Commodity ETF’s – When Fundamentals Matter Most

The ETF explosion includes both increasing assets in existing funds and the creation of new ones.  During September alone ETF assets increased by 9.7% to $554 billion and 15 new funds were added.  There are now 560 U.S. based ETF’s run by 17 different managers, according to Investment News.  Emerging market funds have been a big growth source.  New tools are available to help investors rank and screen the  choices. 

Because of the great interest in commodities, an investor can now find an ETF for nearly anything — even water!  (And a hat-tip to that voracious reader Charles Kirk, who helps us find the leading stories.  Become a member to learn from his valuable screens).

The ETF Series

At "A Dash" we have established a weekly ETF Update, aimed at the following audiences:

1. Investors and fund managers trying to develop an ETF portfolio;
2. Those interested in sector rotation as a strategy; and
3. Anyone trying to develop a trading system.

We discuss our own process with a chance for everyone to see the issues faced by those using trading systems.  It is not as easy as the TV commercials make it seem!

Commodity ETF’s

This week’s topic focuses on commodity ETF’s and the role of fundamental analysis.  In past articles, we argued that a technical approach was more effective for many ETF’s. It is often difficult to get the requisite information for the normal metrics for fundamental analysis.  We expect that several sources will step into this void within the next few months, at least for the ETF’s that have a stable lineup of stocks.

Today’s question relates to gold (and other precious metals).  Taking a position in a gold ETF requires a fundamental purpose — an opinion about inflation, the dollar, and the risk in the  market.  Buying the ETF provides diversification without requiring expertise in specific gold stocks.

Why Not a System-Based Technical Approach for Gold?

Most trading systems have a momentum component.  Some are strictly momentum, while our method combines trend and cycle, but momentum is a classic technical criterion.  "The trend is your friend" is a creed for many investors and managers.

Our long-term historical analysis reveals a problem.  We "pre-qualify" sectors by considering trend persistence.  There must be some ability to identify Period A, the identification phase, and predict Period B, the profit phase.  One also needs the ability to exit with most of the profits intact.  This can be tested on various time horizons.

In the case of gold, we have discovered that the Period A moves are often much sharper than Period B.  Exits are often difficult. For this reason, we do not include precious metals in our sector universe.

Weekly Update

The system continues to do well, with little change in the overall ranking.  The table below shows the rankings and trades as of last night. (click to enlarge)

The position has one closed position for a 5.2% gain during the period described.  It is a bit unusual to have so few position changes, since our average holding time is 29 days.  The current ratings suggest some probable moves during the next week.

Conclusion

ETF investing, whether through a system or fundamentals, can be an important part of a strong portfolio.  Sometimes the choice should be based upon fundamentals rather than technical analysis.  Gold is such a case.

Investors must have some confidence that the system works, as Dr. Brett Steenbarger describes in this excellent  post.  Whether one uses a trading system or discretionary choices based upon  fundamentals, discipline and confidence are required.  This comes through careful testing, a future topic.