Using ETFs for portfolio building: Part 2

Reader Alert: This is the second of a three-part series on how ETFs can help control costs when constructing core portfolios.

The alarm rings reliably every morning just before daybreak. If it doesn’t sound, does that mean the sun will not rise?

Maybe, if you live in the shadow of Iceland’s volcano, but otherwise get a new battery! The difference between coincidence and causality is important and too easily blurred in the investment business. In my experience, technical analysis is particularly prone to this kind of distortion, establishing links like, “The stock went up BECAUSE it broke out of a six-month period of consolidation.”

Technical analysis

Technical analysis’s simple underlying tenet is that security prices go up or down based on supply and demand that is best determined by studying the price and volume activity of a security. The theory holds that all information about a security is reflected in its price. Furthermore, prices tend to move in trends and, since technical analysis holds that history repeats itself, these price patterns can be identified to indicate future price movement. Most online brokerage firms offer pattern recognition and other technical trading tools.

Specialized education in financial analysis is not required for technical analysis – it doesn’t care about companies, products, margins or market share. All that matters is price movement. Some portfolio managers and analysts may use traditional fundamental analysis (balance sheet, income statement and business analysis) for security selection and use technical analysis as a short-term tool to time entry or exit points. Academic research is unclear about the value of technical analysis, although momentum has proven a useful area of study.

Some technical approaches are geared for the longer term (defined here as any period longer than one year). The Elliott Wave Principle, for example, is based on the Fibonacci sequence of numbers (0,1,1,2,3,5,8,13 etc). Based on a third-century Southeast Asian hypothesis, the Western version of this sequence was used to explain the rate of growth in a hypothetical population of rabbits. Beyond zero, the sequence is the sum of the previous two numbers. The waves in up and down trends are said to follow this sequence. While longer-term applications exist, technical analysis is primarily a tool for trading.

Trading with ETFs

One of the most attractive attributes of exchange-traded funds is they offer good diversification. As groups of securities, ETFs are usually well diversified (although there are always exceptions) and diversification dampens volatility. This is great for the long-term investor looking to build long-term returns. But it is suboptimal for the trader.Traders thrive on volatility, but ETFs dampen it. One solution is leveraged ETFs. In Canada, levered ETFs offer the holder two times the daily price movement of an index. Inverse versions go up two times the inverse daily price movement of an index. In the U.S., three-times leverage is available. If action is what traders want, levered ETFs provide it.

Leveraged ETFs come with a special warning that higher volatility can distort returns because of the compounding effect. Volatility drag is real and should always be considered.

Other factors

Some argue that stock selection is a mug’s game and that the proliferation of ETFs has allowed them to trade in relatively concentrated areas. One example is Canadian banks, through Bank of Montreal’s S&P/TSX Equal Weight Banks Index ETF (ZEB); another less-focused way that includes insurance companies and Power Corp. is the iShares S&P/TSX Capped Financials Index Fund (XFN). It may be easier to make a call on a sector with more confidence than on an individual security.

Guidelines

ETFs have removed barriers and changed the rules of investing. Nevertheless, it may be useful to have some guidelines if you intend to trade, using technical analysis or any other method.

Volatility is your friend.Leveraged ETFs give you the pop and adrenaline rush you crave, but watch out for volatility drag from compounding during extended periods of fluctuation. Here is a link to PUR’s volatility drag calculator .

Concentrated ETFs such as single commodity, currencies and narrowly focused ETFs – for example, the five holdings of iShares Technology ETF (XIT) – can be reasonable trading vehicles; and If you must, sector ETFs.

The rules apply to the short side as well – volatility is good. However, ETFs make shorting easy, so all ETFs are fair game.

When using technical analysis to trade, remember the clock. Those patterns are man-made and like it or not, the sun will rise in the morning.