April 30, 2005

Through the Looking Glass Dimly

Things aren't always as they appear. Perceptions are sometimes
deceiving, and we don't always see the whole picture. To illustrate,
here are some trivia questions that pertain to investing
in today's markets.

1. Korea's oil demand is what______% of China's?
2. Adjustable rate mortgages are what_____% of total mortgages?
3. How many times in the last century did the Dow move more than 3.4% in one day?

Answers below.

ETFs

As mentioned last time, this issue will focus on ETFs and how
we trade them using the Mutual Fund Investing, Trading, and
Market Timing strategy. ETFs are good products, gaining in
popularity with investors. For pro-active investors who favor the
diversification and efficiency of mutual funds, ETFs are a welcome
addition.

Because of my original perceptions, I wasn't sure the Mutual Fund
Investing, Trading, and Market Timing strategy could be applied to
ETFs with the same kind of reliability and results we get with mutual
funds. However, after using them and testing them with our mutual fund
strategy rules, I am enthusiastic about them.

Take, for example, the ETF that represents the S&P 500 stock index
(symbol SPY). A SPY share can be exchanged for each proportionate share
of the stocks that make up the S&P 500 index, all 500. But, only
institutional investors dealing in thousands of shares are
eligible to make this kind of exchange; retail investors cannot.

As a matter of fact, the ETF was invented by investment banking firms
so that institutional investors like banks, insurance companies, money
management firms and other large corporate investors could exchange
large blocks of individual shares by proxy. Because the ETF is
exchangeable for its underlying shares, institutional size investors
can obtain large positions of certain share classes of stocks and bonds
for hedging, leveraging, or exchanging positions very efficiently.

Organized Like Funds, Traded Like Stocks

ETFs are like both closed end funds and open ended funds (mutual funds)
in that they are pools of money invested in shares of stocks and bonds.
There are approximately 177 now traded representing almost every index
and sector.

Like closed end funds, ETFs are issued in an underwriting. An investment
banking firm issues ETF shares representing a stock index, industry
sector, or a regional global market index and holds in custody the actual
shares that make up the index the ETF represents. The ETF shares are
priced at the value of the shares held, divided by the number of ETF
shares issued. The ETF is listed and traded on the exchange continuously
during trading hours, like stocks are traded.

The ETF, in theory, trades at net asset value like regular open ended
mutual funds. However, because of liquidity factors, this isn't always true
during the course of the trading day. For many ETFs the amount of available
shares for trading, or the liquidity of the issue, can pose a problem.
In ETF shares that do not have a lot of shares available for trading,
the spread between ETF bid and ask prices can often be wide apart.
Selling a position "at the market" may result in selling at a big
"discount" to get the trade completed, or buying a position at a big
"premium".

However, because ETFs are exchangeable with their underlying shares
(by institutions), arbitragers keep prices in check, particularly
toward the end of the trading day. In other words, even if there is a
small discrepancy in the ETF price and its underlying shares, big
traders will short one side and go long the other driving the variance
back to parity. In this way, ETF closing prices change day to day
percentage-wise almost identically with their mutual fund counterparts.
This is a key factor enabling us to apply our strategy for mutual
funds to ETFs.

Perceptions

ETFs fit right in with our theme of trading mutual funds for profit
and protection. After all, ETFs and mutual funds are mirror images of
each other. The prices of ETFs and mutual funds tracking the same sector
or index over the same time frame correlate almost 100% with each other.
The data below shows several ETFs and how they correlate with well known
mutual funds or indexes that have gotten good results with our strategy:

ETF Name	Symbol	Correlation	Mutual Fund in Strategy
Nasdaq 100 Index	QQQQ	97.9	Rydex OTC Fund
Smallcap Value Index	VBK	93.7	Rydex Smallcap Growth
Large Cap Value Index	VTV	91.6	Morningstar Value Index
EAFE International Stock	EFA	93.7	Fidelity Overseas
Technology Sector	XLK	96.7	Rydex Technology Fund

However, even though they look the same and act the same, ETFs and
mutual funds are perceived quite differently by investors. Investors
own mutual funds and do not think to trade, or are reluctant, to trade
mutual funds. Investors own ETFs and think they should trade ETFs all
the time. Both viewpoints are, of course, off the mark. The best use
for both of them lies in between.

Differing perceptions of ETFs and mutual funds occur because of the
way they are promoted.

ETFs representing the major stock indexes have been around since 1993,
but they really took off in the aftermath of the mutual fund scandals.
Suffering through charges of excessive fees, promotional excesses, and
poor performance, the industry found an alternative to promote. Blaming
"after hours trading" and "market timing" as the source of their
problems, the industry jumped behind the screen of restricting trading
and setting redemption fees as a "solution". What better way to deflect
their unwillingness to allow trading mutual funds but for the industry
to get behind the ETF as an alternative. ETFs were low cost, passive
(and therefore tax advantaged) mutual fund substitutes that could be
traded.

Only one thing was needed. In order to make them truly viable, ETFs need
to be trade-ABLE and that takes daily volume. Thus, they are promoted as
trading vehicles.

E$F, Follow The Money.

