In the February 2011 CI Online Exclusive, we introduced Leslie Masonson’s Stock Market Dashboard approach, which he discusses in his book “Buy—Don’t Hold” (FT Press, 2010). Masonson uses this dashboard, which is composed of eight indicators, to determine the future direction the market. Why is this important? According to research he cites, as much as 70% of an individual stock’s return is a result of the overall market trend. Masonson believes that his dashboard removes the guesswork from trying to predict where the market is headed. The February article can be accessed in the Online Exclusive archives at www.computerizedinvesting.com.

Beyond gauging the market’s trend, Masonson’s book also outlines his methodology for selecting individual investments—when the Stock Market Dashboard indicates that the overall market trend is favorable. He uses relative strength analysis (RSA) to choose exchange-traded funds (ETFs) from a diversified ETF universe. In this article we describe his methodology for selecting ETFs.

Relative Strength Analysis

In the context of this discussion, relative strength pertains to the price performance of a security—such as a stock or ETF—compared to that of an index such as the S&P 500. (An alternative measure called the relative strength index gauges internal price strength and is the focus of this issue’s Technically Speaking column beginning on page 30.)

Masonson cites a wealth of research indicating that relative strength analysis can be used profitably to select investments. Based on research that seems to show that price momentum—or a lack thereof—can continue over weeks and even months, Masonson concluded that a profitable investment strategy would be to buy securities ranked highest by their relative price strength and hold them until their ranking falls to some pre-determined level. At that point, he would sell the securities and replace them with the current top-ranked securities.

Relative strength analysis compares the price performance of a stock to that of an index over a specific period of time—four weeks, 12 weeks, 26 weeks, 52 weeks, etc. The most basic calculation of relative strength is to divide the percentage price change of a security over some time period by the percentage change of a market index over the same period.

If you wanted to calculate the 26-week relative strength of a stock using the S&P 500 as the benchmark index, the calculation would be as follows:

(((Current Stock Price ÷ Stock Price 26 weeks ago) ÷ (Current S&P 500 Price ÷ S&P 500 Price 26 weeks ago)) -1) × 100

Stocks are then ranked from best performing (highest relative strength) to worst performing (lowest relative strength).

Studies have shown that ranking stocks based on price performance over periods less than one month or longer than 12 months does not yield profitable results. Masonson splits the difference and uses six-month (26-week) relative strength in his analysis.

Relative Strength & ETFs

Masonson uses exchange-traded funds for his investing, and throughout his book “Buy—Don’t Hold” he espouses the virtues of ETFs. He mentions several benefits ETFs hold over traditional mutual funds:

• Transparency—cash and stock holdings are available for all to see;
• Liquidity—ETFs can be sold throughout the trading day using market, limit and stop orders;
• Low expense ratio—Annual expense ratios are usually much lower for ETFs than mutual funds;
• No 12b-1 fees—ETFs do not usually charge marketing fees, and if they do they are capped at 0.07%;
• Tax efficiency—ETFs have minimal transactions or portfolio turnover so there are minimal capital gains distributions;
• Passive management—ETFs have minimal portfolio management fees because index funds rarely need changes; and
• Good performance—Lower fees lead to better performance relative to actively managed mutual funds.

Masonson also prefers passive (index) investing over active because the majority of actively managed mutual funds underperform the market. A Standard & Poor’s study shows that, between 2003 and 2008, 70% of large-cap mutual fund managers underperformed their benchmark. Even more telling is a study from Professors Eugene Fama and Kenneth French: Of the 3,156 equity mutual funds they studied between January 1984 and September 2006, except for the top 3% of all funds, active managers’ results were less than what would have been generated by pure chance.

ETFs by Category

With more than 1,000 ETFs to choose from, the ETF universe can be overwhelming. To help simplify the selection process, Masonson focuses on “popular, widely traded and representative ETFs” to arrive at a more limited universe of 66. He breaks them down into categories as shown in Table 1.

Masonson begins his selection process by first ranking the ETFs within the five categories using six-month relative strength. He also ranks all 66 ETFs as one universe.

For comparison, Masonson also looks at two additional sets of ETFs to get a “top-down” picture of the top-ranked exchange-traded funds, three benchmark ETFs and five inverse ETFs.

The benchmarks he uses are:

•  PowerShares NASDAQ 100 (QQQQ);
•  SPDR S&P 500 (SPY); and
• Vanguard Total Stock Market ETF (VTI)

An inverse exchange-traded fund is designed to perform as the inverse of whatever index or benchmark it is designed to track. This means that an inverse fund rises when the index it is tracking falls, and vice versa. The inverse funds he uses are:

•  ProShares Short Financials (SEF);
• ProShares Short MSCI EAFE (EFZ);
• ProShares Short MSCI Emerging Markets (EUM);
• ProShares Short NASDAQ 100 (PSQ); and
• ProShares Short S&P500 (SH).

When inverse funds, along with bonds and gold, start to rise in ranking, Masonson sees this as an early warning that the current market uptrend is coming to an end, even if the dashboard has yet to signal a trend reversal.

