• Exchange-Traded Funds
  • Using ETFs in a Tough, Sideways-to-Bear Market

    by Max Isaacman

    The past 10 to 12 years have been difficult for stock market investors, with high volatility making it risky to buy and hold stocks and exchange-traded funds (ETFs).

    This has forced long-term investors to become traders and to use securities they never thought they would, such as inverse and enhanced ETFs. This volatile, sideways market could continue for several more years. Investors and traders have to use the volatility to make money, while attempting to limit losses.

    In my book “Winning with ETF Strategies” (FT Press/Minyanville Media, 2012), I point out that you should determine at what point in a cycle the market is currently and where it might be heading. Markets move in cycles, which take years to complete. In my book there is research by Guggenheim Investments showing that over the past 113 years, there were more bear market years than bull market years. Bull markets lasted an average of 10 years, and bear markets lasted an average of 18 years. The bear years were more similar to sideways markets than big down markets.

    Since there are usually more bear market years than bull market years, you have to get the best return you can during bear market years. Instead of using broad-based ETFs, you might use specialized ETFs such as sector ETFs, foreign country ETFs, non-stock-market-correlated ETFs, inverse ETFs (which enable you to short the market), and enhanced ETFs (which enable you to leverage a position).

    You have to be careful with inverse and enhanced ETFs, however, understanding how they work before using them. These are effective and useful trading securities that pretty much do what they are structured to do, which is to give a percentage return over a given period of time, such as a single day. However, there is a compounding factor when enhanced funds are held longer than their given time. There is much information about how traders and investors did not understand the compounding effect and how it affected their returns, which were different than the anticipated returns.

    Studies show that asset-class exposure is the most important determinant in how a portfolio will perform. You have to determine the exposure that will give you the best performance and the amount of risk you can assume, both financially and emotionally. Once you are clear on this, you can look for appropriate securities. ETFs are the most effective securities, but there are many to choose from. For instance, you might have to decide between buying a large-cap weighted ETF versus a small- or mid-cap ETF. Or perhaps you may want to buy an equal-weighted ETF, or buy gold or short gold, or short a precious metals ETF.

    Ways to Pick ETFs

    Once you determine your objectives and risk profile (and you may want professional help since it is often hard to determine your own status and predispositions), there are a couple of ways to decide which ETFs to buy for asset-class exposure or to short asset classes.

    One way is to pick the desired asset class or classes in which you want exposure, and then choose the ETF to invest in. For instance, you can buy emerging markets at 10 to 12 times earnings, which are low multiples for this asset class. Some emerging market ETFs also have good dividends. If you want emerging markets exposure, you can go to a number of financial sites to research the ETFs. Some of the emerging market ETFs that look attractive to me are RevenueShares ADR (RTR), WisdomTree Emerging Markets SmallCap Dividend DGS, WisdomTree Emerging Markets Equity Income (DEM), iShares MSCI Emerging Markets Index (EEM), PowerShares FTSE RAFI Emerging Markets (PXH), and WisdomTree India Earnings (EPI).

    Another way is to find an ETF that has the strategy you like and that you think will perform well. For instance, the Guggenheim Insider Sentiment ETF (NFO) is modeled to include companies that are having their stock actively bought back by the company’s management. A secondary feature is that it includes companies that have strong earnings prospects. The style allocation is mid-cap growth, which is a category that has been performing well. When you find an ETF with a strategy that you like, check its chart to see how it has performed relative to other ETFs in its asset class.

    Ways to Weight ETFs

    After an investor decides what asset class he wants, he has to decide how to get exposure. For example, say an individual likes the energy sector. He could research individual stocks, which is difficult and can have large risks, or he could choose to invest in an ETF or several ETFs.

    A cap-weighted ETF, such as Energy Select Sector SPDR (XLE) would give him exposure to the bigger companies in the sector, and at times this is advantageous. But there is the risk with the biggest companies that their stock prices have already gone up. These companies therefore might have the biggest decline in a market correction.

    An equal-weighted energy ETF would not have the heavy concentration of bigger stocks in the index, but it also might not have the upside bias that a cap-weighted ETF sometimes has. An investor could buy a small-cap energy ETF, such as PowerShares S&P SmallCap Energy (PSCE) and get exposure to the smaller, probably faster-growing companies in this sector. But the small-cap energy ETF will be much different in composition than the big-cap energy ETF: For instance, XLE has about 17% in equipment and services companies, whereas PSCE has about 52% in equipment and services companies.

