Posted on 20 August 2012.
ETF trend following, which consists of analyzing Exchange Traded Funds (ETFs) trends and making investment decisions based on the trends, is generally considered a bad investment strategy; however there are exceptions to this rule. The reason why ETF trend following does not work very well as an investment strategy is because unless investors get in early on a trend, they run the risk of being one of many investors who pile in at the end of a trend and cause a blow off top, which is followed by a steep decline. In fact, trend following is the main reason why the stock market and individual stocks often overshoot to both the upside and downside, and often trade at seemingly irrational levels.
A better investment strategy than ETF trend following is to look at stock sectors or other investment classes, such as commodities, that appear to be undervalued and are poised to move higher based on future earnings growth or other macro-economic factors. After all, ETFs derive their valuations from the underlying assets that they hold, and therefore instead of engaging in ETF trend following to make investments, an assessment of the valuation of ETFs underlying assets and their potential to increase in value over time is a more rational way to invest money in ETFs. It is also very important to read the prospectuses for ETFs and gain a clear understanding regarding how ETFs derive their valuation and how well they actually track the price changes in their underlying assets.
ETF trend following makes sense for some investment circumstances. If a long term trend reversal from negative to positive occurs in a stock sector or other investment class, buying a tracking ETF makes sense soon after the trend reversal occurs. As long as the long term fundamentals underpinning the price of a stock sector or other investment class have turned positive and have a positive long term outlook, a tracking ETF is likely to maintain an increasing price trend over time, increasing the value of an investment.
ETF trend following in high growth stock sectors can be a profitable investment strategy, but is more suitable for short to mid-term ETF trading. ETF trend following in high growth stock sectors takes advantage of the buy high and sell higher trading and investment strategy; however this strategy of ETF trading and investing is risky since a slowdown in the growth rate of high growth stock sectors would likely send tracking ETFs cascading lower. Tight stop-loss orders on ETF holdings are the a good way to ensure that ETFs are sold once the uptrend loses momentum.
Another case in which ETF trend following is a valid investment strategy is contrarian investing. Some of the biggest gains in the stock market are made when investors have the guts to buy the stocks when everyone else is selling. While it takes determination to buy an ETF that is in the midst of a long downtrend as a contrarian investment, ETF trend following that identifies ETFs that have fallen hard and have indications that they are nearing the bottom of a downward trend can be a profitable long term investment strategy, if a trend reversal occurs.
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