Market’s Finally Take Some Time to Digest Volatile February Market Action
After an exciting first couple of weeks of February, the markets indulged themselves in a bit of a pause here to digest, and possibly get fuel for another leg up. The SPY ended the week almost perfectly flat, only a few pennies down, while the ETF Sector Plus Strategy holdings were up an average of 1.4%.
We continue to hold our three main sectors, Semiconductors (SOXL), Healthcare (CURE), and Technology (TECL). These three sectors continue to be market leaders. Energy and financials, laggards in the recent move, have finally started to show some life and have moved into the middle of our pack of ETFs. Almost everything consumer related, especially retail, has a difficult time finding any footing in the wintry landscape. A lot the disruption is probably weather related, but either way, it might take some time for those areas to sure up.
This Week’s Strategy Lesson: Leveraged ETFs
Leveraged ETF are some of the newest products in a category (ETFs) that are already the new kids on the investment block. In 2006 the first leveraged ETFs were introduced. Similar as to how a normal ETF attempts to mimic the performance of an index, sector, or group it is based on, leveraged ETFs attempt to duplicate that same performance, except a certain multiple of it. So if the SPY were up 1% on a given day, a 2x leveraged ETF attempts to be up 2% on that day. To create this kind of performance, they often use related equities, options, futures, or other derivative products depending on the type of instrument or market they are attempting to mimic.
Using these complicated financial products is not without its difficulties. Fund managers have gotten better at matching these multiples accurately, but they are not always perfect. Another factor is that these funds attempt to duplicate the daily performance of the underlying, but there can be “tracking errors” or inconsistencies between the long run performance of an index and its corresponding leveraged ETF. While you lose some precision, in reality, the divergences between the two are often within acceptable levels. Over a six-month period, a 3x leveraged ETF might achieve somewhere between 2.5x and 3.5x performance, not precise, but close enough to keep them as a handy and valuable tool in our financial toolbox.
For the ETF Sector Plus model, we specifically wanted to include leveraged ETFs as a way to make even stronger concentrated bets on the sectors that we believe will outperform. In 2013, the S&P500 was up around 28%. Being in the right sector groups at the right times would have bolstered that performance. But to get the 87% performance that the ETF Sector Plus model delivered in the well-trending 2013 market, you really needed that extra leverage.
When selecting which leveraged ETFs to consider for our model, we went in with a goal of considering using leveraged ETFs to replace a basic sector ETF only if it fits within our criteria. We focused on those ETFs from established companies that have a history of releasing solid ETF products.
All of the leveraged ETFs we decided on were from Direxion Funds (www.direxionfunds.com). These products have found the most traction in the market place. One key measure of that traction is volume. Admittedly, the leveraged ETFs, in-part, being a new product, have much lower volume than many other ETFs available in the markets. However, with our ETF model, we weren’t looking necessarily for “daytrade-ability,” but simply for enough volume and price prints that would make them suitable for position trading.
All of the products we finally settled upon had sufficient average daily volume to meet our criteria. While this can be a little thin for aggressive day trading, it is suitable for our longer term ETF model.
Leveraged ETFs are an important new product category in the financial landscape. They offer investors an easy way to add leveraged performance to portions of their portfolio. But they still should be handled with caution.
Care must be used to make sure that the ETFs you trade are liquid and you must always be aware that extreme moves in these instruments are possible in very short periods of time. Up or down swings of 20-30% can be possible in just a few weeks.
With the ETF Sector Plus strategy, we use our proprietary method for determining the best sectors to be in. These are sectors that are outperforming the market and the most likely areas to see continued outperformance. This edge is what gives us the confidence to trade leveraged ETFs. However, always remember to trade carefully, monitor your positions, and respect the trading tools you are using.
Weekly Performance Summary
Here is a summary of the weekly performance of all the ETFs that the strategy monitors:
Best wishes for your trading,
James Kimball
Trader & Analyst
MarketGauge