    There are many ways to weight indexes, including capitalization weighting, fundamental weighting, revenue weighting and equal weighting, among others. Each has advantages and disadvantages. It behooves the individual investor to understand the differences so that he can make an investment decision that reflects how he sees the market.

    The Upcoming Cycle

    Stocks usually outperform bonds, and a Guggenheim study referenced in my book showed that in the last 50 years stocks outperformed bonds in each 10-year interval, except for the last decade, the 2000–2009 period. In that decade, bonds outperformed stocks. In fact, almost all investments, including gold, silver, oil and even Treasuries—both bonds and bills—outperformed stocks.

    All asset classes have cycles. It is rare to have an asset class underperform for long, and 10 years is a long time. Many people have given up on the stock market. When people give up on an asset class, that is usually when it is selling at its cheapest. Currently, stock valuations are low, the interest in stocks is not there, and people have poured their money into bond funds. This is understandable, given the two market declines over the last 12 years and the haunting memory of the Lehman Brothers meltdown. That scare will continue, leading people to avoid the stock market and its high volatility. But history suggests that this decade should end with stocks outperforming bonds.

    If you stayed in bear markets in the past, you would have lost a little money, but bull markets have always returned. Unless the U.S. is in a long-term irreversible decline (and while there are those who think this, I am not one of them), history will repeat and there will be a bull market. The U.S. is a major player in the global economy and should continue to grow no matter how global economic interconnections develop.

    Take Information From the Pros

    In “Winning with ETF Strategies,” I wrote about what some of the brightest, hardest-working, and most passionate managers on The Street are doing and the thought processes and models that lead them to buy and sell different asset classes at different times. The thread running through my book is that the managers devise and stick to an investment plan: Their models are constructed so that they do not run after a hot stock of the day, and they don’t panic and sell when markets go down or rush into markets that are running up. The managers are people, like you and me. Down markets bother and worry them, and up markets make them feel better—but worry is never far away. We are all affected by what the markets are doing.

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    ETFs are effective tools for converting strategies into action and attempting to achieve your objectives. You have to clarify, as best you can, what your objectives are, however. The more you know your objectives, the better you can identify what you are trying to accomplish in the markets; the more you understand how much risk you can stand, financially and emotionally, the better investments you will probably make.

    Managers buy and sell asset-class securities according to their investment models. Clients of those managers should be comfortable with and understand the risk the managers are taking. This is possible only to the extent that the client understands his risk profile.

    Individual investors would find it difficult to clone a strategy used by an investment manager because individuals don’t have the infrastructure needed to build and operate esoteric timing and valuation models. But an individual investor can understand that managers use processes that keep them from jumping in and out of markets at inopportune times.

    Valuations are now low in the stock market. Few investors want to buy stocks, which makes it a good time to buy them. Some of the ETFs that I think look reasonably valued are PowerShares QQQ (QQQ), First Trust NASDAQ-100 Equal Weight Index (QQEW), iShares S&P SmallCap 600 Index (IJR), RevenueShares Small Cap (RWJ), iShares MSCI Emerging Markets Index (EEM), Guggenheim Insider Sentiment (NFO), PowerShares FTSE RAFI US 1500 Small-Mid (PRFZ), Guggenheim S&P 500 Equal Weight (RSP), iShares S&P SmallCap 600 Index (IJR), and PowerShares S&P 500 High Beta (SPHB).

    RWJ is among the revenue-weighted ETFs offered. I think it is worthwhile to look at the revenue-weighted ETFs and understand how they work. Vincent T. Lowry, the CEO of VTL Associates, explains the methodology behind them in the next section.

    One Manager’s Approach

    Vincent Lowry established VTL with the goal of providing clients with a full range of investment consulting services and innovative solutions. He believes that creating the optimal asset allocation structure for a client’s portfolio from the beginning of the relationship is a critical step in the investment management process. VTL uses revenue weighting in its ETFs because it believes that revenue is the most fundamental of the fundamental factors.

