ETF Update: Why Weighting Is Important

When there are several ETF choices related to the same sector, which one is best? There are plenty of considerations, many of which relate to the expected holding period. In our ETF trading we make choices with a three-week time horizon, but trade more frequently if necessary. Liquidity and the bid-ask spread are important.

The right choice may also depend on the method of weighting employed. Tom Lydon asks, "...did you know that different indexing strategies can either make or break your success?" Read his entire ETF Trends article for some great examples. Tom also points to a more comprehensive piece by Ron Rowland at Money and Markets.

This week we illustrate this topic by looking at the semiconductor sector, one of the top current choices from our sector rotation model.

Background

Before turning to the specific analysis of chip stocks, let us briefly describe how we determine sector ratings, as well as the current market implications.

We study sectors continually, looking at the charts and ratings for hundreds of ETF's. Each week we provide a list of our top-rated sectors for the next three weeks, along with some of our current observations. ETF investors can check out the list and compare our findings with their own conclusions.

In our analysis, we consider Trends, Cycles, and a bit of Anticipation. Since we apply the model to nearly 300 ETF's, we call it the TCA-ETF system. (For new readers, there is a more complete description of our methods at the end of the article. We also have a free report with more detail on the system and results, available on request.)

The Macro View

From an overall market viewpoint, our indicators continue in positive territory. The key elements are as follows:

• We now find 99% of our ETF's in positive territory (96% last week). The average strength rating for the overall list is 32, up slightly from 31 last week. (A score of "0" implies the average long-term ETF expectancy.)
• 86% (up from 70%) of our sectors are in the "penalty box." This means that they are currently disqualified from the buy list for technical reasons. You can think of this as a sophisticated "stop loss" rule, often applied in advance.
• Our index package remains slightly positive. For this rating we look at the ETF's (both long and short) for the S&P 500, the Dow, and the Nasdaq. You can see these ratings is the results table for this week.

Spotlight on the Chip Stocks

Part of the market rally has come from strength in semiconductor stocks. At Investors' Business Daily, Chip Stocks Lead Rebound On Nasdaq, Trang Ho provides a look at the fundamentals of the sector (hat tip ETF Expert):

Needham & Co. issued a buy rating on shares in March. In the near term, demand for chips is being driven by better-than-expected back-to-school sales of laptops, said Edwin Mok, an analyst with Needham.

Mok says that in the longer term, chip demand will come from companies upgrading their computer systems after putting off IT spending during the recession. "We believe there's pent-up demand for PCs, which should drive growth in the coming year," Mok said.

Oppenheimer also upgraded Intel (INTC) this week, upping earnings estimates and setting a 12-18 month price target of $28

Tom Lydon cited the fundamental demand from both smart phones and computers.

Which ETF to Buy?

Consider three different semiconductor ETF's with dramatically different weightings for the underlying stocks. The ETF's hold many of the same stocks, but in widely different proportions.

The Merrill Lynch Semiconductor Holders (SMH) is a capitalization-weighted fund. The top holding, Intel, constitutes nearly 25% of the fund. The top three holdings make up nearly 60%, and the top ten constitute over 90%. The P/E is about 29. Here is the chart (click to enlarge).

The iShares S&P North Amer Tech-Semicondcutors (IGW) is only partially based upon market cap, so the top three holdings make up about 27% of the fund. The top ten constitute 57%. Here is the chart (click to enlarge).

The SPDR S&P Semiconductor (XSD) fund has an equal weighting for all holdings -- a bit over four percent each. Here is that chart (click to enlarge).

Comparing the Choices

There is not much to choose among the funds based upon P/E and the charts seem very similar. The TCA-ETF model identified a difference, seeing a poor risk reward on XSD. (Note the penalty box rating in the chart below.)

While the exact calculation of risk and reward is complex, it is a guide for our choices. We hold no more than two positions (25-35%) in any specific sector.

Your own choice may depend upon many factors, especially including the time frame for your investment. We share our choice as a matter of public information, based upon our own trading horizon. The model has chosen to emphasize the large cap stocks.

Whatever you choose, you should keep the issue of weighting in mind.

Weekly TCA-ETF Rankings

We had a loss of about 2.7% last week, trailing the S&P 500 by almost one percent. Our current holdings are not near the top in strength rank, but they still have good strength ratings. Our testing has shown what Vince calls "robust" results for anything with a positive strength rating. We do not buy ETF's in the penalty box or those with poor liquidity. We provide these ratings as information for readers who may not trade as frequently as we do. Those signing up for our free weekly email update can also get the entire list.

[We also note that last week implemented what our modeling guru, Vince Castelli, calls an improved filter. While the underlying model has not changed, the inputs used reflect our best efforts to improve the signal-to-noise ratio. We have advanced the timing (the Anticipation factor) reflecting the recent "hot money" tendencies in ETF's. This means earlier recognition and also faster moves to the penalty box. Those tracking our entire data series should keep this in mind.]

As noted above, all of the macro market indicators remain positive, although most are in the penalty box. Based upon the current model signals, we have maintained (by a whisker) our bullish position in the Ticker Sense Blogger Sentiment poll.

Here are the top sectors from our expanded universe of 280 ETF's. The list also includes the values for the broad market ETF's and their inverses.

Note for New Readers

Our weekly ETF Update is designed to assist both investors and traders interested in ETF's and Sector Rotation. Before turning to the current rankings, let us undertake a review for readers new to this series.

Our Method. In this past article, we described our basic methodology and why we believe the rankings are useful for fundamental traders and technical traders alike. While we urge readers to check out the entire article, the key point is that ETF's pose challenges and opportunities different from investment in individual stocks. The fundamentals may be more difficult to assess. Even with a good grasp on fundamental trends, there is a lot of technically-based trading in ETF's. This means that those trading with a fundamental approach (and we do this as well) want to monitor the "hot money" moves. Here is an article on that point.

The system synopsis. We look at Trending sectors, Cyclical Sectors, and build in an element of Anticipation for both entry and exit -- thus the name of the model, TCA-ETF. While we do not reveal the exact methodology for spotting trends and cycles, the system is not a "black box." The basic elements are used by many, and widely reported. We even discuss the need for human analysis as opposed to black box trading.

We report the rankings each week, now on the weekend with a one-day delay, using the Thursday output from the model. We monitor and trade this daily, and offer a free report (request via the email address on the top left of the site) for those interested in our weekly trading program.

[We also hold Intel in individual and client accounts.]