with them. We recommend ETFs with options to utilize various strategies that produce returns in bull markets, bear markets and range bound markets. Dividends Many of the stocks held in ETF baskets pay dividends. Since your purchase of an ETF represents ownership of these dividend-paying stocks, you are entitled to and will receive your share. The trustees will generally pass along the dividends as a quarterly payout to the shareholders. Various account types ETFs can be held in virtually any type of account from the standard brokerage account to IRAs, Roth IRAs, Custodial Accounts, Trust Accounts, Corporate, Partnerships, and the like. Your broker can give you the final word on what products they offer for the various account types. Outside of a 401(k) plan that often has a very limited menu of investment choices, you should have access to ETFs. If you have an old 401(k) from a former employer and you want more choices for trading and investing, you should consider opening a Rollover IRA and transferring your 401(k). DISADVANTAGES Complexity With the recent creation and popularity of leveraged ETFs complexity and risk have increased. Some of these ETFs seek returns that are double (200 percent) and triple (300 percent) the move of an underlying index or commodity. As an example, if the S&P 500 experienced a 20 percent drop in value, an investor who utilized a double leveraged ETF would now be down more than 40 percent. Remember, just because these are diversified investment products does not mean they are without risk. Another example of the increasing complexity is the bear ETFs, which increase in value when their underlying index or commodity drops. A double inverse bear ETF might be appropriate for some investors but probably best avoided by novice investors. Leveraged ETFs, like the QID (double inverse NASDAQ 100), are simple to trade but the investments that make up their baskets are often complex. Leveraged ETFs are really designed as trading, rather than investing, products. A double inverse leveraged ETF does an excellent job of replicating a move equal to an inverse that is twice the daily movement of the underlying. A position that is held more than one day will begin to experience a divergence of returns.

5 Appendix B: Exchange Traded Funds (ETFs) 241 Fees The original ETFs were created largely in response to the often hidden and always complex fee structures of the mutual fund industry. Many investors were unfamiliar with industry terms like 12B-1 fees, front-end load, back-end load, STR Fees, etc. ETFs such as the original SPY are very cost-efficient. Contrast this to a newer, more exotic triple inverse ETFs with an expense ratio of 1.15% or $115 for $10,000 per year held. Granted, this is still far less than what many mutual funds charge, but is something to be aware of if you intend to use a vehicle designed for short-term traders as an investment. Liquidity With so many new ETFs in the marketplace, the competition for trading volume is higher than ever. It is better to avoid thinly traded ETFs, because spreads (the difference between the quoted buy and sell price) increase, which in turn eats into your profit or increases your loss when the position is closed. Another concern with light volume is slippage. Slippage occurs when the price moves adversely as a buy or sell order executes. For example, suppose you placed an order to buy 1,000 shares at the ask price of $ The furst 200 shares executed at $20.00, but then the price changed to $ You changed your order to buy the remaining 800 shares at $20.01, and this time you were able to buy 400 shares at $20.01, but the price changed again to $ Not only is the slippage costing you more, but many brokers will also treat each change to the order as a new order, increasing your transaction charges. As a general rule of thumb, we don t consider trading anything with an average daily volume less than 500,000 shares. There are exceptions, of course, but generally speaking, for orders of up to 1,000 shares, this has served us well. Risk and Reward With a diversified investment product like an ETF, there is theoretically less risk than in an individual stock, since risk is spread out over the stocks that make up the ETF. At the same time, the opposite is also true the reward is also spread out over the stocks that make up the ETF, and that has a tendency to water down profits. Consider, for example, QQQ, which is made up of 100 NASDAQ stocks. Currently, the largest holding in the QQQ is Apple Inc. (AAPL), at approximately 11.5 percent. Although Apple is just one of a hundred stocks, it is weighted at over 10 percent. In one three-week period, AAPL stock moved higher by 29 percent, so an investor in AAPL stock would enjoy the entire 29 percent move. An investor in the QQQ ETF would also profit, but he would be up just 10.5 percent, as the QQQ moved from $28.43 to $ Although some see this as a negative, we do not. The diversification value of an ETF has been especially important in the face of many stocks that have simply vanished as a result of market meltdowns. Stocks like AIG that previously ranked in the top 5 holdings of the S&P 500 and are down 98 percent from where they

