Meet Felix and Oscar
At NewArc Investments we have two “advisors” on short term trading: Felix and Oscar. These are two different models with a three-week time horizon. Both approaches have a strong long-term record, but the risk/reward characteristics differ.
For some time we have been observing the results from two different models. To illustrate the difference, let us imagine that Vince Castelli, our modeling guru, described two different clients – the classic Odd Couple:
Oscar believes in the long-term strength of the economy and the stock market. He has a lovable and irrepressible enthusiasm. When things go wrong, he steps back for a bit, but soon tries again. He expects to do better than others during good times. Oscar understands that this approach involves more risk. Oscar is opportunistic.
Felix also has a positive long-term outlook, but he is something of a fussbudget. He is much more cautious, with an emphasis on capital preservation. He is perfectly willing to step aside from the market when there are signs of danger. He knows that he will miss some moves, but that is OK. He scores big gains when the market moves lower and he escapes the loss.
There is a little bit of Oscar, and a little of Felix, in all of us. That is why Neil Simon’s play, movie, and television show “The Odd Couple” were so successful. Thinking about your own approach to risk and reward is the first step to successful investing.
Understanding the model requires a grasp of certain terminology.
The universe is the list of ETFs we track. The NewArc universe is a list we have chosen for frequent trading. The ETFs on this smaller list were selected for liquidity, a narrow bid/ask spread, and lack of correlation with other choices. The list avoids including several ETFs reflecting the same underlying stocks. Here is a brief summary of the new list and our reasons for the choices:
- The list reflects a wide range of sectors with little overlap.
- When choosing a specific ETF to represent a sector, we have emphasized the consideration of frequent trading. We seek high liquidity and narrow bid/ask spreads. Other choices may make more sense for investors with different time frames.
- We avoid having several sectors with similar properties. We have studied the correlations among ETF’s and looked for a pure list.
- We seek maximum information for readers. If your ETF is not on the list, you can find one that is a close substitute. If you wish, you can request that we add your favorite.
- The strength rating is based upon normalized historic ETF performance. Average performance is a zero rating. Performance expected to be one standard deviation above average (over three weeks) gets a score of 50. A score of 100 is two standard deviations above average.
- The Penalty Box is used when the model rates the ETF as too risky. It is something like a stop loss, commonly used by nearly every trader. Vince has analyzed thousands of situations with risk/reward and hot money in mind. His conclusion helps us to find faster exits and to avoid trades with high danger in our three-week time frame. While I cannot reveal all of the elements of his method, I have conducted many tests. The penalty box is a good short-term indicator of uncertainty, but may not be relevant for investors taking a longer view.
How We Use the ETF Models
We use these models in three different ways—trading, macro analysis, and assisting with entry/exit decisions.
In our frequent trading program we select the top ETFs in the rankings. We exclude any that are in the Penalty Box. We run the model an hour before the market close and adjust positions during that time. Since the trading is so frequent, it is important to have a low-cost broker. We have a trading group at Interactive Brokers, so clients all are part of a block trade, getting the same price and low cost.
In our weekly trading program we currently select the top three ETFs in the rankings, although we sometimes take four positions. We exclude any that are in the Penalty Box. In general, we adjust positions once each week on Monday or Tuesday. If there is a significant change in the market, we adjust more frequently. Clients in these programs participate in block trades, each getting the same price.
When circumstances warrant, we may delay a trade until the next day, especially when many non-US stocks are involved.
The overall pattern from the sector ratings is very helpful in getting a feel for the market. The ratings for the index ETFs are especially useful.
Entries and Exits
When making decisions in our long-term trading programs we often consider the ratings as a short-term guide. When buying a stock in a low-rated sector, for example, we might watch for a bounce in that ETF.
Things to Keep in Mind
We provide a public list of the ratings (on a slightly delayed basis) as a source of news information to assist investors in making their own decisions. The program was developed and tested in an expert fashion, but there are certainly no guarantees. In particular, the world can change. This can make the model less effective. It may seem not to work for weeks on end, especially if all sectors are moving in a correlated fashion. The approach is not suitable for all investors. Sectors can make big moves in a single day.
While investors can profit from following the ratings, we believe that our trading expertise and vigilance adds value. Anyone who monitors the program and likes the idea should consider joining one of our groups. The fees are very reasonable. It is important to make this a part of a complete investment program. We help in matching this program with complementary trading approaches.
Our ETF models incorporate a high level of science and technology, but also cater to differing risk profiles. Those following our ratings may use the information to guide both short-term trading and also entries and exits for investment decisions.
We hope that the information is helpful, and welcome questions and comments. You can sign up for Felix’s weekly ratings updates via email to etf at newarc dot com.