ETF Trading Strategies

What are ETFs?
ETFs are “Exchange Traded Funds”. From an economic perspective they are identical to mutual funds, with a few wrinkles. The “Exchange Traded” part of the name means just that – they trade on an exchange. So rather than buying directly from the fund company, you the investor buys units in the fund from another investor on the stock exchange. In all other respects, an ETF is basically identical to a mutual fund.

How are ETFs different than Mutual Funds? Than Closed End Funds?
The primary difference between the Vanguard S&P 500 Index fund (VFINX) and the Vanguard S&P 500 ETF (VOO) is that you buy the ETF on the stock exchange when you want to buy VOO, whereas to buy VFINX, you have to buy directly from Vanguard. In both cases, the number of shares in the funds can expand to meet demand, and can contract if there is net selling. The price of the fund will, because of arbitrage pricing, always equal that of the underlying index, eventually. If the index was $100, and the ETF was $110, an ETF trader would 1) sell short the ETF, 2) buy the shares that comprise the index, 3) tell Vanguard they want to issue new VOO shares, 4) Vanguard would deliver VOO shares to the ETF Trader’s account and 5) The ETF Trader would deliver these new VOO ETFs to cover their short position created in #1. The net would be $10 – buy at $100 and sell at $110. 
This exact same mechanism is why closed end funds often trade at significant premiums or discounts. The fund manager will not issue new shares. As above, 1) the ETF trader would sell at $110, and then 2) buy the underlying shares that make up the portfolio. However, when it comes to step 3, asking the fund manager to issue more shares, the ETF trader will politely be told, “No”. So there is no market mechanism by which closed end funds can see their premiums and discounts arbitraged away. 
Be very careful when buying a listed fund. A closed end fund might behave like an ETF, until something goes wrong. Then you compound your market risk with the risk of everybody else wanting to get out.

How should I buy ETFs?
ETF Trading can be executed with any online broker. Be aware that many online brokers have a variety of agendas. Some try to get you to pay extra commissions for their, “cutting edge research”, some take the informational value of your order and sell this information (i.e. Allow other traders to know that you will be buying, so that these other traders’ computers can trade ahead of you), some try to make it easy to invest.
One of the cheapest and most scalable ETF trading platforms for individuals is www.ShareBuilder.com. They charge $4 to buy, and allow you to purchase fractional shares. If you want to invest $1000/quarter, and the ETF you want to buy is $33.25, they will credit your account with $1000/$33.25 = 30.0751 shares. You will also receive your dividends as additional fractional shares. So you can have all the advantages of an index fund – reinvested dividends, fractional shares – while being allowed to make your ETF trading decisions outside the confines of the “no active trading” policies of most index mutual funds.

Should I pursue a “Buy & Hold” strategy with ETFs?
As with most investment strategies, it depends on you. If you want to know that you will absolutely never be doing worse than the markets, then a Buy & Hold ETF Trading strategy works best. It ensures you will have the lowest costs, the lowest expenses and the “purest” market exposure. It also means you surrender all chances to improve your odds, take more risk for more reward, and requires the most patience. This final point is significant – most investors bailout out of long-term winning strategies only when they are performing at their worst. 
An alternative ETF Trading Strategy would involve varying weightings in various sectors, depending on market conditions. This, “Modified Indexing Strategy” has the advantage that 1) your are always invested (just as with Buy & Hold) and you can avoid the worst performing sectors at the worst times e.g. Tech 2000-’03. Ten years ago, adjusting your portfolio with this strategy in mind would have been prohibitively expensive. Commissions were north of $50/trade, and there were not enough ETFs to meet your diversification goals. Now, commissions are less than $5/trade, and ETFs exist in size and market depth to accommodate investors of any size.

What other ETF Trading strategies should I pursue with ETFs?
With the wide array of ETFs available, “modified indexing” can now be widely practiced by any investor. Whereas in the past, “buying the index” was all but impossible for individual investors, ETFs have made investing in almost any market sector easy and cost effective.
One of the primary tenets that used to favor Buy & Hold strategies over asset allocation strategies was transaction costs. Broker commissions were $75 in the US, and the bid-ask spread was wide enough to add an additional 1% to costs. Try doing that 500 times to mimic the S&P 500. When Vanguard introduced their S&P500 Index fund, they limited short term trading for 2 reasons. The first was that the buyers and sellers impose costs on those remaining in the funds. So this conflict is most easily resolved by adding a 1% backend load to those who hold less than 90 days to discourage this active trading. Fair enough. But the other reason is, Vanguard does not want you to take your money out. They get paid only when you have your money in their funds. Any thing short of this, and their paycheck declines. So even a firm as transparent and investor-oriented as Vanguard still has conflicts of interest. This does not mean they are a bad firm, out to get you. But they do have their own agenda.

What about leveraged ETFS, or other strategies?
There is a long list of articles explaining why ETF trading strategies using leveraged ETFs will not improve your returns, and will, in fact, significantly reduce any gains you might hope to earn in many cases. Further, day trading ETFs in general is a losing game. In addition, if you bought the S&P 500 Index ETF (SPY) at the open of every market day, and sold at the close, assuming zero transaction costs, you would have lost +50% over the past 20 years. If you had bought at the close every day, and sold at the open the following day, you would have made +700%, or almost twice the returns of buying 20 years ago and holding.
Short terms gimmicks for quick profits are in fact just that – gimmicks, like “7 Minute Abs” designed to relieve you of your money. There are many ETF trading strategies that use inappropriate securities, or churn your portfolio.

In general, the simpler the ETF trading strategy you employ, the more reliable your returns will be. The most reliable is Buy & Hold. Indeed, this is the standard to which the entire investment industry is held. There exist strategies such as Modified Indexing which can enhance returns. However, as with any strategy, when comparing one ETF trading strategy to another, there will always be periods where one outperforms another. If, however, the strategy is built on solid ground, the goals of capital preservation with upside participation will be met. 

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