    VTL’s RevenueShares ETFs are based on well-known indexes, such as the S&P 500 index and the S&P MidCap 400 index. The difference is that instead of using S&P’s market-cap weighting, the relative proportions of holdings in the indexes are based on each company’s top-line revenue. Through its studies, VTL Associates has come to the conclusion that revenue-weighted indexes will produce higher returns than cap-weighted indexes over time and will also have a slightly lower beta. VTL points out that its weighting does have a bias in favor of low-margin industries, which is a negative during the initial stages of an economic slowdown, but this negative is offset by other advantages.

    VTL Associates ETFs include RevenueShares Large Cap (RWL), RevenueShares Mid Cap (RWK), RevenueShares Small Cap (RWJ), RevenueShares ADR (RTR), RevenueShares Financial Sector (RWW), and RevenueShares Navellier Overall A-100 (RWV).

    Sticking With a Long-Term Strategy

    “My career of over 30 years has been in asset allocation modeling, primarily for institutions but individuals as well, and I’ve become a behavioral finance believer. And I’m convinced that the individual investor has got to stay with a long-term asset allocation strategy, and not react to market fluctuations,” Lowry says.

    Lowry points out that this is the third year in a row that hysteria has been created in the May–June time frame over economic problems and potential defaults of the banks, both in Europe and the U.S. This caused people to sell. “A lot of people have moved out of markets,” Lowry says. “For the most part, those who have moved out did it at the wrong time, and this has not worked out for them.” He says that even those who stayed in the markets since 2005 or 2006 have done much better than those who tried to time the market by getting out during extreme conditions, such as when the markets are getting hit.

    Immunizing Against Risk

    Lowry says an individual investor should take a look at what he needs for living expenses over the next four to seven years and “immunize” that amount against risk, meaning put that amount in bonds or fixed-income investments.

    Lowry says that some of the fixed-income portion could go into the PIMCO Total Return ETF (BOND). He also likes fixed-income ETFs iShares Barclays 1-3 Year Treasury Bond (SHY) and iShares Barclays 1-3 Year Credit Bond (CSJ).

    Portfolio dollars not used for immunization should be committed to global asset allocation, in a strategy that the investor has thought out well and feels comfortable with.

    Revenue Weighting

    “We consider the revenue and the sales number as almost the same number,” Lowry says. “It is the top-line number, which, for the most part, is not subject to a lot of the accounting changes that occur across industries as pertaining to the income statement.” There are some companies that have a lot of write-offs and deprecation charges, and these companies should not be compared with companies that do not have these charges, which vary from industry to industry, according to Lowry. Once you go below the revenue/sales number, comparing companies with many charges and those with few charges is like comparing apples and oranges.

    He says, “Our goal is to use known indexes, where the index provider has an institutional history of assembling an array of stocks that best represent what the index should accomplish.” Lowry says that the S&P 500 has done a great job: Since its inception, it has outperformed about 80% to 85% of the active managers in the big-cap space. He says, “The only way to change the weighting of those stocks from cap weighting, and to own them all, is to weight them through their revenue number. Once you use any other fundamental factor to weight the index, it gets difficult. Not every company has net revenues, or dividends, or significant book value. But everybody has a revenue sales number.”

    Using revenue weighting maintains the breadth of the index, Lowry says, because all the stocks are represented. He feels this contributes to the good performances of the ReveneShares ETFs. In his view, in the long term the stock market is a weighting machine and in the short term it is a voting machine. So by keeping the portfolio weightings close to the revenue number, which is an economic variable, Lowry thinks you can prevent an investor from unwittingly being overweighted in overpriced stocks. Continuous re-weighting based on revenue keeps investors out of the high-priced and overpriced stocks and keeps them invested in next year’s upside surprises.

    Lowry has found that “the small-cap and mid-cap (stocks) do even better than the large-cap (stocks), when revenue weighted. Our studies include a lot of data about the S&P indexes. By revenue-weighting the S&P MidCap 400 and SmallCap 600, the numbers are more staggering.” As an experiment, his team revenue-weighted the emerging markets in China, South America and other foreign markets, and found that revenue weighting has added performance value in every index.

    He thinks the reason for this is that when you get into small- and mid-cap companies, as well as foreign companies, there is greater unpredictability of company revenues and other fundamental factors. Having revenue weight, which gives discipline to the overall index weight, adds even more value.

