ETF Country Plus Strategy Insights: ETFs

James Kimball | March 9, 2015

The Basic model took another hit this week.  It was a tag-team effort from FXI and TMF.  The selloff in FXI was severe enough for the model to issue a change. On Monday, we will be selling FXI and buying EWJ (Japan).

The market had a big selloff on Friday, which came on the heels of a robust jobs report. The conventional wisdom is that the strength in the jobs market will put increased pressure on the FED to finally raise rates, possibly as soon as June..

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This Week’s Strategy Lesson: ETFs
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TAN, the Guggenheim Solar ETF has been hotter than the sun recently up over 30% from its January lows. On Friday, the ETF Complete model rotated into this position based on its improved TSI ranking. But such a large quick move led us to start asking some questions. And some of those questions bring us to the very core of the instruments we are trading.

Exchange Traded Funds

ETF’s had their genesis in the early 1990’s. Financial markets were quite different then than they are now. Transaction costs were high. Trade execution was slow. You had to be a big player to cost-effectively diversify your portfolio or make sophisticated multi-stock or sector-based trades. This was a world ruled by Mutual Funds—expensive and opaque.

Then along came the SPDR (S&P 500 Depository Receipt). The first of its kind, it allowed an investor to mirror the holdings of the S&P500 index without having to buy an appropriate weighting of each of the 500 component stocks (an expensive and impractical proposition for a smaller investor). And all this for a management fee substantially lower than those charged in the Mutual Fund business.

ETFs work by first defining an objective. This can be trying to track the movements of all the stocks in an index or focusing on one trading idea, like Technology stocks or tracking a foreign Countries markets. Then the managers buy an appropriate amount stocks, commodities, futures, or ADRs of foreign companies to try and achieve its stated objectives and roll all these holdings into a trading instrument that can be easily traded.

There are a few unique benefits to ETFs:

  1. Lower costs. Due to economies of scale and the more automatic nature of managing an ETF, they typically have substantially lower costs than equivalent Mutual Funds. A savings of 1-2% on fees each year adds up through compounding over longer periods of time.
  2. Easy Diversification. Modern ETFs allow you to buy exposure to whole sectors, countries, indexes, or even specialize in emerging themes, like the growth in social media, cloud computing, or clean energy. There is no need to research individual companies or take on single-stock risk.
  3. Trade Execution Flexibility. Since ETFs trade just like stocks you can buy and sell them throughout the day, go long and short, and employ more advanced trading tools than Mutual Funds which can only be purchased at the end of the trading day.

Issues with ETFs:

  1. Tracking Error. ETFs are designed to mirror the exposure to a set of assets. For some asset classes, like the S&P500, this is a complicated but doable task. For other classes, like those involving futures, commodities, foreign currencies or holdings, or leveraged and inverse funds, providing a perfect mirror of their objective goal can be difficult. As always, the simpler the objective and the more liquid the underlying instruments are, the smaller the tracking error will be.
  2. Liquidity. There are a handful of extremely liquid ETFs and more and more are being traded every day. But it remains the case that there are hundreds and even thousands of new ETFs that never gain the interest of the public and languish or die with no trading volume. As such, it is always important to look for volume or to use ETFs from reputable, larger ETF issuers.

Guggenheim Solar ETF

Which brings us back to the ETF that spurred this conversation. TAN, the Goggenheim Solar ETF attempts to track the MAC Solar Index, which has been around since March 2008. Solar energy, while still an expensive emerging technology, has the promising possibility of replacing a large amount of our old pollution-intensive energy needs with a clean alternative. It will require vast improvements in efficiency before this dream is realized—but there are a number of innovative companies that are trying to take us there.

A lot of the innovation is happening in China. China remains controversial from an investment perspective. There is significantly less transparency. Regulations and oversight is lackluster compared to U.S. markets. And concerns about government corruption and “cooked” books remains common.

Hanergy Thin Film Power Group surged up over 50% in the last couple weeks. This was caused by the company releasing a much improved forecast for over 55% growth next year in net profit and an increasing number of third-party customers.

This report also comes off the heels of a new major populous push to reduce pollution and clean up China’s environmental record. Analysts at Jeffries went so far as to call this a “watershed moment” for change in China’s environmental policy.

So is Hanergy on the leading edge of an exciting new industry that will transform Chinese energy production?  Or is Hanergy misleading investors and overstating its potential growth? Perhaps only time will tell.

But in the meantime, its huge growth to over 20% weighting in TAN raises questions about whether this ETF remains appropriately weighted or if bad news on just one of its 27 holding could cause outsized negative moves in the whole ETF.

With these lingering concerns and no real way to separate the facts from the speculation, we made the decision to only put half of the normal sized position on in TAN. Should the situation sort itself out and TAN remains in the lead 30 days from now, we will put on the rest of the position. For now, though, we will have less risk and exposure to one little-known Chinese company.

ETFs offer an exciting new way to invest in markets. They are a great low-cost way to participate in many interesting or previously untradeable markets. But this recent example in TAN reminds us that it is always important to remain vigilant and understand the tools we are using to trade.

The Current Condition of the Model
We have the following position change on Monday:

Sell FXI at the market on the open 3/9/15
Buy EWJ at the market on the open 3/9/15.

Stay tuned to daily updates for any position changes.

Here is a summary of the weekly performance of all the ETFs that the strategy monitors.

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Best wishes for your trading, 

James Kimball 
Trader & Analyst  
MarketGauge