Got a theory that healthcare stocks are going to take off? Forecasting that a rise in oil prices will send money scrambling into the energy industry? Or maybe you’re bullish on biotechnology shares?
Both traders and long-term investors have found in stock sector funds an ideal vehicle for practicing strategies that try to beat the market by putting money to work in the hottest industries.
Some fund houses make this type of moneymaking even easier by offering enough sector funds to allow you to rotate among widely different industries without ever leaving the same fund family. This simplifies record keeping and tax preparation, since all your transactions run through a single account, the one you set up with your fund company.
Investment companies that offer a variety of sector funds including Invesco, Rydex and Fidelity.
Jay Kaeppel, director of research at Wheaton, Ill.-based Essex Trading Co., has shown how one can trade sectors successfully within the offerings of just one fund company using his own strategy for trading Fidelity’s Select family of sector funds. We’ll dig into Kaeppel’s system shortly, but first a couple of basic points about sector funds.
A sector fund is simply a stock fund that invests in a specific industry. Because they concentrate in single areas, sector funds tend to behave with a great deal more share-price volatility than do diversified funds which spread their dollars among stocks from a variety of industries. Consequently, you’ll often them ranked among the best- and worst-performing funds.
While a sector fund subjects you to more concentrated risk than a diversified fund, the former still reduces your exposure to any single company. So in one transaction, you can usually get enough diversification to avoid getting killed if one stock in your favored sector goes belly up. In the meantime, you get the concentrated exposure to the industry area that you desire.
Of course, funds don’t provide these advantages for free. Some charge one-time sales fees or “loads” whenever you buy shares. Funds levy management fees and other charges to recoup their expenses. Many funds also erect redemption fees to discourage active trading.
So whenever you consider buying fund shares, be sure to consult the fund prospectus. Depending on their size, these costs can take a nibble or a bite out of your returns.
Fidelity, for example, collects a 3% sales charge every time you invest new money in fund shares. Then Fidelity imposes a $7.50 redemption fee, although that is waived for automated online orders, either via the Web or touch-tone phone.
The 3% load only applies to fresh money coming into Fidelity. Once a dollar is inside Fidelity, it can be shifted among Fidelity’s different funds without incurring the 3% load.
However, Fidelity does levy trading fees — 0.75% of the trade on shares held 29 days or less; $7.50 or 0.75% of the trade, whichever is less, on shares held 30 days or more.
There are no trading fees imposed when moving cash out of the Fidelity Select money market fund. But trading fees are imposed whenever cash is moved out of any other fund.
Kaeppel’s system for trading Fidelity Select funds uses a weekly signal. In other words, he checks his signals and positions once a week, then enters his orders, if any are indicated, before the close of the next trading day. Kaeppel’s system is a mechanical system. No human judgment is involved. Decisions are taken in lock step with the signals.
So far, Kaeppel’s approach has proven successful. He back-tested the system to Dec. 30, 1988, by which date he figured Fidelity offered enough sector funds to allow a valid study. In 1997, his first full year using the system, Kaeppel returned 40% on his capital vs. a 31% return for the S&P 500 Index. In 1998, his sector system returned 24% vs. the S&P’s 27% gain. In 1999, the approach produced a 65% return, more than triple the S&P’s 21% return.
Because it uses weekly signals which can be consulted over the weekend, Kaeppel’s method may accommodate people who lack the time to trade more frequently as well as active fund investors who want to minimize trading fees while still enjoying enough mobility to move into the hotter areas of the market, then exiting when those areas cool off.
“In the most active year, I think the system made 17 trades,” Kaeppel said. “Consider a person with $15,000 to invest, which means that person could hold up up to five Select funds with a minimum of $3,000 in each, net of loads. If you make 17 trades at $7.50 a pop, that’s $128, or less than 1% during the most active year.”
The system’s entry-and-exit signals use just two tools: long-term relative strength and each fund’s Net Asset Value compared to the NAV’s 28-week exponential moving average.
TradingMarkets.com offers a variety of relative strength and moving averages. For those who wish to use our metrics, Kaeppel suggests substituting in the TM 12-month relative strength and 200-day moving average “would get very similar results. The concept is still the same. The best-performing funds will show up at the top of the list.”
Once a week, the investor looks at the eight strongest-performing Select funds in terms of long-term relative strength. (Gold or precious metals funds are ignored if they appear in the top eight. Just focus on the other six.)
Next, evaluate the top-performing fund. Buy if the lowest daily close of the fund’s NAV during the week was not more than 2 cents below its 28-week exponential moving average. Continue to work down the list, deploying equal amounts of cash into qualifying funds.
The maximum number of funds you can hold will be five. Each new position will receive one fifth of your capital.
Any spare cash is left in the money market fund. The following week, the investor will generate a fresh list of the eight top relative-strength funds, excluding gold and precious metals, as well as any funds already held. If no such funds are found, the cash remains in the money market account.
“The reason for going to cash rather than just working further down the relative strength list is to hopefully provide some protection should we ever experience another drawn out bear market,” Kaeppel said. “In other words, the concept is that should there occur a repeat of, let’s say, the 1973-74 market, this system would likely spend a lot of time sitting in cash.”
The investor stays invested in each chosen fund until the system signals a breakdown in its trend. A sell signal is generated when a fund’s NAV makes a weekly low that is more than 2 cents below its previous week’s exponential moving average.
Whenever a fund is sold, the investor creates a fresh list of the eight top relative strength funds over the past 240 days. Cash is deployed in the best performer or performers on the list that are not gold, precious metals or already-held.
Sometimes, an investor will sell two or more funds but not find any new qualifying funds that aren’t already held. Let’s say you end up holding three funds while plowing the proceeds of the two sold funds into your money market account.
Over time some funds will perform better than others, bringing the investor’s positions out of balance. Kaeppel prefers to keep his allocations between different funds more or less balanced.
The investor also can sell and buy shares among his funds to effect transfers that even up his holdings. But as a practical matter, this becomes a big pain. Rather than trying to fine-tune his allocations each week, Kaeppel waits for balancing opportunities afforded when he has moved proceeds from two more funds into cash.
For example, an investor is fully invested in five funds. Then sell signals cause him to liquidate two funds. Kaeppel would divide that sum in half, evening up the imbalance left by the between divergent performance of between the two funds. Then each half would be invested in a fund as new candidates qualify.
For example, a hypothetical investor sells Fidelity Select Software and Electronics funds with proceeds of $29,278 and $33,064, respectively, on Dec. 12, 1994. The total $62,342 goes into a money market account. This amount is then split into equal parts, $31,171, and awaits reinvestment. On Dec. 23, 1994, the investor shifts $31,171 into the Medical Delivery fund and $31,171 in the Technology fund.