ETF Selection Strategies

Before you buy an ETF using Masonson’s strategy, you must first decide whether the market is in an uptrend. This is where Masonson’s Stock Market Dashboard comes in. Masonson is only in the market when the dashboard indicates the market is in an uptrend. See the February 2011 CI Online Exclusive for information on how to implement Masonson’s Stock Market Dashboard.

In addition, Masonson also consults an ETF’s two-year price chart with the 50-day moving average and MACD indicator (moving average convergence/divergence, a momentum indicator) before buying. Again, he wants to make sure the ETF is in an uptrend. An ETF can be ranked highly based on relative strength even when its price is falling. The February 2011 CI Online Exclusive also provides sources for these charts.

Risk Considerations

Before you begin investing in ETFs, it is important to consider your risk tolerance. This will help you determine your allocation between equities and bonds.

Masonson also points out that retirement accounts and regular investment accounts have different considerations due to factors such as their time frame and the impact of capital gains and losses.

To help guide you, Masonson offers several sample allocations for different investor profiles (Table 2). These include percentage allocations for each of the five ETF categories he uses, as well as the number of ETFs in which to invest, assuming his recommended size of 15 ETFs in the portfolio.

Strategy #1: By Category

The first strategy Masonson suggests for investing in ETFs is to rank the ETFS in each of his five categories, and then select the top ETFs in each category.

Based on a 15-ETF portfolio, he suggests the following allocations:

• Style: top two to four ETFs;
• Sector: top two to four ETFs;
• International/Country: top four to six ETFs;
• Fixed income: top two to four ETFs; and
• Specialty: top one or two ETFs.

The number of ETFs you choose from each category will depend on your investor (risk) profile.

Strategy #2: Entire Universe

A more aggressive approach is to rank Masonson’s 66-ETF universe as a whole and select the top 15 ETFs. However, this can lead to a concentrated portfolio—for example, in international ETFs. While he feels that this strategy will likely be more profitable than the first strategy, he also warns that it carries with it higher risk and volatility. For this reason, Masonson suggests this approach only for aggressive and disciplined investors.

ETFScreen.com

To help rank the ETF universe, Masonson suggests a few different websites, one of which is ETFScreen.com. This free site offers ETF price performance and relative strength rankings by fund family, style, country, industry or sector. With the site you can rank ETFs based on price performance over varying time periods and by relative strength over approximately the last six months. Furthermore, the site has a section devoted to those following Masonson’s strategy (Figure 1). Here you will find listings for his five ETF categories—style, sector, international, fixed income and specialty—saving you from having to manually enter the listings for each category.

Figure 1 is the performance matrix for the Morningstar-style ETFs, ranked in descending order by six-month relative strength (column titled RSf) through the close on Friday, February 18, 2011. Over the last six months, the iShares Morningstar Small Growth ETF (JKK) has had the strongest relative strength at 89.36. This means it has outperformed over 89% of its universe over the last six months. At the bottom of the category is the iShares Morningstar Large Core Index Fund (JKD), which has outperformed only 49.3% of its universe over the last six months.

If you were choosing ETFs based on Masonson’s ETF categories, you would choose the top two to four ETFs from this listing, depending on your risk profile. You would repeat this process for the other four ETF categories.

Also, at the bottom of Figure 1 is a table showing the trend in relative strength over the last 13 weeks for each ETF. Ideally, we would like to see the relative strength of the top ETFs in the five categories rising over time.

Figure 2 shows the page listing the entire composite ETF universe that Masonson follows, plus benchmarks and inverse funds, again ranked in descending order by relative strength. The figure shows the top 15 ETFs, as well as the PowerShares QQQ index ETF (QQQQ), one of the benchmarks Masonson follows. If you are a more aggressive investor, you might select these top 15 ETFs instead of choosing the top ETFs from each of the five categories.

As of February 18, 2011, this would give you the following breakdown among the five categories (assuming a 15-ETF portfolio):

• Style: five ETFs;
• Sector: four ETFs;
• International/Country: three ETFs;
• Fixed income: zero ETFs; and
• Specialty: three ETFs.

When to Sell

After you have built your ETF portfolio, Masonson recommends monitoring it on a weekly basis to see if the ranking of any of your holdings has fallen. If any ETF has fallen to the lower half of its category, based on the latest six-month performance, it should be sold and the highest-ranked ETF that you do not already hold should be purchased with the proceeds.

If you select ETFs by category, here are the ranking positions Masonson uses to decide if an ETF should be sold:

• Style: fifth-ranked or lower;
• Sector: fifth-ranked or lower;
• International/Country: 17th-ranked or lower;
• Fixed income: sixth-ranked or lower; and
• Specialty: fourth-ranked or lower.

If you rank the entire ETF universe and select the top ETFs from this composite, you would sell an ETF if it fell to the 34th position or lower out of the 66-ETF universe. Again, you would then replace it with an ETF you do not currently own that is now ranked the highest from the composite universe.

Conclusion

Masonson uses relative strength analysis to help him invest in a limited ETF universe. For investors who don’t wish to invest in individual stocks, ETFs offer instant diversification just like traditional mutual funds, but with the added advantages of lower costs, liquidity and transparency.

Using free online tools such as ETFScreen.com, individual investors can rank the ETF universe to identify ETFs with the strongest relative price performance and then create a portfolio to match their risk tolerance.