Guidelines for ETF investing

The increasing popularity of exchange traded funds has led advisers to seek new ways of incorporating ETFs in client portfolios. Adviser Tom Lydon and personal finance writer John Wasik's new book, "iMoney: Profitable ETF Strategies for Every Investor," explains how this can be done. Below is an excerpt from their chapter on ETF portfolios. Before you do anything else, there is a basic strategy everyone should follow. It doesn't matter who you are or what your goals are or how much money you have — these strategies are the same across the board. The goals investors have often vary from person to person, but it can safely be said that everyone has one thing in common: They don't want to outlive their money. This is why strategy matters and why you should choose your plan of attack and stick by it. Here are some key guidelines: • Buy and hold. This is one of the most common strategies you will come across, and it works for most investors. It involves just that — buying and holding. If you choose this strategy, you should pay no mind to market swings on any given day. Your eyes are on the prize, and the prize is way in the future. You believe that, over time, the markets will go up. If you sit back and do nothing, regardless of how your portfolio holdings shift, then you are practicing a pure buy-and-hold strategy. Why go for the buy and hold? Warren Buffett is among many successful investors who favor the strategy. It costs less, and there are tax benefits involved because the [Internal Revenue Service] taxes long-term capital gains at a lower rate than short-term ones. You also won't be trading as much, which means fewer commissions and other fees. • Rebalance. The only changes, if any, to your buy-and-hold portfolio over time will generally be to rebalance. For example, if the stocks in your portfolio rise so much in value that they increase to 70% of the portfolio from 40%, you might do some moving around to bring everything back into proportion by selling some of the stocks or purchasing securities in other asset classes. This is known as active investing or tactical asset allocation. • Ignore the noise. If you can tune out the random static the market generates every day, you believe in Princeton economics professor Burton Malkiel's theory of the Random Walk, which basically says that the prices of securities are random and uninfluenced by anything that has happened in the past. For this reason, attempting to outperform the market is a fruitless task, so you might as well just sit still. Don't believe the hype. Ignore ads and testimonials that claim the potential for large profits from active trading. Those ads should have a "results not typical" disclaimer because the truth is that the profits could be few or nil, and it could all happen in the blink of an eye. • Remember that it is not when you buy, but what you buy. According to a 1986 study ("Determinants of Portfolio Performance" by Gary P. Brinson, L. Randolph Hood and Gilbert L. Beebower), 95% of the time it is not when you buy or sell, but what you buy or sell. Asset allocation decides how your portfolio will do over the long haul. Carl Delfeld, president of Chartwell Partners [Inc. of Colorado Springs, Colo.], suggests you take a different tack and divvy up your portfolio instead of dividing it up into various things, risking all of your assets. For example, have one portfolio for growth and one for core. The core portfolio is for the safer, low-risk investments and is the larger of the two. The growth portfolio is for the high-risk stuff: currencies, health care, high-tech, and emerging markets. Having two portfolios with different objectives will ensure that if you lose your shirt in one area, at least your entire portfolio won't go down with it. • If you want to be more active, have a discipline and stick to it. What if the buy-and-hold strategy is too tame for you? You crave action. You are itching to monitor the markets from the first thing in the morning until the last thing in the afternoon. You want to make trades. You want to buy new [exchange traded funds]. You want to be your own active manager? And why would you want to do that? Here are a few reasons: If you take an active role, you think you will be able to enhance your role even more over time. You might even be able to sleep better at night. You like trading. Some people love it. It is important to figure out why you are not in the buy-and-hold category of investor, if you [are] really looking to take charge of your portfolio. You need to be honest with yourself and be willing to put in the time and effort to get results. You need to do it because it gets your blood pumping. You live for this stuff. If you can't say that, then perhaps you should reconsider your motives and determine whether this is right for you. To be an active trader, you need to have a thorough knowledge of the securities markets, along with disciplined trading techniques. After all, you are going to be going head-to-head with professionals who do this for a living. They are well-trained and they know what they are doing. You will quickly be in over your head if you try to roll with them before you are ready.

DO YOU TRACK TRENDS?