6 242 were in May 2008, have done far less damage to the owner of the SPY than to the owner of AIG stock itself. In extreme bear markets, having a diversified portfolio is sometimes the difference between surviving to trade another day and not. Boring Although we do not consider this to be a disadvantage at all, we are surprised at the number of people we know who do. There are plenty of stock junkies who are in the business for the rush of the trade. These folks often enjoy the anticipation of earnings announcements, watching financial news shows from market open to close, and the intrigue of an opening gap of a stock that missed earnings. Although this level of excitement can be fun, we don t often find people who make money with it. To them, it s a hobby. There s nothing wrong with it as a hobby, as long as you have the proper expectations. ETF TYPES Now that you have a better idea of what the ETF can do for your portfolio and the various advantages and disadvantages, let s take a look at some common types of ETFs. Index ETFs Index ETFs were created as an alternative to index mutual funds, allowing you to buy and sell the underlying index with a single, low-cost transaction. Today, index ETFs are among the most actively traded of all securities. QQQ typically trades around 100 million shares each day. In addition to the basic long index ETF, there are also the short index and leveraged index. The following are a few popular index ETFs: Long S&P 500 Short S&P 500 Long NASDAQ 100 Short NASDAQ 100 Long S&P Midcap 400 Short S&P Midcap 400 Long Russell 2000 Short Russell 2000 Long Dow Jones Industrial Average Short Dow Jones Industrial Average SPY SH QQQ PSQ MDY MYY IWM RWM DIA DOG

7 Appendix B: Exchange Traded Funds (ETFs) 243 Sector ETFs The S&P 500 consists of 500 of the largest companies that represent nine various sectors of the U.S. market. By investing in SPY, you would technically have ownership in all 500 stocks across all nine sectors. If, through your analysis, you determined that one or more of these sectors presented a better opportunity for you, then you could utilize one of the ETFs in the following table. Material Energy Financial Industrial Technology Consumer Staples Utilities Health care Discretionary XLB XLE XLF XLI XLK XLP XLU XLV XLY International ETFs Utilizing international ETFs allows you to tap into markets around the world just as easily as you can invest domestically. While trading an international ETF is no different than a domestic ETF, it s important to remember that the basket contains various international stocks that are subject to political, social, economic, and natural forces that are unique to specific geographic regions. Exchange rates will also have an effect on the ETF value and trading volume tends to be light. Don t let these dissuade you from considering these; it just requires a little more diligence and education on your part. The following is a selection of various international ETFs for you to explore: Canada Hong Kong South Africa Malaysia India EWC EWH EZA EWM EPI (continued)

8 244 Mexico Brazil Japan Xinhua China 25 Germany France Italy EWW EWZ EWJ FXI EWG EWQ EWI Specialized ETFs In this category, you will find ETFs that cover everything from replicating the double inverse relationship of the NASDAQ 100 to commodities like gold and crude oil. One reason we are placing these under specialized is that we believe these ETFs are best utilized by seasoned traders. More trading experience will help you appreciate the added risk associated with leveraged and/or inverse ETFs. While we present these as a category of ETFs with which you should be familiar, we consider options to be a better way to achieve both leverage and direction in your trading strategies. Ultra QQQ Ultra Short QQQ Ultra DJIA Ultra Short DJIA Ultra S&P 500 Ultra Short S&P 500 Ultra Midcap Ultra Short Midcap Ultra Russell 2000 Ultra Short Russell 2000 Ultra Short Gold Ultra Short Crude QLD QID DDM DXD SSO SDS MVV MZZ UWM TWM GLL SCO

9 Appendix B: Exchange Traded Funds (ETFs) 245 ETF WRAP One of the elements of ETFs as an investment vehicle is that of trader accountability. One of our favorite market pearls of wisdom is don t mistake a bull market for brains. In bull markets, it seems everyone is making money, and they attribute their profits to being good stock pickers or having the Midas touch or even having the trading gene! Contrary to what some might think, no one is born with the gift of trading. This becomes painfully evident when the bulls vanish and the bears appear. Being consistent and making money in a variety of market conditions will always come down to a trader s skill, not luck. Yes, luck will be a factor in your short term trading success, but over time luck will only play a minor role. Trading ETFs forces accountability, because profits and losses are all on you. There are no CEOs or analysts to blame, and no hot tips or news alerts to distract you. You should rely less on your ears and start to rely on your eyes for trading. What you hear is noise; what you see in the chart is reality. ETFs help you focus on your technical trading skills and block out the noise. Becoming a technical trader can be liberating, but it will take some time.

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