I’ve always been an outspoken proponent of using major market trends as guideposts for sizing the stock allocation of my portfolio. Trend lines like the infamous 200-day moving average have never been perfect predictors of stock market direction. These types of technical indicators, however, are useful tools in making incremental adjustments over time, but they can also work against you.
Pacer Financial is a relatively upstart company in the exchange-traded fund world, operating a suite of TrendPilot ETFs designed to automate the trend-following process. Their lineup includes a range of well-known U.S. and European indexes with several hundred million in combined assets under management.
The largest and most popular fund in its mix is the Pacer TrendPilot 750 ETF (PTLC), which is based on the Wilshire U.S. Large-Cap Index. This includes a diversified basket of 750 large-cap stocks aiming for broader exposure than the stalwart S&P 500 Index.
PTLC currently has $336 million in total assets and enough consistent daily trading volume to be considered liquid for most investor’s purposes. It also charges an expense ratio of 0.6%, which is on the high side for a typical ETF, but not necessarily abnormal for a quasi-active approach.
The basic premise behind PTLC is to participate when the stock market is going up and move to cash (or Treasury bills) when it is going down. It accomplish this through a systematic, rules-based methodology indicating positive or negative trends using the 200-day simple moving average.
In an uptrend, PTLC owns 100% stocks. The fund then moves to 50% stocks and 50% treasury bills when the index falls below the trend line for five consecutive days. It then uses a final confirming indicator to move to 100% treasury bills if the simple moving average falls lower than its prior reading for five days. The process starts over again once the index regains its 200-day moving average on the upside.
Simple. Logical. Automated. Sounds easy right?
The Fatal Flaw in Trend-Following ETFs
The obvious advantage here is the safekeeping of your money during prolonged bear markets, incase we experience anything akin to the Great Recession. Multiple months, or even years, of persistent selling pressure can be avoided by protecting your capital near the top quartile of a new down cycle. The goal is also to get you back into the market at a much lower point, and with more starting capital than if you had held your way through on the downside.
This trend-following system, however, hinders ETF investors during sharp corrections and subsequent rapid recoveries, the likes of which we’ve experienced over the past year. The constant gyration from bullish to bearish and back again creates a counter-productive effect on the strategy.
When comparing the PTLC ETF against the Schwab U.S. Large-Cap ETF (SCHX), you can see how the trend-following strategy moves to cash prior to the upswing in both 2015 and 2016. This means PTCL ETF investors miss out on the recovery, rapidly falling behind the more conventional Wilshire index. (SCHX purely follows the Wilshire U.S. Large-Cap Index without the trend following component.)
The time period involved here is admittedly quite short, and a proper analysis should be done over multiple cycles of the market. Still, it should be observed that this recent trading pattern does not sit well with a trend-following strategy built to follow a long-term moving average. The timing component may frustrate investors, causing them to jump ship just prior to the market rolling over once again.
Last Word on the PTCL ETF
The trend-following Pacer ETF is ultimately doing exactly what its creators set out for it to do. The more recent price action should be considered a known risk of this type of enhanced index, rather than a strategic failure.
The lesson is that there is always a double-edged sword of opportunity cost that must be considered when you move to the safety of cash.
This same risk is entrenched with the use of stop losses or physical sell orders for individual ETFs and stocks as well. They call it getting “whipsawed,” and it is certainly an uncomfortable feeling when you are on the wrong end of it.
David Fabian is Managing Partner and Chief Operations Officer of FMD Capital Management. To get more investor insights from FMD Capital, visit their blog. Click here to download their latest special report, The Strategic Approach to Income Investing. Learn More: Why I love ETFs, And You Should Too.