The Active Index Strategist

July 12, 2004

Introduction

To many investors, the words 'active' and 'index' are opposites, and to use them together is an oxymoron. However, you can be as active as you want to be when using index products -- index funds, ETFs, and index futures/options. Whether you are a long-term investor who chooses to make annual asset allocation rebalances, or a 'hyperactive' market timer, index-based vehicles are usually the most efficient way to get precisely-targeted exposure to sectors, style categories, market-cap ranges or entire markets. ETFs are growing and could soon cover virtually every asset class, including domestic and international equities, fixed income, real estate --- and in the not-too-distant future, precious metals and currencies.

As in the inaugural version of this column back in January my aim is to provide an opinionated view on major asset classes, with a focus on investment strategies that can be implemented with index-linked ETFs. I derive my opinions from a blend of fundamental views based on global economic and political trends, as well as technical analysis of both the asset class or sector and the specific ETF. My perspective is medium term --my definition of this being a three- to six-month view -- with the goal of taking ETF positions to capture asset class trends.

Fixed Income ETFs

For this week's column, I focus on trends in U.S. interest rates and some fixed income ETFs that could provide opportunities for investors. The capital markets fully expected the rise in Fed Funds rates announced on June 30th. What they didn't expect were for U.S. bonds and notes to rally since then. But this is what has happened, and in the same week that the Fed raised short-term rates, fixed income ETFs rallied strongly, despite also going ex-dividend on July 1st with their relatively healthy interest/dividend payouts.

So what is going on? In many ways, even though the Fed is reacting to economic growth and signs of inflation, the bond market is seeing more evidence of an economic slowdown. Treasury notes and bonds are now solidly above their long-term (200-day) moving averages. Furthermore, as equity and currency markets adjust to the riskier geopolitical situation that has evolved in the past few weeks, and oil and gasoline prices rapidly spike back up toward their late Spring highs, a "flight-to-safety" effect could develop, with capital leaving equity markets and moving into U.S. treasuries.

Here are some of my thoughts on how to invest with fixed income ETFs in this environment:

First, don't be short fixed income ETFs - that opportunity (which I discussed in this column earlier this year) is gone and the yield of these products means that you pay a lot for the privilege of being short. If you want to bet on or hedge against rising short-term rates, use the options on fixed income ETFs (which have become increasingly liquid) or the interest rate futures markets (which have become increasingly price-competitive, with the entry of Eurex into the fray versus the Chicago exchanges).

Second, consider a long position, especially if you can buy on a minor dip in the coming weeks. As mentioned above, bonds have 'crossed over' their long-term moving averages, and this is visible in the major fixed income ETFs, such as the iShares Lehman 20+ Treasury (TLT) and the iShares Goldman Sachs InvesTop Index corporate bond fund (LQD). Although the fixed income ETFs have rallied sharply from their May and June double-bottoms, as is visible in the chart below, they've consolidated in a new range above their previous resistance levels, and appear poised for further gains. And longer-term indicators such as RSI and MACD on weekly charts confirm that the markets have made a significant multi-month bottom.


2-year daily return of TLT shown above. Source: CBSMarketwatch.com/BigCharts.com, all data as of 7/9/2004.

 


2-year daily return of LQD shown above. Source: CBSMarketwatch.com/BigCharts.com, all data as of 7/9/2004.

 

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