ETF’s --- The Mainstreaming Of Advanced ‘Basket-Trading’

May 01, 2010 in Backtest | Strategy

In a recent institutional research piece by Goldman Sachs targeted at European portfolio managers, they offer various ways to trade ‘the divergence theme in the Eurozone.’



In the note, they discuss the problems with domestic demand in Europe within the construct of strong global growth, led by the BRIC (Brazil, Russia, India, China) theme. This note was on April 28th and followed a similar note discussing a similar theme targeted at US portfolio managers.

The basic idea of the note is to “Go long international growth & short Eurozone domestic demand.” In both research pieces, they do a lengthy analysis of long lists of ‘basket trades’ that portfolio managers could do to implement this longer-term trend. The bottom line of these studies was to create a long basket of stocks (to be long) that has companies with high sales exposure to the strong parts of the world and create another basket with high sales exposure to mainstream Europe and go short that basket.

To execute this, you would submit a list of trades, with quantities of shares, to a firm like Goldman or Morgan Stanley or Merrill Lynch and say ‘buy(sell) this basket of 70 stocks on the market close today.’ Then, Goldmans quantitative ‘experts’ figure out how they are going to both ‘guarantee you closing price’ – and make money for themselves. They ultimately do some kind of elaborate combination of trades that hedges themselves --- and can use the liquidity in the futures market with a hedge ratio or whatever else they do to create a profit for themselves – and then they charge an extra fee to the buyside firm to do the program trade.

Now – enter ETFs. Think about what you can do now – you can buy any of 1000 pre-set trading baskets that were created by index construction experts at MSCI, S&P, Russell etc. In some cases, such as at Schwab or Fidelity, you can do this for zero transaction fee. Its like the world has aligned in favor of the small investor/advisor here. This is very powerful.

I should go on to note that in this most recent research piece by Goldman on ‘trading the divergence’ --- they spend nearly 1/3 of the report going into backtests of their newly created trading baskets.





Well, with ETF’s – the trading history total return chart of the ‘basket’ is known. You don’t have to simulate it with portfolio management software --- you can just run the total return chart on our site.

So this is the power in ETFs: 1) the index has been constructed for you by index experts already (the people at firms like MSCI are every bit as smart (I would say smarter) as the people at your typical large financial institution) – they know what they are doing. 2) the trading history of the ETF ‘basket’ is known and 3) you haven’t done any actual work yet and you are already analyzing the characteristics of the ‘ ETF basket’ (its volatility, out/underperformance, historical relationships etc).

The bottom line is that banks makes good money recommending these kinds of things for portfolio managers. The longer the list, the more the profits. Big portfolio managers with huge assets under management cannot buy most ETF’s – the ETF’s just aren’t big enough. But you – as the small advisor, small hedge fund or individual investor can -- and that is what our site is all about -- leveraging the inherent and underrated power that ETF’s bring to neutralize the investment landscape.

(by the way, our relative strength model pointed towards this weakness in Europe months before Goldman wrote research on this – just go into the ETF screener and move the date back to January and see for yourself)

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