In praise of ETFs ~ urban forex trading strategies
I have learned some years ago that ETFs are strange and wonderful creatures. Simple, long-only mean-reverting strategies that work very well on ETFs, wont work on their component stocks. (Check out a nice collection of these strategies in Larry Connors book "High Probability ETF Trading". He has also packaged these strategies into a single indicator, the ETF Power Ratings, on tradingmarkets.com.) Simple pair trading strategies like the one I discussed in my book, also work much more poorly on stocks than on ETFs. Why is that?
Well, one obvious reason is that, as Larry mentioned in his book, ETFs are not likely to go bankrupt (with the notable exception of the triple-leveraged ETFs, as I explained previously), because a whole sector or country is not likely to go bankrupt. So you can pretty much count on mean-reversion if you are on the long side.
Another obvious reason is that though there are news which will affect the valuation of a whole sector or country, these arent as frequent or as devastating as news affecting individual stocks. And believe me, news is the biggest enemy of mean-reversion.
But finally, I believe that the capital weightings of the component stocks also play a part in promoting mean-reversion. Typically, weighting of a component stock increases with its market capitalization, though not necessarily linearly. Perhaps large-cap stocks are more prone to mean-reversion than small-cap stocks? But more intriguingly, can we not construct a basket of stocks, with custom-designed weightings, with the objective of optimizing its short-term mean-reversion property? I (and others before me) have done something similar in constructing a basket of stocks that cointegrate best with an index. Can we not construct a basket that is simply stationary (with perhaps a constant drift)?
Now, perhaps you will agree with me that ETFs are strange and wonderful creatures.
More info for In praise of ETFs ~ urban forex trading strategies:
