The ETF Discipline is a defined process for buying and selling exchange-traded funds, and methods for managing a
portfolio of five to fifteen funds. If you have the knowledge to do this, you can profit from market upswings and
protect yourself from the inevitable reversals. You will need no one else’s advice.
The objectives of this process are to anticipate market changes, follow leading funds, and limit risk. The objective
of the ETF-Letter is to teach the ETF Discipline by example. The ideas in the ETF-Discipline come from trading
practices: well-defined steps, consistently repeated, to achieve a favorable risk-reward trade off. Extended the
process to five to fifteen stocks or funds, and voilà! You are a portfolio manager.
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Step 1: Direction and Momentum
Three quarters of all stocks follow the market;
consequently, most stocks, ETF’s and broad
market averages display variations of the same
chart pattern. Our analysis of this
characteristic pattern tells us the prevailing
trend, its momentum, and potential
reversal prices. We buy in uptrends, hold in
bases (sideways movement), and sell at the
beginning of down-trends.
Step 2: News and Sentiment
Simply following trends is not enough. If you
can sense when something serious is happening
to the markets you can enter or exit a trend
sooner. Only rarely does the market give no
clue where it is going, and that’s usually a
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Click Charts to Enlarge
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The chart above shows typical annotations to a chart that the ETF- Letter
explains in detail. It tells us market direction and momentum, buy
and sell prices, and indicates possible trend changes.
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geopolitical event. The causes of big, sustained moves take a while to come into play. That’s why we monitor
market-moving news, and gauge market sentiment. Sentiment is what happens when news hits the trading desks.
For example, when sentiment is bullish, we often don’t sell when bad news hits, because we have assessed that the
market will ignore it. On the other hand, when something like the real estate bubble bursts, early reports that
banks had loaded up on toxic securities told us to get out when the market rolled over in 2007, because we bet that
much more bad news was to come. It did!
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Step 3: Market Leadership
Money is continually sloshing among the 37
equity categories defined by Morningstar. We
find the leading leading categories and the
leading funds at the beginning of every rally.
But the hottest funds are so volatile that they
trip stop orders too often. We look for the best
tradeoff between performance and
volatility.
Step 4: Plan All Trades in Advance
Each week we review the 80+ funds that we
continuously track, updating buy and sell
prices on each. We decide in advance where
we get in and where we get out, to form our
weekly trading plan.
Step 5: Execute On Time
When we have funds to buy, we execute orders
at our buy prices and let the market come to
us. When an order has executed, we
immediately create a stop order at our
predetermined sell price.
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The Relative Strength Chart shows funds representing the
leading categories. In this case new leadership is emerging after
the market recently began a new uptrend.
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The five steps of this disciplined method help you create mechanical process that pre-defines risk and reward
ahead of execution and removes emotion from investing. You know the risk you are taking in advance. When
the market sells off, you won't don't panic, because you know the worst that can happen. When the market gets
crazy, your job is primarily to check that your orders are executing as planned. A market crash will quickly take
your entire portfolio to the safety of cash.
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