Process and Spot. Part 2

Last week was part 1 of a 5-part series of commentaries discussing the 5 critical components of an investment process geared towards earning superior investment returns: Focus Markets, Market Bias, Actionable Price Targets, Position Sizing, and finally, Execute, Monitor and Close the Trade Idea.

I opened last week’s commentary by discussing the secret to Rory McIlroy’s success. In his own words, Rory says that he focuses on two things: “process and spot.” He focuses on the process of making the right swing with long and chip shots and focuses on hitting the right spots on the green with his putting.  That same focus on process and spot can make you a successful investor.

I also began discussing the process that investors could use to determine their own set of Focus Markets. Today, I’m going to finish the Focus Markets discussion using ETFs to walk you through the rest of the Focus Market process. However, determining your investment universe will work with any financial instrument that trades on an exchange.

Liquidity, Liquidity, Liquidity

The first consideration when choosing a potential Focus Market is liquidity. I'm rabid about trading in markets with ample liquidity.  Given all of the financial instruments available to trade across the globe there's no reason to ever trade in a market that doesn’t have more than enough liquidity.

The liquidity rule I use in managing my hedge fund is that my entire position in a given security can’t be more than 5% of the average daily volume.  So, knowing what my average position size is a percentage of the overall fund allows me to periodically screen the markets I’m trading to make sure I won’t have a problem getting in or out of that particular market at the price I want.

You're going to want to determine your own liquidity rule.  However you determine the liquidity requirements for potential Focus Markets make sure to only trade instruments that allow you to get your whole position in and out at the prices we calculate in Step 3, “Actionable Price Targets.” ETF tracks 1,500 ETFs.  A simple screen using a liquidity rule eliminates over 1,000 of those funds.

Eliminate the Asinine and Unnecessary

At this point, I have a universe of a couple hundred ETFs with ample daily volume that cover everything from U.S. equities to T.I.P.S and natural gas. 

I then remove all of the “leveraged” and “inverse” ETFs. Before I go on a small rant about why I eliminate them and how they will someday ruin the world, let me say something about the general use of leverage in investing.

Leverage can be a great thing when it’s working in your favor and it can be potentially catastrophic when it goes against you.  Leverage is like gator wrestling -- better left to the professionals who can afford to gain the nickname Lefty as some kind of a badge of honor. 

More importantly, trading with leverage isn't necessary to earn superior returns consistently.Simply put, there's no reason to ever trade a leveraged or inverse ETF and there is certainly no reason to EVER trade a leveraged-inverse ETF.

Keep this as your warning that some time in the not so distant future there will be a market event that wipes one of these ridiculous ETFs out and causes sweeping reforms across the entire ETF industry.

Anytime there's an instrument that allows Joe Anybody with $1,000 in an IRA account to trade the inverse of the platinum market with 2x leverage (IPLT) or German Bund Futures with 3x leverage (BUNT), it’s not going to end well.

Categorize into Asset Classes

There's a lot of overlap between ETF providers. For instance, every provider has an ETF that tracks the S&P 500. So, I eliminated all of the duplicates and I was left with approximately 100 ETFs that I then categorized into 4 asset classes: equities, fixed income, currencies and commodities.

You can’t exactly break stocks down into asset classes but you can certainly categorize them geographically and/or by sector.  The point is to organize your Focus Markets candidates in a way that allows you to easily evaluate them as we walk through the final two steps.

It's All About Relationships

Now that the ETFs are categorized, it’s important to do a correlation study within each asset class.  For instance, if there were 20 ETFs in the “equities” category, I reviewed the correlation between those ETFs over different time frames. 

The reason I look at correlations is to eliminate any unnecessary or redundant ETFs. For instance, if the S&P 500 ETF (SPY) has a significant correlation to the European ETF (IEV) over several different time frames, then one of them can be eliminated. 

Both ETFs will essentially move up and down at the same time so why keep track of two when you can get the job done with just 1 ETF?  It’s redundant to have both as part of the Focus Markets.

Once I trimmed down the number of ETFs in each asset class based on correlation, I did a cross-asset correlation study to see if there was any redundancy between asset classes, not just within the asset classes. This is a critical step in narrowing down your potential candidates list. 

Remember, the idea is to put together a manageable list of investments that are easy to monitor and yet still give you an opportunity for superior returns.  So no matter what instruments you are choosing to include in your potential Focus Markets, make sure that you aren’t being redundant.

Obviously, correlations between instruments can and will change.  For the purpose of this particular step we are only interested in the long-term correlations, 1-3 years in duration.  There are correlation calculators all over the internet that allow you to plug in ticker symbols and choose a duration to evaluate. 

Generally speaking, a correlation greater than 0.65 is considered significant positive correlation.  This means that two instruments with this type of correlation will generally move in lock-step with one another.

I encourage you to do this correlation study with all of the instruments still remaining in your candidate universe.  You might be surprised at the relationship between some of those instruments.

At this point, I now have approximately 4 ETFs across the 4 different asset classes. 

The final step is to evaluate the opportunity set of each ETF within each of the asset classes.  The opportunity set is simply the total return available in a given calendar year; if you could have picked the high and low price of every peak-to-trough move. Here’s an example.

For the full year of 2013, the Chinese equity ETF (FXI) was down 2.14%.  So was that 2.14% the opportunity set for FXI in 2013?  No.  The opportunity set for FXI in 2013 was 101.6%.

I define an opportunity set by looking at the number of trends a particular market has during a given calendar year that lasts at least one month.  In 2013, FXI had 7 different trends lasting from 3 weeks to over 3 months.

Trend #1 -  January 2, 2013 – April 17, 2013 = -17.8%

Trend #2 – April 17, 2013 – May 8, 2013 = +12.0%

Trend #3 – May 8, 2013 – June 24, 2013 = -18.7%

Trend #4 – June 24, 2013 – September 18, 2013 = +28.0%

Trend #5 – September 18, 2013 – November 13, 2013 = -8.0%

Trend #6 – November 13, 2013 – December 2, 2013 = +11.7%

Trend #7 – December 2, 2013 – December 31, 2013 = -5.4%

So, looking across the 16 ETFs I had left, I chose the 2 in each category with the largest average annual opportunity set and the least correlation within and across asset classes.

I started with 1,500 and eliminated every ETF that didn’t offer us an opportunity to effectively and efficiently earn superior returns on a consistent basis, leaving me with just the 8 Focus Markets that I cover in The Whaley Report. The purpose of the Focus Market process is to determine a manageable number of instruments to monitor and trade that give you enough of an opportunity set each year that you can earn superior returns by applying a sound investment process to those markets.