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Fabrice Taylor: This unique ETF strategy will improve your returns

Fabrice Taylor, CFA, publishes the President's Club investment letter, for which The Globe and Mail provides marketing services and receives compensation. He is also a contributor to Capital Ideas Research.

Unlike most of the shiny dross that tumbles off the Wall Street assembly line, ETFs have withstood the test of time by – surprise! – actually adding value. They've cut costs, allowed for increasingly targeted bets and have increased the amount of money going into the investor's pocket instead of into the financial industry's coffers.

Every do-it-yourself investor should lean heavily on a diversified portfolio of exchange traded funds for the bulk of his portfolio, with more active stock-picking conducted at the margins.

I'm practising what I preach here: While my day job is writing about smaller names and turnarounds, ETFs comprise the biggest part of my portfolio.

But I'm not your average ETF investor. I'm far too restless for that. The traditional ETF approach is to set weightings for a handful of asset classes – say bonds, Canadian stocks, U.S. stocks, foreign stocks and cash – and recalibrate every once in a long while to bring the weightings back in line, which means selling what's gone up and buying what hasn't. There's nothing wrong with that, especially for passive investors who have better things to do than watch the ticker tape.

But I take a different approach, which has, for me, done considerably better than simply investing in an index fund or using a traditional ETF strategy.

I'm a momentum ETF investor, meaning I want to go to geographies, industries and asset classes that are attracting money. Put another way, I'm trying to surf on the waves created when big money flows from one jurisdiction or sector to another.

These flows are caused by institutional money – the trillions of dollars managed by big pension and other funds – moving money around from one place to another. A nimble investor can benefit from these flows.

Here's how it works, and don't worry, it's pretty simple: First, you need to understand that institutional investors tend to think alike, so they move like a herd. Second, you need to appreciate that they move slowly because of their size. It takes them weeks or months to reposition, whereas it takes us little folk a few hours or days.

As money flows into assets that represent the latest institutional theme of the day, an ETF that reflects that theme will start to move higher as the shares it owns are bought by these big investors.

As this ETF moves higher on the back of the stocks it owns, it will eventually make new 52-week highs. Of course – and this is important – once it makes that high, it will most likely continue to make subsequent new highs, and for a considerable amount of time, because these institutions are not traders. There is nothing so wonderful as owning a stock that is setting repeated new highs.

So what you need to do is find ETFs that are hitting fresh 52-week highs. By "fresh," I mean that they haven't hit a high in a long time, or at least not many, and are just starting their run. The reason for this fixation on fresh highs is that, while ETFs that hit a high will tend to do so repeatedly, the more highs they hit, the richer the valuation of that theme becomes and the more likely it is that money will start to flow out of those assets. You want to get in early, and exit early.

Using the fresh 52-week high list has worked well for me over the years. But at one point, I asked myself, "What about trying to predict which stocks will start to hit a streak of 52-week highs?"

In other words, why not look at, say, a 39-week (a.k.a., a nine-month high), with the idea of trying to get in even earlier? Computing power makes this relatively easy, and after trying it out, I found that, while riskier, the returns were indeed better on average. In other words, not every ETF hitting a nine-month high would go on to set an annual high, but those that did tended to provide a much better return, and even factoring in the failures, the overall outcome was superior.

Here are some examples: Earlier this year, I bought the SPDR Gold Shares ETF when it broke through the 39-week high barrier. So far, I'm up almost 10 per cent in seven months. I also bought a general mining ETF earlier this year that did even better.

And the system works on the downside too: the iShares Global Healthcare ETF hit a nine-month low in August of last year and a few months later was down 11 per cent.

The table below shows ETFs that are displaying signs of life, and may start hitting fresh highs soon.

There is, however, a caveat: This system won't protect you from a market crash, and may in fact exacerbate the outcome because of the increasing correlation in asset classes.

But in normal times, and especially in a sideways market, this strategy, if you have the time, can definitely improve your returns.

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Below is a partial list of ETFs momentum investors should look at. They have all made nine-month highs recently and also are in industries about which analysts are becoming more bullish.

Momentum ETFs

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