Tom Lydon's ETF Playbook: The Trend Is Your Friend

 |  Includes: EEM, JNK, LQD, RSP, TIP, VWO, XME
by: Tom Lydon

Tom Lydon is editor and publisher of ETF Trends, a website with daily news and commentary about the fast-changing trends in the exchange traded fund industry. Mr. Lydon is also president of Global Trends Investments, an investment advisory firm specializing in the creation of customized portfolios for high-net worth individuals. He has been involved in money management for more than 25 years and is currently a board member of Rydex|SGI. Mr. Lydon is the author of 'The ETF Trend Following Playbook', as well as 'iMoney: Profitable Exchange-Traded Fund Strategies for Every Investor'.

Tom recently took time out of his busy schedule to talk with Seeking Alpha's Jonathan Liss, touching on ETF investing strategies, which ETF investors should be looking at right now, and where the ETF industry is headed.

Jonathan Liss [JL]: You talk a lot about 'trend-following' (see Tom's An ETF Trend-Following Plan For All Seasons). What exactly do you mean by this? Is this something any retail investor can do? What are the risks of this strategy?

Tom Lydon [TL]: ETF investors are usually more savvy than typical mutual fund investors and want greater portfolio control. They are generally in the process of shifting away from buy and hold into more tactical strategies. ETFs allow this in that you can trade them intraday and they're fully transparent. Mutual funds aren't.

When people hear the term 'trend following', they think it must be very complex. That's not the way we do it. It is actually a fairly simple discipline that involves using the 200-day moving average to determine when to buy and when to sell. This allows you to protect the downside of a given position at all times while getting you into an ETF as it's trending upwards. The key is actually to buy an ETF as it's moving above its 200-DMA. This generally produces the best results.

We don't feel you can really time the market or make predictions. That's why even though the trend-following strategy we recommend is fairly simple to follow, it requires a lot of discipline. By using a mathematical model in the form of the 200-DMA, you take things like emotion and intuition out of the game.

Additionally, we only recommend establishing positions in ETFs with $50 million or more in assets. This assures reasonable liquidity. We also recommend an 8% stop-loss on all positions, or else, selling when an ETF crosses below its 200-DMA. You can automate these types on conditional trading in most standard deep discount brokerage accounts meaning when you go away on vacation, or if you don't feel like constantly checking in on your portfolio, you can sleep easy knowing your downside is very limited. Ultimately, we don't want investors to be 'wed' to their portfolios.

JL: This sounds like a lot of trading and significant annual portfolio turnover, which is clearly opposed to the buy and hold crowd. In fact, Vanguard founder John Bogle's main concern with ETFs as opposed to mutual funds is the temptation to trade frequently, which his research shows consistently undercuts long-term gains. How do you respond to this sort of criticism?

TL: I have the utmost respect for [John] Bogle however in my opinion, he has one major flaw in his thinking: he underestimates the intelligence of the average retail investor while overestimating their emotional fortitude. ETFs combined with deep discount brokers make a more active, trend-following strategy more feasible to carry out than ever before. Bogle also discounts emotional pain of seeing a portfolio fall 50% leading many 'buy and hold' investors to actually dump their mutual funds at the worst possible time (something which we saw in late 2008/early 2009).

The 200-DMA, as opposed to the 50-DMA, isn't that fickle a metric. We find sticking to this strategy only leads to 100%-150% portfolio turnover in a given year. The 200-DMA isn't something that is breached too frequently.

JL: What advice do you have regarding the emotional aspects of investing, especially coming out of the current 'Great Recession' and widespread sell-off in stocks?

TL: Investor psychology is still extremely bruised with lots of investors still suffering from an economic hangover. However once things get euphoric and everyone becomes a bull, it's too late to start buying equities. The exit strategy we recommend of always having a stop-loss and following the 200-DMA is especially important with emotional investing.

JL: Do you apply the same trend-following strategies to short ETFs?

TL: We don't buy short ETFs in our money management division due to the nature of many of our clients. We want them to understand exactly what we're doing with their money at all times. When there's a widespread sell-off in equity ETFs, we seek out other asset classes such as bonds, currencies, etc. that are crossing above their 200-DMAs. But absolutely, you could carry out a trend-following with short ETFs. Leveraged and leveraged short funds are harder to do this with in any sort of long-term way due to compounding.

JL: Let's talk portfolio building specifics. Which areas of the market would you bet on for the next 5 years?

