Time Frames and Diversification: Are ETF’s Different?
Diversification is a key consideration for any investor. The standard approach is described in Investopedia, a source that is especially handy for new investors (and often useful for the more experienced to check facts).
is a risk-management technique that mixes a wide variety of investments
within a portfolio in order to minimize the impact that any one
security will have on the overall performance of the portfolio.
Diversification lowers the risk of your portfolio.
Reward Follows Risk
The problem with reducing risk is that it also means less potential reward. Sophisticated traders turn to Dr. Brett Steenbarger for advice on such matters. Six weeks ago he had a provocative observation about some "hidden" correlation in markets, especially with respect to time frame. He wrote as follows:
All of this is relevant to what you
watch when you trade, how you size positions, and how you view your
risk when positions are correlated. In the end, there’s just two
settings on traders’ current thermostats: risk seeking and risk
aversion. And the two are playing themselves out daily.
The two important themes are finding unsuspected sources of correlation and making a conscious decision about how much risk to take in a position.
Applying the Concepts in ETF Trading
On a theoretical basis the ETF automatically provides some diversification. The investor is less susceptible to events affecting a single stock. That helps.
Including several ETF’s in the portfolio also increases diversification, but perhaps not as much as one might think. Looking at fundamental factors for each sector group is important. When the portfolio consists of (as ours has in recent months) a number of emerging markets, basic materials, and energy holdings, there is a consistent theme: Dollar weakness. This means that apparently diverse sectors may actually be highly correlated, at least in the short run.
We verify our interpretations by consulting the leading sources on ETF’s. One that we find consistently valuable is Gary Gordon’s ETF Expert. He often considers macro themes of the sort we find important, like this recent article on recession potential. A search of the site for ‘dollar weakness’ shows many articles describing the key theme.
A More Aggressive Viewpoint: Gil Blake
Legendary mutual fund timer Gil Blake, a subject of the Jack D. Schwager book, The New Market Wizards, had a very different view of diversification. In response to a question, Blake responded as follows:
I’m not a big fan of diversification. My answer to that question is that you can diversify very well by just making enough trades per year. If the odds are 70% in your favor and you make fifty trades, it’s very difficult to have a down year.
Casinos follow a similar principle with much less edge and more "trades." Getting into the "long run" depends upon how many truly independent trades you make. By comparison, an investor following a macroeconomic theme or picking value stocks may be following the same market signal for many months. This provides a false sense of diversification and safety.
Diversification depends upon what it takes to get into the long run. Time frame and independence of decisions both matter.
Each Thursday we update the current signals from our very successful TCA-ETF system, which clearly incorporates some of the Gil Blake philosophy. We understand that short-term results will be more variable, but rely upon extensive testing to determine our long-term expectations.
The weekly update shows a number of trades that reflect the rapidly changing environment of the last few weeks. The model ratings show sector strength. Double asterisks in the ranking mean that the sector does not qualify as a "buy" based upon our risk/reward tests.