ETFs: Comparing The Incomparables, A Second Time

by: Peter F. Way, CFA


ETFs intentionally are constructed of stocks representing discrete industries, geographies, capitalization sizes, investment strategies, or of varying securities like currencies, commodities, or bonds, even concept and broad market indexes.

Is it possible to directly and fairly compare such a variety of investing activities, or must each orientation be pursued separately?

By reducing the investment decision-making process down to its essentials, it is possible, with the proper inputs, to treat every ETF on the same measurement scale.

At the same time, individual investor objectives and preferences can be applied to those essential dimensions, so that a wide variety of intentions and purposes can be met.

The catch is that some seriously erroneous investment thinking may need realignment and expansion, perhaps even discipline.

Money management service markets have been both seriously threatened and seriously helped by the advent of Exchange Traded Funds, or ETFs.

The Mutual Fund industry is confronted with an easy do-it-yourself alternative to their relatively ineffective active management efforts, widely publicized, of the bulk of its members. Further they are injured by the effect of their "management" fees on the investment returns to the benefit of clients in comparison to the more competitive ETF costs. In addition, the lack of any effective discipline on some of its members caught cheating their customers at large but remaining in business, raises questions for some investor-clients as to the moral standards of the entire mutual fund industry.

In combination with serious concerns over the banking and brokerage community as a result of the mortgage-backed securities frauds impact on the economy, the securities markets, and unemployment fallouts, many investors have come to realize the need to tend to their own investment needs quite differently from what they have been doing.

Some investors retain enough personal self confidence to confront this second (if they are lucky) job themselves, and find ETFs a major help in the process. Others turn to advisers with more personal, and often local, touch to client relations. Those money management professionals find that ETFs greatly lighten the apparent research load, and to the extent that clients believe they understand the instruments, so too is that dimension benefited.

How to choose between over 1500 ETFs

Strange how all those ETFs are needed if their purpose is to put many stocks or other securities in a bundle for the sake of diversification and ease of handling and record-keeping. It kind of reminds one when at the peak of its orgy, there were more Mutual Funds than there were stocks. And I am told that now there are approaching 100 ETPs (an ETP is a Product that may be legally not a ETFund, but an ETNote, the obligation of some financial organization - like a bank, perhaps of the type that used to have their own Mutual Funds) where a principal original advantage of the ETF is blithely destroyed.

That advantage is in knowing what is actually held by the ETP. Which is not difficult when its holdings contents are not being actively traded by the "sponsoring" organization, but instead are the relatively static published components of a widely-followed index.

Appraise an ETF's suitability for your portfolio by its performance, not by its label

There are relatively few investment missions for an individual investor's portfolio. They include 1) Income, 2) Emergency financial resources, and 3) Wealth-building for various purposes. Between these, only the Income mission may appear at odds with wealth building, and if harvesting capital gains for income purposes is an acceptable strategy, then wealth-building becomes, for most investors, a common overall objective.

Many investors look to categories of fund holdings as a means of judging an ETF's capacity for wealth building. That inevitably leads to economic judgments about longer term trend fundamental earnings growth where expectations of anything beyond +20% to +30% are extremely rare. Caught up in this kind of thinking is the buy-and-hold delusion, and attempting diversity of economic activities as a means of seeking diversification against risk.

Justification for such approaches usually is "that's the best that can be done.

But it's not.

Nearly every stock, and ETF, fluctuates in price every year from low to high, by amounts two to ten times its long-term-trend growth. Capturing only part of such positive moves, and avoiding the negatives greatly expands the rate of wealth building. Rejoinder: "But nobody can time those swings."

Wrong again.

Market-makers, whose high-paying job it is to help big-money-funds and institutions make volume changes in their portfolios, have to anticipate those swings day after day, to remain successfully employed, which they usually do. Supported by resource-rich information-gathering systems of skilled people and ultra-contemporary communications equipment utilizing decades-long world-wide contacts, they are arguably the best-informed players in this very serious game.

Their function requires them to put firm capital at risk temporarily in filling out the "other side of the trade" hundreds of times daily in market-making firm after firm. That demands protection against the losses possible, accomplished by hedging in alternative markets. What they will pay for such insurance and the way the deals are structured tells how far they think prices will range, both up and down.

The balance between upside and downside expectations can be indicative of near future price change. The Range Index tells what proportion of the forecast range is below the current market quote.