Somewhere between the buy-and-hold strategy and active trading is trend following. It [is] the strategy Tom [Lydon] recommends for his clients and the basis of much discussion on ETF trends — watching for trends and setting stop losses to minimize the damage. Most important, we stick to our plan regardless of what happens. In the book "Trend Following" (Pearson Education Inc., 2006), author Michael Covel says that the objective is to have a clearly defined strategy. Mr. Covel pokes holes in the argument that the analysis and projections of Wall Street are the end-all and be-all of investing, and says instead that they [are] actually of very limited use to investors. His theory is that you can do best when you [are] in tune with a trend, and we subscribe to his way of thinking. Getting in tune is simple, and getting there involves adhering to a strict discipline. It means ignoring your intuition and your gut and instead following only what is right there in front of you. There [is] no anticipation of something going one way or the other. The only time you take action is when something is actually occurring. [Mr. Lydon's] firm's investment strategy uses the 200-day moving average as the basis for all of its decisions. If the price drops below the long-term trend line or dips to 8% off its recent highs, it [is] time to sell. It [is] time to get back in when things begin to show signs of a turnaround. When something is sold, the firm views the cash generated as a "free agent," meaning that it is free to be used for any investment for which a trend is developing. If no areas show an up trend or momentum at that time, the money stays in a money market fund. When you can't be in a winning position, the least you can do is minimize the hit your portfolio takes. You never know if it [is] a tiny, fixable leak or a sinking ship when the numbers tumble, and that [is] why it [is] best to bail out when you can — before you wind up dog-paddling in the middle of the ocean. Having a stop loss is just another way of saying, don't get sucked into the hype. Don't let the excitement that analysts and friends might feel about a particular stock sway you or keep you from making smart choices with your money. Be wise, and don't get caught up in a giant wave of possibly undeserved enthusiasm about a particular fund, or you could just wind up with a mouthful of seaweed. What do you do when things turn around? That means you [will] need an entry strategy, too. When something is sold, it [is] helpful to look at the cash generated as a free agent, whether it [is] in an asset class, a global region, or a market sector. If none of those areas is showing any particular momentum, hang on to the money in a money market fund until something turns around. What [is] a trend? A general rule is that if something has been happening in the markets for 20 uninterrupted days, you [have] got yourself a trend. Anything can cause the market to take a big spike up or a plummeting descent down on a particular day, and that in and of itself isn't the most troubling scenario. But if the numbers are heading lower and lower for a stretch of time, you [have] got a situation. History has already shown us, for example, that the Dow Jones Industrial Average moves in well-defined cycles. Over the last 110 years, there have been four bull markets and four bear markets. The stock market typically enters long periods of high returns, followed by long periods of lower ones. How do you know when a bear is a bear and when a bull is a bull? In a bull market, each successive high point is even higher than the one that came before it (higher highs offset by higher lows). The opposite occurs in a bear market — the trend drops and offsetting price levels do not rise above the previous high (lower lows offset by lower highs). Long-term trends actually stick around much longer than most investors realize. Think about it — how many times have you heard the financial pundits sound the alarm after a bad week in the markets? But a trend's establishment is never that simple. You don't trade based on long-term trends alone. It [is] more advisable to use them for guidance. For example, if the trend is up, the probability is that the odds will favor long trades and investments over short ones. Basing decisions on probabilities doesn't always work, but if you invest using them, over time you should be able to do well. If every day you calculate the general trend of a market, through either ETFs or a particular global region, why not simply allocate to those markets riding above their trend lines and steer clear of the ones that have fallen below? It [is] simple: 1. Allocate your assets to those areas that are above their trend lines. 2. Sell whatever positions fall below those trend lines or those that dip 8% off their highs, whatever comes first.

MOVING AVERAGE STRATEGY

When Tom worked at Fidelity Investments of Boston, one of his clients was Dick Fabian. Dick was a transplanted New Yorker who arrived in Southern California around the same time the Dodgers did. During 1973 and 1974, the Standard and Poor's 500 stock index declined 45%. Dick was a financial adviser at the time, and his clients suffered along with most Americans. He made a commitment to himself, his family and his clients to try to avoid ever reliving that experience. Dick spent weeks in the basement of the [California State University, Long Beach] Library, researching markets, trends and technical analysis, and concluded that the general trends of the market can be identified mathematically. His 39-week average indicator was the key trading indicator. He launched a newsletter in 1976 called Telephone Switch Newsletter. This was shortly after mutual fund companies allowed investors to switch within fund families from a growth fund to a money market or vice versa. The newsletter grew into one of the most popular mutual fund investment newsletters in the country during the 1980s and early 1990s. Dick always said there was a higher probability that investors would follow a plan if it was simple, and following a 39-week average over the decades has helped investors avoid bear markets and participate in bull markets. Today many active investors are comfortable identifying a 200-day moving average, a well-known indicator for identifying general trends in the marketplace. When the S&P 500 goes below its 200-day moving average, it will be talked about on CNBC and throughout the financial press as an indicator that there is weakness in the markets. That same 200-day moving average can be applied to all asset classes, sectors and global regions. The key is having the discipline to monitor the average and sticking to it consistently. Better yet, if you are an active trader, you have available a number of new ETF hedging tools.

200-DAY MOVING AVERAGE

Whatever strategy you choose, the most important thing is this: Be disciplined, have an exit strategy and set stop losses. If you say you are going to do X when Y happens, and Y does happen, follow through. Don't rationalize or get emotionally attached to your holdings. Even if you [have] invested in a scrappy little company that has done well before it falls on hard times, don't talk yourself out of following through with what you always said you would do just because you like the company. It is not personal — it is business, right? On the flip side of that, if you plan to hold for the long term and your investments suddenly take a big spill, stick to the plan. Don't suddenly fret, worry and sell everything. As you manage your portfolio, you might feel a need to always have a set amount of money designated for a certain area, whether it is India or large-caps or something else. In this case, hang on to the cash until that area moves above its 200-day moving average or gains 5% from its recent low. No matter what your plan is when it comes to investing or what your ultimate goals might be, do your best to keep your poker face at all times. When emotions enter the equation, it becomes nearly impossible to remain rational or objective. Tom Lydon is president of Global Trends Investments of Newport Beach, Calif., and John F. Wasik is a personal finance columnist for Bloomberg LP of New York. Reprinted with permission of the publisher from "iMoney: Profitable ETF Strategies for Every Investor" by Tom Lydon and John F. Wasik (Pearson Education Inc., 2008).