An Active Manager's Guide to Trading ETFs

For my entire career as a trader, portfolio manager, and investor, I've relied on a combination of systematic (or rules-based) methodology, fundamental analysis (understanding the trends of significant economic indicators), and technical analysis (the historical review of price data and charts) to understand market trends and actions. The building blocks of successful active management (alpha generation) must incorporate elements of each of these analysis tools. How is this done?

Keep Things Simple

The best advice I ever received about investing in the markets came from my grandmother (affectionately referred to as "Big Mama"). As a preteen, I spent each summer at my grandparents' home, visiting and working. Big Mama’s catchphrase was "make it plain." I remembered that because she said it often—particularly when my young mind tried to explain why I did something wrong. As an analyst early in my career, I translated that to mean "keep things simple". Take a position, have several defensible reasons why the position was taken, and provided a detailed exit strategy if the position is going wrong. All of this can be accomplished with a simple plan established pre-trade. I've applied this advice to my market analysis and have especially applied it to trading, managing, and investing money in the market.

As a top-down market analyst, I begin with a basic notion when analyzing and positioning in the market. 

A Basic Notion

The notion captures everything one should desire when engaged in the markets. When the market has a high probability of upside reward, increase your exposure and even take on leverage selectively. Conversely, if the market has a high probability of downside risk, reduce your exposure. The tools used to establish both upside reward and downside risk (rules-based systems, fundamental economic analysis, or chart-driven technical analysis) must be easy to define, inexpensive to implement, and most importantly, repeatable under a variety of market conditions.

An Active Manager Example

That simple notion is behind Probabilities Fund Management, LLC which manages and trades US equity index exchange-traded funds (ETFs) and develops strategies that take on directional market exposure with opportunistic leveraging. 

The Probabilities strategies are based on underlying seasonal and technical factors derived from the analysis of the historical return series of market indices. Factors determined to have the most significance are utilized to generate buy and sell signals, which the manager then utilizes to implement discretionary trades. Like all equity investments, the strategy will experience volatility, which may be magnified during periods the manager has implemented a leveraged position.

Probabilities’s flagship strategy seeks capital appreciation by systematically investing to gain long, short, or leveraged exposure to US equity markets through index ETFs. The strategy places special emphasis on risk management in an attempt to limit loss by using disciplined, rules-based methods.

The analysis is built by reviewing historical trends and patterns based on frequency and magnitude of market moves. Those trends and patterns are continuously reviewed and adjusted when and where necessary so the strategy evolves to reflect current market dynamics.

The strategies are based on underlying seasonal and technical factors derived from the analysis of the historical return series of market indices. For example, the Dow Jones Industrial Average (DJIA) was analyzed between the years of 1950 and 2019. The following charts provide the results:

In summary, DJIA performance between November and April of each year was significantly higher than performance between the months of May and October of each year. The simple conclusion for trading would be to implement and increase upside exposure during the months of November and April. Conversely, implement a plan to decrease market exposure and increase downside exposure during the months of May and October.

ETFs and the Access to Markets

Exchange-traded funds are liquid and numerous. Long and short positions can be purchased on indices, sectors, commodities, currencies, and baskets of fixed-income securities. Most attractive are the list of "leveraged" ETFs which give the trader the options to opportunistically and cheaply increase their exposure when the time is right by factors of 2 (2X) and 3 (3X). Whatever method one uses to establish a market view, ETFs allow for aggressive and inexpensive access to the desired position and create the opportunity for alpha generation and capacity for diversification never before available to the individual or emerging manager.

Conclusion

A simple, rules-based approach for analysis, market entry, and market exit is usually the best. Active managers have many tools available to establish their market view. Utilizing ETFs and implementing an opportunistic leveraging strategy can increase alpha during strategic periods of each year when the markets provide the highest probability of upside reward or downside risk. Even "passive," index-following investors can utilize ETFs to opportunistically generate additional alpha over their benchmark index while remaining true to their "passive" orientation.

About the Author

Sidney Hardee, CFA, is the managing partner and chief investment officer of Hardee Brothers, LLC and research consultant for Probabilities Fund Management, LLC. He has a broad base of experience in the areas of global investing, derivatives research, quantitative analysis, and portfolio management.

Mr. Hardee is a former trading manager at the Bank of NT Butterfield in Bermuda, where he led fixed-income and derivatives trading initiatives. He began his career as a market analyst at Salomon Brothers focused on European bond markets. Later he joined Lehman Brothers in both New York and London as a bond trader. He was also a vice president in both the credit markets trading and global rates strategy groups at JPMorgan.

He is a member of the Alternative Investments and the Performance and Risk Analytics Groups of CFA® Society of New York (CFANY). He is a former member of the United States Investment Performance Committee (USIPC) and a current member of the Global Promotions Committee of the Global Investment Performance Standards (GIPS). He is also a member of the advisory board for the Master of Science Program in Financial Risk Management at the University of Connecticut School of Business.

Mr. Hardee holds a BA in economics and mathematics from Yale University and a MS in applied statistics from Columbia University.