We then put those forecasts to a time-efficient sell-discipline test to indicate where their past judgments have been highly prescient - or not. The results of that standard test for all stocks and ETFs are a Win Odds (proportion of prior forecast producing a profit), the average size of % Payoff net gain or loss from all prior forecasts like today's, and the average number of market days of time that had to be invested to reach that payoff. An annual rate of net gain is thus calculated for comparison between alternative investment candidates.

Further, the discipline of limiting the holding period of any investment forces re-examination of alternative investment candidates and reinvestments at varied time intervals. This forces a diversification of investment entry and exits that is an additional important risk management dimension.

The credibility of the current upside price change prospect can be checked against what like forecasts have previously achieved as % Payoffs. Then the upside potential return is compared against the average worst-case price drawdown in a Reward-to-risk measure.

All that data is laid out here in the following table, covering the top ETFs whose prior like forecasts were profitable in at least 6 out of 8 (75% of their prior like forecasts).

Please note the top ten ETFs have some 900 prior experiences in the past 4-5 years where average annual rates of price gain averaged over 110%, following forecasts like those of this Friday. The typical holding periods were 34 market days allowing the same capital to be similarly productive more than 7 times a year. It is this kind of compounding that demolishes the rationale of buy and hold as an effective wealth-building strategy.

The best risk-to-reward ETF buy now is PowerShares QQQ (NASDAQ:QQQ) which tracks the Nasdaq 100 index, with prior drawdowns of only -2.2%, but has one third of its current forecast to the downside, or -4.7%, half of the upside.

Tracking the same index, but with a 3x leverage engineered into its track of price change, is ProShares UltraPro QQQ (NASDAQ:TQQQ). It offers a much larger rate of gain, and in effect a better reward-to-risk prospect than QQQ.

The Direxion Daily Mid Cap Bull 3x Shares (NYSEARCA:MIDU) offers a smaller upside, supported by prior like forecasts much larger, which had been accomplished in a day longer than one month, on average, to push its annual rate up into a 3-digit stratosphere.

ProShares Ultra QQQ (NYSEARCA:QLD) is simply the 2x leveraged version of TQQQ. Its presence reinforces the notion that the Nasdaq 100 index of AAPL and many other technology-intense issues appears oversold to the market-making community.

The smallest upside potential now is in the Vanguard Emerging Markets Stock Index ETF (NYSEARCA:VWO), at about the level of MIDU, but with a history of smaller worst-case price drawdowns - by as much as half. The average time investment of two months makes VWO one of the smaller potential producers in rate of reward achieved, still it is twice that of the market average proxy, SPDR S&P500 (NYSEARCA:SPY).

Two 3x leveraged small-cap stock index trackers, Direxion Daily Small Cap Bull 3x Shares (NYSEARCA:TNA) and ProShares UltraPro Russell 2000 (NYSEARCA:URTY) vie with one another at high return potential levels. TNA has a current-day forecast upside of nearly +18%, but prior performance from similar forecasts of only +14.3%. URTY offers a +10.4% upside, supported by priors of nearly +13%. Both have win records of 7 out of 8, but URTY has accomplished its target in time investments of only 27 market days, compared to TNA's requirement of 33 days. So URTY has gains at an annual rate well above 200%, while TNA's has been at about +180% -- neither being ignorable.

Direxion Daily's Financial Bull 3x Shares (NYSEARCA:FAS) rounds out the high return prospects, although at a drawdown risk exposure of -11% it approaches a stress level nearly equal to its +12.3% upside promise. That promise is nearly matched by prior gains of +11.8% in just a month and a half time commitment, for a past return rate of +140%.


These best ETF choices are significantly above the SPY market average representative with win odds of 90 out of 100 in comparison to 84 of 100. But it takes the thick skin and steady nerves of a leverage investor to tolerate the emotional stress of being confronted with immediate loss of -8% instead of SPY's -3%+ even though in most cases the threat turns out to be temporary. The reward of an annual rate of gain above +110% is what makes that tradeoff tolerable for many.

But not all ETFs are so magic. Investors need to do their own DD, since these good ones are buried among a dung heap of 354 that, despite the jewels, produces prior average returns at a miserable +9% annual rate, and even under a highly productive portfolio risk management discipline wins only slightly more that 2 out of 3 commitments.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.