ETF Investing – 4 Steps to Picking the Right Funds

by Teeka Tiwari | July 26, 2010 4:33 pm

ETF funds and ETF investing is relatively new, and that means that some investors are unsure where to start. How do you pick the best exchange traded funds for your strategy?

Well, first remember that stocks are like people, and with people, as a general rule of thumb, you can really see what they are made of when they go through extreme adversity. Do they crack? I ask myself the same questions when it comes to stocks. In a weak stock market, all sectors stand naked for the whole world to see. The flabby and out-of-shape ones have no bull market to hide their jelly rolls.

If you really want to boost your overall annual returns, you must have a strategy for exploiting market weakness to your benefit. You must develop a strategy for identifying the sectors that will lead the next new bull cycle.

Let’s take a look at four easy steps that will help you identify the strongest sectors and pick the best ETFs to buy.

Step #1: Use relative strength to select a sector

What I like to do is to compare the relative performance of multiple sectors over the recent down period. My first sectors to investigate will be those sectors that are showing any gains for the period.

Now, in a broad market sell-off, typically all of the sectors will be showing losses. What I will do, then, is look at those sectors that are showing the smallest losses.

What we are doing, of course, is analyzing sector relative strength. We are determining which sectors are outperforming other sectors on a relative basis.

Step #2: Measure the sector’s performance.

This is where exchange-traded funds (ETFs)really help in the analysis process. You can use ETFs as sector trackers that will give you a “pulse” on just how each sector is doing versus another. You
simply find a well-diversified ETF that represents a sector; and then you do this for all the major sectors. Then you simply compare their percentage gain performance over a standard period of time.

But let’s say that you’ve now found a sector that you want to buy, but the sector has 20 ETFs covering it.

That brings us to Step #3…

Step #3: Determine the timeframe

First of all, you pick a time frame that you want to compare the ETF’s performance to. I will generally use a 12-month period. However, if we’ve recently experienced a big drop in stock prices, I like to use a shorter time frame, typically three months.

The shorter time frame will tell me how the ETF behaved up to and during the period of market weakness, and that’s the information I need in order to find the real champion.

Remember, in a bull phase, even a kitten can look like a tiger; it’s in the bear phase that we find out who the real jungle cats are.

Step #4: Test the performance.

Let’s assume we are using the three-month time frame to test relative performance. What I will do is pick a date three months in the past. I will then use a chart service ([1] is an excellent free resource) to find out where the ETF was trading three months ago and where it is trading today.

When on, be sure to use the interactive chart feature. This will allow you to see the day’s open, high, low and close. But for the purposes we’re discussing here, only the closing price is important.

I’ll then pull out my trusty calculator and figure out the ETFs’ percentage performance over the last three months. I will do this for every ETF in the sector that I am interested in.

After you are done with this process, you will have the clearest picture possible of which ETF to buy. You’re going to buy the strongest. That means you will buy the one up the most or the one down the least.

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