TL: Small caps and mid caps continue to outperform large caps despite the fact that most investors are overweight large caps. U.S. investors are also overallocated to U.S. equities. This means they're especially missing out on emerging markets which I expect to continue to outperform developed markets in the long-term.

In terms of ETFs, the iShares Russell 2,000 has significantly outperformed the S&P 500 SPDR (NYSEARCA:SPY) over the last 1, 5 and 10 year periods (+58.8% vs. -12.5%). I expect that story to continue going forward. For emerging markets, Vanguard's VWO and iShares' EEM both track the MSCI Emerging Market Index which gives you very broad emerging market exposure. VWO does so for a fraction of the price (0.27% vs. 0.72%) so I'd recommend that over EEM.

JL: How about alternative indexing strategies. You're on the board of Rydex - what about their equal weight funds?

TL: Equal weighting in funds like the Rydex S&P 500 Equal Weight ETF (NYSEARCA:RSP) are much better diversified in that they give larger weighting to smaller companies. These funds' outperformance can be understood through their greater weighting of smaller market cap companies than standard market weighted ETFs (Full Disclosure: Tom Lydon is a member of Rydex SGI's board).

JL: Which fixed income ETFs do you recommend in the current environment?

TL: Most U.S. Treasury ETFs are currently below their 200-DMAs. TIPS are the one exception to that. iShares Barclays TIPS Bond Fund (NYSEARCA:TIP), the largest of the TIPS ETFs, currently offers a 4% yield. Moving up the yield curve, iShares IBoxx $ Investment Grade Corporate Bond Fund (NYSEARCA:LQD) is currently paying out 5.37%. Moving over to high yield bonds ETFs, SPDR Barclays Capital High Yield Bond Fund (NYSEARCA:JNK) is paying a whopping 11% yield at the moment while managing to stay above its 200-DMA. We've had that in our portfolio for around three months now and we'll continue to hold it until it falls below its 200-DMA.

In general, we're utilizing higher yielding ETFs to provide income for investors that are closer to retirement, or are already there. It would be a disservice to our clients to buy long-term treasuries right now. There are much better yields out there for minimally more risk.

JL: How about commodity funds?

TL: It has been truly amazing watching the commodities boom, which has been largely due to emerging market growth. I think another factor is more and more investors have access to commodities markets - both physical and futures - via ETFs.

In terms of specific commodity plays, gold costs $275 on average to take out of ground, and is trading for $1150. With that profit margin, Miners are a better long-term bet than the spot metal which may not appreciate much in value from here. The SPDR S&P Metals and Mining ETF (NYSEARCA:XME) offers access to large cap international metal miners, both base and precious, as well as some energy plays. It's actually a diversified commodities producer play. That's what we're currently holding in the commodities space.

JL: If you could buy only one ETF right now with a long-term timeframe in mind, what would it be?

TL: You mean like 5-10 years?

JL: Sure.

TL: Vanguard Emerging Markets ETF (NYSEARCA:VWO). Sure, we'll see bumps in the road but the long term growth story for emerging markets will be there for a long time to come.

JL: What are your thoughts on some of the active ETFs coming out now? Does it makes sense for investors to still use mutual funds?

TL: We only use mutual funds in very rare cases at this point.

In terms of active fund managers and ETFs, what will ETFs from a company like T. Rowe Price (NASDAQ:TROW) look like in terms of transparency? How much time will they be given to succeed in the ETF space? These are unanswered questions. I'd stay away from actively managed ETFs for the most part until the answers to these questions become clearer.

JL: What advantage would actively managed ETFs have over mutual funds if they're not transparent on a daily basis?

TL: There are tax advantages for one thing. Also, they should be cheaper than active mutuals. In terms of active ETFs getting out there, there's a definite psychological barrier for the managers of active mutual funds to doing the same thing with ETFs and having to show their hand every day.

JL: Where are the price wars headed? Will this ultimately be good news for retail investors?

TL: ETF supermarkets (similar to mutual fund supermarkets, where you can enter and exit a variety of funds for free) are likely coming in the long-run - many funds will be commission free ultimately, especially with additional income from securities lending. The recent deal between Fidelity and iShares to offer 25 funds commission free is a great example of where things are headed.

JL: Thanks so much for taking the time to speak with me Tom. This has been extremely enlightening.

Disclosure: Tom Lydon is long VWO, JNK, LQD and XME in his client portfolios.