    Disclosure: At the time this article was written, Max Isaacman and/or his clients owned ETFs with the symbols DGS, DEM, EEM, PXH, EPI QQQ, QQEW, IJR, RWJ, NFO, RSP, IJR, SPHB and PSCE.

    What an Investor Can Do Today

    Determine how much money you need for living expenses over a period of time, how much risk you want to take, and how much money you can invest. Everybody has different financial needs and investment comfort levels. Money put into bonds and stocks is capital at risk, with no guarantee that the principal will be returned. Also determine when you want the investment dollars available for withdrawal, so that you have an investment time horizon.

    This could be a good time to invest. A study in my book showed that in the last 50 years, stocks outperformed bonds in each 10-year interval except for the last decade, the 2000–2009 period. History suggests that the current decade should end with stocks performing well against other asset classes. With market valuations low and interest rates very low, stocks look like a good investment.

    Investing in companies mostly engaged in the U.S. economy could be a good strategy. You can do this through investing in small-cap stocks, which over longer periods of time have often outperformed large-cap stocks. Small caps are often considered to have more risk than large caps, so you must determine how much exposure you want. You should also determine the type of weighting strategy you prefer, as RevenueShares Small Cap (RWJ), iShares S&P SmallCap 600 (IJR), and PowerShares FTSE RAFI US 1500 Small-Mid (PRF)Z have different portfolio construction methodologies. You could invest in small-cap sector ETFs. The best earnings gains in the small-cap space, according to S&P Captial IQ, will occur in the energy, financials and materials sectors.

    You may also want to consider emerging market countries such as China and India, which have relatively good growth rates and are selling at the lowest multiples they have sold at for years. Investors who want this exposure plus dividend income could consider dividend-weighted ETFs such as WisdomTree Emerging Markets SmallCap Dividend (DGS) and WisdomTree Emerging Markets Equity Income (DEM).

    —Max Isaacman

    Max Isaacman is a registered investment adviser in San Francisco. His book “Winning with ETF Strategies” was published by FT Press/Minyanville Media in 2012.


    V Parachini from CA posted over 4 years ago:

    Why no mention or use of any of Vanguard's various ETF offerings? In most cases the lowest fees available and for Flagship clients no commissions. Results in most cases are competitive on a lifetime basis.

    H Mc allister from AR posted over 4 years ago:

    An excellent article, but the individual still has to determinr what his overall objectives are and which ETF's are most appropriate. This article should be read and reread.

    Joe Petti from CT posted over 4 years ago:

    Great Article!
    I wish you could list all of the ETF's in a separate column so that I can copy them and paste them directly into my trading software .

    Thomas Clasen from Virginia posted over 4 years ago:

    Some good specific suggestions of ETFs for specific purposes. Discussion of Vanguard ETFs would be useful

    G. ed Connett from CA posted over 4 years ago:


    Charles Rotblut from IL posted over 4 years ago:


    Real estate ETFs are included in the annual ETF guide, which is also in the August issue. They are also discussed in the September Journal, which will we have up soon.


    Leonard Lofrisco from NY posted over 3 years ago:

    Why no model portfolio for ETF's? You have one from Mutual Funds and Shadow Stocks.

    Charles Rotblut from IL posted over 3 years ago:

    Leonard, the Model Fund portfolio holds both ETFs and mutual funds.


    Karl Reseck from CA posted over 3 years ago:

    Have you considered SYLD, the Cambria Shareholder Yield ETF?

    Russell Chevrette from OR posted over 3 years ago:

    Max Isaacman cites a Guggenheim study that states bear markets last, on average, about 18 years. But Mark Hulbert, in an article entitled Bear Markets by the Numbers, states "The average bear market since 1900 has lasted 410 days, according to calculations conducted by Ned Davis Research." (By comparison, Guggenheim looked at the last 50 years.)
    So why the difference? Perhaps the time period examined? Perhaps different definitions of what constitutes a bear market? You can't tell from these soundbite articles. One can write an article that produces anxiety, while another can produce Stoic resolve. Unless the fundamental assumptions are defined and clarified and defended, I can't help but be skeptical about any conclusions derived from them.

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