The ETF ranking is an extension of our newly designed stock ranking system that ranks every stock based on its valuation, financial condition, and return on capital. Although the ranking system is fundamental based, it actually drives short term return. We observed that stocks with higher ranks had a strong tendency to outperform those with lower ranks over a period of one week. The data show that moving up 10 rank points translates to an extra annualized return of 1.7% in the past 10 years, if ranks range from 0 to 100.
However, traders can not immediately put to use the stock ranking system. Liquidity is an imminent issue. Sometimes highly ranked stocks are thinly traded. Traders with short term perspective do not have the luxury to spend days or even weeks to load or unload shares. Constructing a portfolio may reduce liquidity requirements on individual stocks. However, traders need to spend more effort to manage the portfolio.
Volatility is another daunting one. A big price swing is psychologically stressful and may push traders to make irrational decisions. A portfolio addresses this problem as well, but there is a better solution.
The solution is an ETF. An ETF is naturally diversified, thus it reduces volatility. Popular ETFs such as SPDR sector ETFs enjoy abundant liquidity, which also minimizes bid / ask spread. Sector ETFs are ideal trading vehicles.
Extending our fundamental ranking system to ETFs is straightforward. The rank of an ETF is the weighted average over the ranks of stocks in its portfolio. Although we don’t have historical data for ETF ranking, we believe it is effective because the ranking on individual stocks is effective.
Of the 9 SPDR sector ETFs, 3 are defensive (XLP, XLU, and XLV). The rest are offensive. A key difference traders want to be aware of is the beta. Beta measures how fast a stock or ETF moves in relation to the market, usually represented by the S & P 500 Index or its proxy SPY. Offensive stocks or ETFs typically have higher beta and move faster than the market. Defensive ones are on the opposite side. In a bull market, traders like to chase offensive ETFs because they rise faster than the market. In a bear market high beta ETFs are supposed to fall faster. Traders can still be offensive by shorting them.
We list this week’s ranks of offensive ETFs in the table below, together with their last week’s ranks.
Rank as of 4/30/11
Rank as of 4/23/11
Depending on a trader’s market view, we recommend three trading plans:
- Bullish: Long XLE, the one with the highest ranks. Although the ranking system is designed for one week return, traders can hold it for four to six weeks because the ranks of ETFs change slowly.
- Bearish: Short XLF, the one with the lowest rank.
- Neutral: Long XLE and short XLF for the same dollar amount.
We pick the last one mainly due to our neutral market view. Another noteworthy consideration is the spread between the ranks of XLE and XLF. At 69 - 24 = 45, the spread is fairly large. As mentioned before, 10 rank points translated to 1.7% annualized return. Hence, our expected annualized return is 1.7% x 45 / 10 = 7.7%. It may not sound exceptional, but do remember that this number is derived from the past 10 years. The S & P 500 returned merely an annualized 2.5% in that period. A 7.7% return is really more than 3 times of market return. That said, historical returns do not guarantee future performance.
If a trader happens to pick the neutral plan, he wants to watch closely the spread. The spread did shrink a little bit compared to that of the week before, which is at 71 - 23 = 48. Because the spread is proportional to the expected return, further shrink would be a warning sign.
Between Fundamentals and Short Term Returns
Graham’s famous saying on voting and weighing machines is well perceived and helps divide market players into two camps: traders who pursue short term returns and value investors who patiently wait for fundamentals to play out in the long run. Putting fundamentals together with short term returns may sound questionable considering the enormous contrast between the two camps.
But the market is a battle field that mingles all parties. Any factors cherished by either camp will have influence on price movement. It pays for traders to think like value investors, because more often than not, traders trade with value investors.
Value investors believe that fundamental quality is “fact”, and fact determines intrinsic value. Good investment opportunity presents itself when the fact is not recognized by the market. Usually, fact is expressed in a form that is obscure and not readily accessible to average market players. For example, the Shiller P/E, the average P/E over past 10 years, is broadly adopted by value investors. The 10 year average adds a layer of stability as it removes the impact of business cycles. But this ratio is not quoted in popular financial websites and the added stability is less likely to drive short term return.
Our trick is to design the fundamental ranking system not based on “fact”, but based on “behavior”. We try to understand and chase popular fundamental ratios in the mind of the market. Regular one year P/E is chosen over Shiller P/E because it is entrenched in the mind of almost every market player and it is quoted in almost every popular financial website. We believe popular ratios dominate in short term. Combining popularity with fundamentals may help us reach a delicate compromise between traders and value investors.
After careful evaluation, we selected the following components in our fundamental ranking system:
- Valuation. This is the most important component. Buying a quality company at wrong price is not a winning strategy.
- Financial condition. Traders pursuing short term return are willing to take more risk. The discipline is the risk has to be manageable. Companies with sound financial condition are less likely to go bankrupt or meet financial difficulties. Related news reports will dramatically weaken confidence, as well as share price.
- Return on capital. This component measures how much an investor earns on his investment. Traders may not care about it but value investors care a lot. Our research finds that return on capital contributes a nontrivial annualized return of more than 6%.
- No growth. This is not a typo. We removed growth from the ranking system because the data show that, surprisingly, growth contributes a negative return. Our theory is that chasing growth is an overly crowded game. Because of intensive research coverage, growth gets priced into shares well before it enters earning reports. Traders are too late to the game if buying shares based on growth numbers from earning reports.
Disclosure: I am long XLE.
Additional disclosure: I also short XLF.