Your first, and most important decision, is in recognizing what you need and want to do.
Are you a wealth builder or a wealth protector?
Are you an executor or a delegator?
In that kind of binary, binary world, the investors for whom there is the most hope are the builder/executors. This article will quickly turn to them, but first some useful considerations for the other quartiles.
Can you afford to delegate the investment job?
Delegating investment decisions can be expensive, in wealth terms. But it can be economical in terms of time, energy, perspective and alternative use of your skills resources if your whole specialized investment job is delegated. Be prepared to provide competitive (big) fee incentives and reserve adequate time and attention to regular, frequent and harsh reviews of promised performance. Be prepared to make changes if the fees are not being earned.
That has to be said, because so few investors understand the need to follow that path.
Just buying ETFs and forgetting them won't do it. ETFs then quickly become an expensive (in time and objectives) delusion.
The hazards now of wealth protection
Wealth protecting is currently harder than it often has been. That is due to artificial Federal Government influences on the rent being paid for the use of capital. There is a direct relationship between the return on capital and the return of capital, usually called risk. US Government securities are generally considered the least-risk, and typically carry the least rent, or interest payment. Everything else is scaled up from there.
Under the notion that the US dollar is the world's primary currency and no other power can muscle aside its presence in world currency markets, the U.S. Federal Government, in the form of the Federal Reserve Bank, conducts "open market operations" that now cause such rents to be near zero (0.02%) from its short-term borrowings, and only about 2 ½% a year for ten-year loans.
Not many years ago the longer-term rates were double that, and for riskier propositions than US govvies they scaled upwards from that double by another double. Given the risk differentials in other countries, without the government's interference here, the rewards for the rent of capital would be considerably higher. Instead, the government is imposing on all capital providers an invisible tax on the rents they can collect, while borrowing from them prodigious amounts at fictitious low rates.
So far, on the other side of that coin, the inflation rate on the US dollar has been held (by government-number scorecards) to show little impact. Longer-term that illusion will have to become evident, and may lead to the kinds of social disorder now being seen in many countries abroad. Not a happy prospect for either wealth-protectors or democracy.
Many who are caught in the income squeeze can only find apparent relief (although usually hidden and precarious) in the acceptance of more risk. Therein lies a hazard for wealth protectors now, as the likely future return of capital in all propositions may be endangered.
How best to protect wealth?
So for wealth protectors, the age-old rule continues: The best defense may be a good offense. Whether the style of seeking modest wealth-building is delegated or executed, it becomes necessary in times like these.
That means that most investors need to focus on wealth building. It's just a matter of how aggressive one needs to be in the trade-off of rate of return in exchange for the frequency and extent of periodic return disappointments. In short, the odds of success versus the size of payoffs becomes the focus of the game.
Let's look at what ETFs currently are best at making those tradeoffs.
First, if the potential for payoff size (in a reasonable holding period) is inadequate, you have to leave the world of ETFs and join the High-Frequency-Trading crowd. That is where few can afford to be, or should want to venture. So find ETFs that offer an adequate upside.
Next, identify those with an upside that have had manageable downside exposures and infrequent actual losses to go along with desirable gains. Some do it in a reasonable holding period so that their average gain experiences can be compounded into an attractive and competitive annual rate.
We do this by enlisting the demonstrated forecasting abilities of market-makers to get an idea of which ETFs at this point in time offer attractive, competitive prospects. We daily update over 250 ETFs to capture the market-makers [MMs] implied price range forecasts, based on the way firm capital is hedged in each name, when it is required to be at risk in filling million-dollar-plus trade orders.
The tops of those ranges mark the upside gains from current prices and the downside exposures are indicated by the range lows. More significantly, the actual maximum drawdowns during reasonable holding periods following the forecasts represent the most stressful investment experiences, where mistakes of loss acceptance are easily made. This is what risk measurement needs to be about, not by using symmetrical statistical variance measures of uncertainty which must include upside as well as downside moves.
Here is a current recap of the forecasts of market professionals for the ETFs with the best reward-to-risk tradeoffs, after excluding those whose inadequate experience histories preclude credible comparisons. First, let's see them ranked for the wealth builders, with the larger upside sell target prospects at the top of the list.
Here IAU and EWJ have bigger upsides than iShares Silver Trust (NYSEARCA:SLV), Direxion Daily Real Estate Bull 3X Shrs (DRN), and PowerShares India (NYSEARCA:PIN), but following prior Range Indexes they had average gains of less than +2%, partly due to win-loss ratios close to 50 out of 100. DRN, PIN and SLV all enjoyed much larger average payoffs of +6%, +11% and even +23%. Now take a look at the same 27 selected ETFs, but ranked by their worst-case price drawdowns following previous Range Indexes no larger than today's. The best (smallest) are at the top of the list.
Once again the top ranked risk avoider, TLT, despite its low Range Index and promised adequate upside, historically failed to perform in the 3 months following many (121) days of similar Range Index forecasts. It had more losses than wins. Better experiences were had by Market Vectors Brazil Small-Cap ETF (NYSEARCA:BRF) and iShares MSCI South Africa Index (NYSEARCA:EZA) while keeping their maximum-stress price drawdowns well under -5% and still enjoying average gains near +7%.
The fact that the best-ranked ETFs of these two approaches provided past results inferior to several less-well-ranked names led us to look at the impact of a different criterion on judging ETF investment attractiveness: The odds for success, as indicated by their win-loss ratios. Those outcomes were the product of a standard strategy that looked for position closeout targets at the first end-of-day opportunity in the next 3 months, or a liquidation by the end of that time if objectives were not reached, a strategy more fully described here.
When we rank the selected ETFs on the basis of their win-loss ratios, the following table shows the impact of odds and length of holding periods on the ultimate score, the annual rate of return from a disciplined strategy.
More than half of these 27 selected ETFs, in 3 out of every 4 cases (75 of 100), have had profitable hypothetical positions subsequent to Range Indexes no worse than their current ones. This measure is a dramatic separation for success when compared to other ETFs and the larger forecast population of both stocks and ETFs. The ranked ETFs averaged win-loss ratios of 71 out of 100 and achieved annual return ratios of +31%. The other 200+ ETFs were able to achieve win-loss ratios of 5 out of 8 (63 of 100). But that is often not enough of a balance to produce desirable results. In this case, they could not even break even and had aggregate losses at a trivial -2% rate.
In general, it is clear that at least at this point in time, market-maker outlooks for ETFs in general are not very promising. Investors need to be quite selective to achieve either wealth-building or wealth-protecting objectives by using ETFs. Indeed, their outlook for a set of investment tools some ten times larger shows far more encouraging aggregate prospects, with past rates of return low, only +10%, but at least positive.