Unleashing the Full Power of ETFs

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By Leland B. Hevner

President, National Association of Online Investors (NAOI)

At the National Association of Online Investors (NAOI), we believe Exchange Traded Funds (ETFs) to be one of the most significant developments in the world of investing since index mutual funds were introduced in the 1970’s. They provide all of the diversity benefits of mutual funds but with the added benefits of being easy to trade and having significantly lower fees. Plus, there exists an ETF that tracks just about every asset class, asset type and segment of the market.

Yet ETFs are massively under-used today. Most people who begin NAOI investor education classes have never heard of them. There are two main reasons for this. First, financial advisors are more highly compensated for selling Mutual Funds than ETFs and rarely recommend them to clients. Second, virtually all portfolios are designed today using an approach called Modern Portfolio Theory (MPT) that utilizes a buy-and-hold portfolio management strategy. They do not take advantage of an ETF’s ease-of-trading benefit. As a result of these factors and others, ETFs today are not close to realizing their full sales potential. This is about to change.

NAOI Dynamic Investments take ETFs “Mainstream”

The unique benefits of ETFs are fully exploited by a new, high-performance investment type called Dynamic Investments (DIs). Developed by the NAOI, DIs are capable of automatically changing the ETFs they hold based on a periodic sampling of market trends. Here is a quick explanation of how DIs work:

The diagram below shows the design elements of all Dynamic Investments. An explanation of how DIs work is presented below the diagram.

A DI designer places multiple ETF purchase candidates in the Dynamic ETF Pool (DEP). On a periodic basis, as defined by the Review Period, the ETFs in the DEP are ranked using the Trend Indicator to identify the one that is moving up in price most strongly. This is the ETF that is purchased (or retained if already owned) and held until the next Review. By frequently sampling market conditions and signaling trades as needed, extensive testing shows that DIs are capable of consistently producing returns that are significantly higher than “static” MPT portfolios and with lower risk.

By embracing a buy-and-sell management strategy, Dynamic Investments take full advantage of the “ease of trading” benefit of ETFs. When investors learn about the superior performance of DIs, they will demand them. And as the demand for DIs grows, the sales of ETFs will grow with it.

Monetizing ETF Combinations

Not only will the introduction of DIs increase ETF sales, they also create a new revenue source for ETF developers by enabling the creation of powerful new investment products that simply combine existing ETFs in the DI structure. By doing so, DIs uncover massive value in existing ETF product lines that is now lying dormant. A simple example will show how.

For this example I will create a Dynamic Investment that includes only two ETFs in its DEP, one that tracks a Stock index and one that tracks a Bond index. I will use the following generic names for the ETFs and show the indexes they follow. Note that these are real ETFs but I will not use their symbols in this demonstration.

  • Stock ETF – Russell 2000 Stock Index
  • Bond ETF – Long-Term Treasury Bonds

The table below shows the performance of each of these ETFs for the period from 2008 to 2017, inclusive, along with the performance of an NAOI Dynamic Investment that combines them in its Dynamic ETF Pool. The Sharpe Ratio shown in the last column is a measure of how much return is earned for each unit of risk taken – the higher the better.

You can see that the performance of the DI is amazing and virtually impossible using MPT methods.

In this example I have taken two existing ETFs and combined them in a very simple, high-return, low-risk Dynamic Investment. Now I have three investment products instead of two. And the Dynamic Investment delivered performance that is significantly higher than either of its ETF components. This example illustrates how Dynamic Investments unleash the value of ETF combinations. This is value that is currently lying dormant in existing ETF product lines.

Opening a Vast New World of ETF-Based Product Development

From the above example, you can see how easy it is to create Dynamic Investments by simply combining existing ETFs in the DI structure. This opens a massive and virgin field of product development in which an unlimited number of high-performance DIs can be created for virtually any investing goal with minimal time, effort and expense. Of course not all combinations of ETFs will provide superior performance. Training by the NAOI is needed to learn the art and science of creating optimal DIs. NAOI Dynamic Investment support offerings are discussed at NAOI.org.

Enabling Rapid and Profitable Product Line Expansion

By focusing R&D resources on creating NAOI Dynamic Investments, ETF developers can expand their product lines exponentially and virtually overnight. The diagram below shows how this is done by creating a new layer of powerful, Dynamic Investments without the need to create a single new ETF.

A product line that offers both a full-range of stand-alone ETFs, along with a full-range of Dynamic Investments that maximizes the earning power of each ETF, gives Exchange Traded Fund developers and vendors a massive competitive advantage in a very crowded market.

Opening New Markets with Dynamic Investments

The inclusion of DIs in a product line also opens significant new markets for ETF developers. Because each DI is a comprehensive investment “product” with built-in management rules, DIs can be sold to portfolio designers, investment strategists and asset managers who will see DIs as a superior, new investment type. And because DIs are self-managing investments, DIs can even be sold directly to the public in conjunction with NAOI education materials that show individual investors how to implement and manage them using an online broker.

Presented below is a diagram that shows the entities and product flows in the current and the future ETF marketplace. The black lines and letters in the diagram show what exists now. The red lines and letters show the new markets, products and sales channels that will be available to ETF / DI developers in the future. Note that “Dynamic Investment Designers” will be a new entity that can create DIs by combining ETFs from multiple vendors.

The fact that Dynamic Investments enable ETF developers to sell their products directly to retail investors opens a massive market that cannot be reached with stand-alone ETF products.

In Summary

As a teacher of personal investing for close to two decades, I know that a large majority of the investing public has no idea that Exchange Traded Funds even exist. And this is a shame as ETFs offer many advantages over mutual funds. In this article I have shown how the introduction of NAOI Dynamic Investments solves this problem by fully exploiting the unique and powerful benefits of ETFs in a manner that static, MPT-based portfolios cannot. DIs are the investment vehicle that will finally elevate ETFs to mainstream status and enable them to challenge mutual funds as the market’s most popular investment vehicle.

The NAOI “Future of Investing” Series

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“The Future of Investing Starts Here” ® is a registered Service Mark of Leland Hevner and the NAOI.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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