To us at Dorsey Wright / DIF Broker, models represent a pattern or mode of structure. Models can be viewed as simplified representations of a rules based systematic method of stock selection and management in a portfolio. Any person referring to him or herself as a money manager should have a systematic approach to portfolio management.
In today’s technologically advanced society, this systematic approach should lend itself to computerisation and thus to automatically executed and managed portfolios. These auto-managed portfolios are more efficient, less expensive to operate and take the emotional factor out of the equation with respect to the money manager himself. If he or she has a rules-based methodology for management, then let the underlying rules manage.
The most important product that has come to market in my 34 years in the investment business is the Exchange Traded Fund. I was privileged to work on the first ETF that came to market at the Philadelphia Stock Exchange. It was called the Cash Index Participation Unit. It was before its time and was ultimately shelved after a battle for control by the Futures Exchanges. A Chicago court ruling, gave possession of this first ETF to the Chicago Futures Exchange where it was immediately shelved, delaying mass marketing of a game changing concept.
What is this Exchange Traded Fund and where does it fit into the investment landscape for individual investors? In my opinion it will ultimately replace the mutual fund, as electricity replaced candle power. The ETF is a transparent index, in that any investor can look inside the ETF and see exactly what it owns and in what weights. You cannot do this with traditional mutual funds. ETFs are also much more tax efficient than mutual funds and generally have significantly lower management fees than mutual funds.
What I found very interesting from the beginning, was that the ETF allows an investor to buy an asset class in general, instead of having to buy one or a few securities. Take for instance, an investor who might only want to own Small Capitalisation Growth Stocks. He could simply buy, say, 200 shares of the Vanguard Small Capitalisation Growth ETF (Symbol VBK). This way he has avoided trying to select a stock that represented small cap growth and instead bought the whole school of fish. I look at ETFs as schools of fish. Think about it for a second: if oil stocks are your focus, why try to find the one stock in the group that will outperform, when you can buy the whole group? The ETF allows you to do exactly that.
Right now there are more than 800 ETFs that cover almost every asset class, sector, country and commodity. If you wanted to own Malaysia, then you could simply buy the EWM. This is a major change in the way professionals and individuals alike invest. In the US this product has caught on like wildfire. It is also beginning to be understood in many other parts of the world. I would say investing using ETFs is in the first foot of a 26 mile marathon.
The interesting thing about ETFs is the investor has the ability to gain great depth and diversification using them. Let’s say I have a defined investment process that is rules based. I can use this rules based system to select a wide variety of ETFs to construct a portfolio. This portfolio would then be automatically run with no human intervention. Remember I said rules-based. If you have a rules-based method of investing, it can be computerised today. Let’s say, I want to construct a portfolio that is comprised of China, India, Malaysia and the US for country representation, and further would like to own gold, commodities in general, as well as a broad international small cap ETF. If this investor wanted to equal weight the portfolio he would simply put an equal dollar amount in the following symbols: FXI, INDY, EWM, SPY, GLD, DBC, GWX. This simple portfolio gives the investor hundreds of stocks while focusing on key areas he might think are good places to invest worldwide. As relative strength changes the model will change. Say for instance, Malaysia lost enough relative strength ranking to cause it to be replaced by the next strongest country, then EWM might be replaced with, say, Egypt if that country was the next strongest in the country line-up. In essence one symbol would be sold (EWM) and one bought (EGPT). As I mentioned above, technology and the ETF have allowed investors to use rules-based systems of portfolio management and computerise the implementation of the portfolio.
Today investors are more interested in a solution to their investment problems instead of having to effect a plan themselves. Professor Theodore Levett of the Harvard Business School used to say, “People don’t want the quarter inch drill, they want the quarter inch hole.” This is exactly how investors are thinking more and more each day. Why would a doctor want to take his precious spare time to become well versed within the stock market. If he could purchase a rules-based model where he embraced the methodology underlying the management of the model, and the model would follow the rules implicitly, and he could have it for a fee; why would he not want to invest his hard earned money in this way?
Auto-managed ETF programmes can either be tactical in nature (move the assets where the relative strength suggests they should be) or strategic in nature (where modern portfolio theory automatically allocates an investor’s funds and automatically rebalances the portfolio twice a year). At Dorsey Wright/Dif Broker we recommend tactical management and only rebalance a portfolio as relative strength changes in the underlying ETFs. If you have not looked into investing in Technical Models DWA, Google it now.
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