Playing hot ETFs

By Jason Chow
Globe Investor Magazine Online,
January 11, 2008

Don’t fight the tape. It’s a wise investing adage that we all should remember.

It’s a saying that’s as old as the markets but it’s an easy one to forget. As hard as investors search for bargains and good buys, sometimes the best investing ideas are the ones that have already proven themselves.

Several pundits have reiterated this notion, including quantitative fund guru James O’Shaughnessy who, in his classic tome What Works on Wall Street, recommended investing in stocks that have already shown price strength the previous year. His book showed that buying last year’s winners outdoes the rest of the market by 56 per cent over a 45-year period starting in 1951.

A recent note by Standard & Poor’s reiterated this idea: If you were to buy the indexes of the best three performing sectors of the previous year, invested in them for one year, then re-evaluated and rebalanced the portfolio again in 12 months, you would have gained 13.7 per cent annually since 1990. That beats the overall Standard & Poor’s 500 index, which has increased 9.6 per cent in value annually since then.

Those who think they were looking for bargains fared worst: Those who bought the worst three sectors in hopes of a turnaround saw an average return of only 7.8 per cent.

The lesson is simple: Follow the trend.

Let’s apply the concept to investing in exchange-traded funds. Here is a list of top-performing ETFs in 2007 in Canada. (Horizons ETFs that are leveraged to indexes have been excluded).

1. Claymore BRIC ETF (CBQ-TSX), 71.2%
2. iShares S&P/TSX Capped Materials Index Fund (XMA-TSX), 29.51%
3. Claymore Oil Sands Sector ETF (CLO-TSX), 22.59%
4. iShares Canadian Growth Index Fund (XCG/TSX) 21.42%
5. iShares S&P/TSX Index Fund (XIU-TSX), 10.91%

And here is a list of top-five performing ETFs of the past 12 months from the U.S.

1. iShares FTSE/Xinhua China 25 Index (FXI-NYSE), 124.08%
2. Powershares Golden Dragon Halter USX China (PGJ/AMEX), 108.39%
3. iShares MSCI Brazil Index (EWZ-NYSE), 95.15%
4. Claymore/BNY BRIC (EEG-Amex), 93.36%
5. iShares S&P Latin America 40 Index (ILF-NYSE) 73.21%

The themes are obvious: Emerging markets were huge winners last year. And in Canada, resources continued to do well last year, with the materials index and the oil sands fund ranking in the top three.

Of course, past performance has no bearing on future returns and some ETF experts are ambivalent about betting on past winners: They warn not to expect a repeat of dramatic returns if you jump on the bandwagon when a trend is so far developed.

“Emerging markets will probably outperform Canadian and American markets again,” says Larry Berman at ETF Capital Management in Toronto. “Would I have a big position in them? Probably. But this story isn’t new. It’s in the seventh inning.”

Mr. Berman also says anybody who employs this strategy is purely trading on a trend as opposed to investing in an underlying fundamental reason.

“This is a pure momentum play,” he says. “It’s not a strategy that I recommend. Markets are just not that simple.”

Som Seif, president at Claymore Investments, says the so-called BRIC nations – Brazil, Russia, India and China – remain a solid buy. They’re the more developed economies of the emerging markets and are strong enough to keep growing even if the U.S. economy slows a bit. “A U.S. recession will affect everything, but the correlation of these countries’ markets to the U.S. isn’t that great,” he says.

And though energy sector lagged the overall market in Canada, the oil sands sector fund outpaced the broader Canadian energy index by 18 percentage points. The reason is because the oil sand companies are less exposed to natural gas, which was weak last year, and because of the underlying production growth among the oil sands companies.

“It’s a better pool of assets for this market. There are no income trusts or natural gas plays. It’s more like buying crude directly.”

But while Mr. Seif says he’s bullish on the top performers, he says he’s against the idea of betting on winners alone.

“I’m not a fan of it. I’m a contrarian investor. You try to buy value. Japan is starting to look undervalued now and at some point, it’s going to be a raging buy. Just because it did poorly last year doesn’t mean it won’t do well this year.”

Maybe not, but the odds are against it.

Special to The Globe and Mail