Underwritings are profitable. Institutions favor ETFs. Fees on them
produce income. The underlying assets are virtually cost free to hold
and manage. They generate commissions when traded. So, while ignoring
that "buy and hold" is one of the great con jobs of all time, the
industry, talking out of both sides of its mouth, advertises to the
very same retail customer that you should not trade mutual funds, but
you can trade, margin and short exchange traded funds.

It seems it is up to us, the retail investor, to sort it out. To read
more on the positives and negatives about the ETF, check out the May
issue of Money Magazine.

Advantages

ETFs are good substitutes for specialty mutual funds, like emerging
market funds, certain foreign national funds, specialized sector funds,
and some smallcap growth funds. Mutual funds that offer these specialties
often impose trading restrictions and redemption fees on them. Paying a
transaction charge to trade an ETF can be a good alternative to a
redemption fee when your strategy triggers a sell signal.

Another ETF advantage are their low administrative costs, as low as 10
basis points in some cases. This makes ETFs attractive as single fund
holdings, or in asset allocation models in those less volatile
investment classes in our strategy that are often held for longer
periods of time. These would be ETFs, like some of those in the
correlation table above, and Sector ETFs like Utilities (XLU),
Financials(XLF), and Real Estate (ICF).

You can see our ETF selections at the tradingmutualfunds.com
website. The following is a list of ETFs in our tables that
would be a good foundation in a Tactical Asset Allocation Model
for a self-directed 401k plan:

Vanguard Value Stock Index (VTV)
Vanguard Growth Stock Index (VUG)
Vanguard Smallcap Growth Fund Index (VBK)
Vanguard Smallcap Value Index (VBR)
MSCI EAFE Index International Stock Index (EFA)
S & P Technology Index (XLK)
MSCI Emerging Markets Index (EEM)
Lehman +20 Year US Treasury Bond Index (TLT)
Cohen Steers Real Estate (ICF)

ETF Investing, Trading and Market Timing Strategy

In our strategy, we treat ETFs as mutual funds. Supported
by our correlation studies, we feed ETF closing prices into our multiple
indicators. Just as for mutual funds, we post entry and exit points as
they are triggered by the indicators for execution on the next trading
day. We enter our trades in ETFs as "market at close" trades. However,
subscribers have the option to set automatic stop loss" or "trailing
stop" orders. Another ETF advantage.

Conclusions

• While ETFs can be day traded, they are, after all, very similar to mutual funds.
  Trade both mutual funds and ETFs using a disciplined strategy that
  combines proven investing, trading, and timing techniques for
  different market conditions. Why not incorporate the virtues
  of the ETF with a good mutual fund investing strategy?
• While ETFs do incur transaction commissions, if your
  account has enough size, this cost percentage-wise should
  be manageable.
• Treat mutual funds like ETF's, find tradable ones, and
  trade them when necessary to protect capital and get better
  results.
• Conversely, treat ETF's like mutual funds and hold them
  in uptrends.
• Remember that a Money Market Fund or cash in a brokerage
  account is an invested position and a good place to be in a
  downtrend.

By the way, a recent study indicated
there is strong anthropological evidence that learning trading
skills enabled Homo Sapiens to evolve, and because they did not
have trading skills, Neanderthals did not.

Answers to trivia questions:

1. 800% or 8 times larger.
2. 15%
3. 1001 times, or 10 times on average per year, equivalent to
   about 400 points on today's Dow index.

What perceptions about the topics did you hold that led to your
answers? What perceptions do you have of ETFs and are they
different from your perceptions of mutual funds?

Best regards,

Ted McDonald

______________________________________________________________________
Ted McDonald is the author of Mutual Fund Investing, Trading, and
Market Timing, a strategy for active mutual fund investors available
at: tradingmutualfunds.com

The site is a one stop resource providing how-to and daily buy sell
signals for trading over 300 leading mutual funds, plus single and
multi-fund trading models, a bond fund trading strategy, and a gold
fund timing strategy, all for the price of one subscription.

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Readers may reproduce the newsletter whole or in part, but must include
the source and not alter the links provided. Just let us know if you do,
so we can see it. Drop us a line at admin@tradingmutualfunds.com.

______________________________________________________________________
This information is not investment advice and is presented for
informational purposes only. The information is not an offer or the
solicitation of an offer to purchase any security, mutual fund, or other
investment. The strategy and trading signals discussed may not be
suitable for particular investors depending on their individual
investment objectives and financial position. The purchase of any
mutual fund, ETF, security, or investment, places the investor and the
money invested at risk for loss. Only a registered broker or investment
advisor may advise you on the suitability of a specific investment
depending on your investment objectives, financial position and ability
to tolerate risk of financial loss.

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Past actual or simulated performance is no guarantee of future results.
All profit performance examples are hypothetical, assuming that
subscribers bought mutual funds at the time strategy rules issued
entry signals and sold mutual funds at the time strategy rules issued
exit signals. Actual results can and do vary based on the day of
execution and transaction costs, if any, that can be incurred.

______________________________________________________________________
All material presented herein is believed to be reliable, but we cannot
guarantee completeness or attest to its accuracy. Ted McDonald and
Trading Mutual Funds, L.L.C. and/or staff, may or may not have
investments, now or in the future, in the mutual funds mentioned herein.
Readers are encouraged to read our complete disclosure,disclaimer and
privacy statements on our website

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