Exchange Traded Funds (ETFs) are the wave of the future, and for good reasons. The Investment Company Institute summarizes the phenomenal growth of the industry with these numbers.

ETF Industry Growth from Dec-06 to Nov-07

            Total Domestic                          290.8              373.4                 27.40%

                        Broad Based                 232.5              286.2                 23.09%

                        Specialized                   58.4                 87.2                 49.31%

            Global/International                    111.2              183.7                 65.19%

            Bond                                         20.5                31.0                  51.22%

These spectacular increases occurred in only five months. It won’t be long before ETFs reach $1 trillion in assets. There are at least 445 new ETFs and ETNs (Exchange Traded Notes) in registration with the SEC today, and more are on the way.

The popularity of broad based and global ETFs stems from their diversity of holdings, their reduced volatilit compared to single stocks, their ease of trading, their passivity of tracking major indexes, their relatively low expense ratios, their financial transparency, their representation of all sectors of the market, and, of course, their profitability. They are also great instruments for penetrating the global market and for taking advantage of commodity and currency cycles.  And, they can be used much like options to short the market or leverage increases in returns.

We can add another and unanticipated benefit: ETFs show a strong sensitivity to seasonal variations in the market, and they do this with reduced risk. 

ETFs SIGNAL INCREASED INTEREST IN SEASONAL INVESTING

Most investors are aware that historically there are six “best” months for investing in the equities market (~ Nov 1 through Apr 30) and six “worst” months (~ May 1 through Oct 31). There are other seasonal cycles, as well, such as the Presidential four-year cycle, the so-called Santa Clause surge, and the “As January goes, so goes the year.” These variations are not cut in stone, but they do tend to repeat themselves about 70% of the time. Those odds are not bad when one considers the frequency of market corrections, recurring cycles of bear and bull markets, and unexpected geopolitical upheavals. A good source of information for seasonal investing is found in the book by Jeffrey A. Hirsch and Yale Hirsch, Stock Trader’s Almanac, 2007 (John Wiley & Sons, Publisher).

The unexpected advantage of ETFs is that they often show seasonality of returns that allow the investor to participate in the market more heavily when there is an increase in return on investment and lower risk. For example, below is a portfolio that the author had on his watch list for the year of 2005. The ETFs were selected for the portfolio because they showed seasonal returns when back tested for approximately three years. They were also fundamentally strong ETFs. The results are presented simply to illustrate a higher return during the “best” six months than during the “worst” six months, and to show how one can choose ETFs that can be expected to perform differentially throughout the year. The general strategy is detailed in www.agavepublishers.com. The fundamental characteristics of the ETFs can be found in the database of www.etfguide.com.

IGV       iShares S&P Software Index Fund          Software                        5.18                 -0.35

FXI        iShares FTSE/Xinhua China Index           China                          25.76                25.72

IIH        Internet Infrastructure HOLDERs Trust     Internet                          1.11                  0.15

IYH       iShares Dow Jones US Healthcare          Healthcare                     0.07                 -0.17

PPA     PowerShares Aerospace & Defense        Defense                         3.08                 -0.27

PPH     Pharmaceutical HOLDERs Trust             Pharmaceuticals            3.80                  -8.10

RWR    DJ Wilshire REIT ETF                             Real Estate                   8.85                  4.31

VTI       Vanguard Total Stock Market                  Total Market                  12.08                 6.30

XLB      Materials Select Sector SPDR Fund        Energy                          6.09                  -0.36

Total % Return                                                                                       66.02                27.27

Average % Return                                                                                    7.34                  3.03

In this illustration there is evidence for seasonality, with the Best Six Months outperforming the Worst Six Months by more than double. Not withstanding, attention must be directed toward the fundamental characteristics of the ETFs and not merely the seasonal changes in return. Sector importance may determine whether or not an investor keeps an ETF. The perfect ETF is one that is in favor because of long-term trends, as well as sector attributes, and shows the expected seasonal variation. One should not ride one horse too long if it doesn’t perform.

The last question we can address here is what criteria does an investor use to determine the overall value of an ETF for use in seasonal investing? 

CRITERIA FOR ETF SELECTION

Here are seven major criteria that should be met in setting up a seasonal portfolio.

1. The ETF should optimally have at least three years of performance data. Look for ETFs where 80% of the time May is followed by a decrease in price and November is followed by an increase in price.

2. The selected ETF should show an overall increase in price during its lifetime.

3.  Look for trader volumes of at least 200,000 daily.

4.  Preferred ETFs represent long-term economic value. Keep the megatrends in mind.

5.  Among ETFs that show a history of seasonal effects, choose those with low expense ratios.

6. A mix of domestic and international ETFs is appropriate.

7. Sell ETFs when the six month seasonal benefits decline (usually around May 1). The money can be shifted to short-term U.S. Treasury Notes or other secure fixed income assets until the best six months rolls around again.

There are other fundamentals that might be considered in selecting ETFs, but the initial general criteria are listed above. If an ETF represents an important sector, has a long history of good performance, shows high trade volume, was initiated by a reputable ETF provider, has a low expense ratio, and possesses good sensitivity to seasonal influences, it probably has all the rest – low risk, good technicals, a good cash flow, and high institutional investing. Use further fundamental analyses of proposed ETFs as you believe necessary.

The proximate reason that ETFs show seasonality is that the underlying stocks also demonstrate seasonality. Just as ETFs reflect their underlying value, they also reflect their underlying seasonal dispositions. Time will tell how well the seasonal approach to investing works with the full range of ETFs and under different conditions, but for now we have a promissory note that ETFs, with all of their advantages, can be used seasonally to maximize investment returns.

Good hunting.