Profiting from ETF Rotation Strategies in Turbulent Markets
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In today’s volatile financial markets, many investors are having a hard time deciding whether or not to be invested in equities and/or bonds. After the stock market turbulence and two severe bear markets of the past decade, as well as the uncertainty about the future, you are probably more cautious than ever about your investments. You might have moved to bonds, relied on mutual funds, followed the broker-friendly “buy and hold” strategy, or deposited your funds in a money market fund (“cash”). You might have made your decisions based on emotion, rather than discipline and fact. You are not happy with the results. So, how can you do better?
After the March 9, 2009 stock market bottom, investors jumped into bond mutual funds at a record pace. Throughout 2009, they extracted $35 billion more from equity mutual funds and ETFs than they invested in them to build up their bond holdings. By February 2010, the major stock indices had doubled in price from the March 2009 bottom. Thus, some investors bought bonds when they should have been buying equities. This illustrates the fact that many investors are consistently poor judges of market conditions that lead them to buy and sell the wrong investments at the wrong times.
Dalbar, Inc., a financial research firm based in Boston, reported in their 2010 annual Quantitative Analysis of Investor Behavior that for the 20-year period ending on December 31, 2009, equity mutual fund investors experienced average annual returns of only 3.2% compared to 8.2% for buy and hold investors in the S&P 500. Thus, investors’ emotion-based investment decisions failed to deliver the returns they were expecting.
Active stock mutual funds did not fare well over the last decade; their annualized return was all of 0.99%. Even with a diversified portfolio of 60% equity index funds and 40% bond index funds, the annualized return was a pitiful 2.6%. Moreover, about 70% of active funds earned less than their benchmark index; you’d have done better to invest in the index! Typical equity mutual fund’s charge about 1.45% in annual expenses, which reduces their returns even further, so for the past ten years, the average active fund investor had a 0.5% net loss. Buy and hold investors in stocks whose value mirrors the S&P 500 Index and held their positions since the market top in 2007 have fared no better. Figure 1 shows the value of the S&P 500 stocks since then. As of February 23, 2011, it was still 16.5% below the 2007 peak. No wonder these investors are perplexed about how to recoup the money they’ve lost.
Many investors are finally getting smarter by placing new money in index funds rather than actively managed funds. They have annual expenses of about 0.50%, which is almost 1% lower than actively managed funds. Thus, index fund investing is less costly and over the long run will provide better performance, although the returns might be negative for bear market years that come along every three to six years. Even a diversified group of index funds will decline in price during bear markets.
So, how can you solve these problems to earn and protect your profits during bull markets and avoid the devastation of future bear markets?
–Leslie N. Masonson. Excerpted from Profiting from Profiting from ETF Rotation Strategies in Turbulent Markets (FT Press Delivers Insights for the Agile Investor).