A Safe Simple Successful Etf Investment Strategy

Let’s get started by concentrating on the S&P 500 – it is intrinsically an index of the 500 largest companies in America. Indeed, it is more. Contrary to popular misconception, the S&P 500 is not a simple list of the largest 500 companies by market capitalization or by revenues.

Rather, it is 500 of the most widely held U.S.-based common stocks, chosen by the S&P Index Committee for market size, liquidity, and sector representation. “Leading companies in leading industries” is the guiding principal for S&P 500 inclusion. We are starting here to achieve safety and diversity.

If you use the S&P 500 as your investment base you won’t have to worry if the CEO has resigned, the CFO has just been indicted, the stock has missed its forecast or any number of things that make stock prices flagellate unsuspecting investors and traders.

You ask: How can you make money investing on the S&P 500?

Consider its graph, the white, bottom most curve on the chart. As you can see, the S&P 500 goes up and down similar to stocks and hasn’t done so well over the past 3 years.

Wouldn’t we do better with a mutual fund? [Actually, you’re getting warmer.]

According to the Motley Fool, “During the 1990s, the S&P 500 has provided an annualized return of 17.3%, compared with just 13.9% for the average diversified mutual fund.” Over the past 3 years only 10 mutual funds had more than a 12% total return [data through 6/4/2010 from 12,392 funds, Morningstar]. You can see that the S&P 500 has not done well, but you would have actually done worse using mutual funds.

Instead of considering mutual funds I’m going to restrict our consideration to just two ETFs, i.e., SSO and SDS. I said simple; this is simple.

We’re going to invest in SSO when the market is rising and SDS when it’s falling. Both SSO and SDS are based on the S&P 500. They track its traded index, SPX. [You have to trade SPX because the S&P 500 is an index that isn’t traded.] The SPX is among the most traded equities and is also one of the most liquid. As an investment it brings diversification.

SSO and SDS are mirrors of each other. Whenever SSO rises the SDS falls, and vice versa. This allows us to trade in rising and falling markets. Simply, pick the correct ETF.

These ETFs have one other unusual property. They move twice the speed of the SPX; they are leveraged 2 to 1. [Proshares has a number of similarly behaving ETFs. They are called Ultra ETFs.]

You said: This would be a safe investment strategy! These are leveraged! Isn’t it safer to invest in sound American stocks?

Rather than give a large list of recently failed stocks, I decided to find if there were any stocks among the current S&P 500 that I would like to have held over the past 3 years. Only 2 emerged, Family Dollar and Autozone. More than 15% of the S&P 500 had more than a 75% draw-down and an additional 35% had losses over 50% at some time during the 3 years. These statistics do not include companies like Enron and Lehman that are no longer included. If they were included these statistics would be much higher.

I don’t know about you, but I’m not much of a stock picker. I want something truly safe. If you are comfortable with your results trading stocks, don’t bother reading further.

What about investing in utilities?

When I began investing, my Dad told me that utilities were always a safe investment. They paid a good dividend that never went down. Their customer base is locked in. Their rates are determined by the states and these always increase. What could be safer?

During the last 3 years, Duke Energy fell over 40% from a high of 20.66 to a low of 12.39. Over the same period, the index of gas utilities had a high of 33.84 and a low of 20.11. Electric utilities fared worse falling from a high of 40.01 to a low of 20.85. Even utilities don’t look safe anymore.

From my point of view, it’s the story of the turtle and the hare. Stocks behave like the hare. You cannot predict in which direction they are going to run.

These two ETFs, SSO and SDS, in comparison are turtles; admittedly turtles with racing stripes. At this point we do not have anything more than a rough plan for investing in the S&P 500. This is not enough to qualify as an investment strategy.

We shall begin to upgrade this plan into a practical trading strategy. First, we need an unbiased indicator to determine on which ETF we should place our money, SSO or SDS. Any day, the majority of pundits on CNBC will tell you the market is going to rise. But on the same day, many of their pundits will provide reasons why it will fall. So, you cannot rely on them. Also, the Futures, prior to the Open, seem no more reliable for choosing either SSO or SDS.

After many years of trying, I developed a market timer that combines the market movement of the SPX with market sentiment. I call this the SPXTimer. There are many market timers available. I’ll let you be the judge which to choose.

They are invaluable for making a well guided decision about which ETF to select. Mine gives you three choices. When it’s bullish take SSO; bearish SDS and when it’s neutral stay in cash. What could be simpler?

The red curve, third from the top judging from the right hand side of the chart, shows the results of trading SSO and SDS from 9/12/2007 until 5/5/2010 only using the SPXTimer. $10,000 invested on 9/12/2007 grew to $13,737. Most investors and funds didn’t do that well over this difficult period.

I think you will agree, these results are not very good in terms of what you would hope to achieve. Look at the yellow oval in the middle the graph. During that interval of time, the investment fell from a high of $14,469 down to $11,158. That’s a big hit. We would like to sleep well at night; that fall would make sleep very difficult.

Sometimes these ETFs do not move in sync with the market timer. A little patience is required before charging into the market. I added a mild momentum constraint to the strategy to ensure the entry is in sync with the timer. The ETF’s momentum, not necessarily the price, is required to be rising over 2 days. [A service bureau provides me with this information.] Sometimes this constrains delays entry for several days.

The blue curve provides the results of adding this constraint. Here, based solely on the S&P 500, my market timer and an entry constraint, the $10,000 investment grew smoothly to 16,525. That’s over 20% per year! There were pull backs, but you could sleep soundly.

I was still concerned with giving back profits. After each big run-up in profit, it seemed there was a comparably big pull back. Many investment managers recommend adding to a position as it is rising in value.

I decided to try subtracting from the position size as the profit rises. If timed properly, this might reduce the amount of profit given back. Plus, it would reduce the risk while adding some of the profit to the bank. To do this, I decided to incorporate the following Money Management with the two strategies that were in place.

Say you started with $10,000. The idea is to keep the money at risk between $9,000 and $11,000 [+/- 10% of the initial investment].

Whenever your equity grows over $11,000 sell enough shares to withdraw $1,000. This should reduce your money at risk to under $11,000. The next time it appreciates over $11,000, do it again.

If, on the other hand, the investment falls below $9,000 add $1,000 worth to the ETF investment.

The results are remarkable. This investment, the yellow, top-most curve, grew to $17,780. That’s close to 30% annually; not bad for a turtle! The chart doesn’t show this statistic, but 75% of these trades were winners.

I repeated this test on three more broad based indexes: the Nasdaq 100, S&P Mid-Cap 400 and the Russell 2000 changing only the two ETFs. Each did better. The statistics of these investments, starting on 9/12/2007 with $10,000 and ending on 5/5/2010, are shown in the table below. All data is based on back-testing, not actual trades.

The basic plan: buy one of these ETFs when bullish and the inverse ETF when bearish, or stay out of the market in cash, is as simple as it can get. The SPXTimer brings order and safety to the investment because you know whether to buy the bullish ETF or the bearish ETF. The entry condition, combined with this money management strategy, will improve your investment results beyond what you might hope to achieve with stocks or mutual funds – with much less risk. Now isn’t that what you wanted all along?

You may be wondering about the choice of dates; particularly since on 5/6/2010 the Dow fell over 1000 points in less than a half hour. Many of these ETFs were first introduced in 2006 and 2007. As a result, data was not collected for the SPXTimer prior to mid 2007. The start date corresponded to the first change to a bullish signal. On 5/5/2010 the timer signaled a close for all bullish positions. Prices in the table reflect the Open of 5/6/2010.