The most common question: How do we make our mutual fund and ETF trading system selections? Ours is a system based on sector rotation using a relative strength. We touch on this in our fund trading course, but we often get asked to supply more information on our systems. Today we will start a small series of postings on just how we select our funds.

When we choose the best mutual funds we do absolutely nothing with value estimations or any type of global econometric evaluation, looking for external market forces to drive the fund selections. I’m sure that there are some very rich traders who do well with that approach, but for us we don’t have the time or ability to backtest that type of trading model. We look at one variable, the price of the funds being traded. We pick the best mutual funds using the relative strength of the mutual funds and exchange traded funds in our list, choosing those that are the strongest, but we do normalize to favor funds that are less volatile.

Market timing: We don’t try to do this either. There are a lot of folks smarter than us that spend a ton of time and effort in trying to time the overall market. We don’t think we have an edge there, so we don’t try to do any of that. Our Fidelity Select system does have the ability to go to cash at some point, but it’s based strictly on sector rotation using the relative strength of the funds being held (or actually lack of relative strength compared to cash), so it’s not a timing vehicle as such. In addition to the fact that we don’t think we have an edge with respect to market timing, it often turns out that there are funds that do well even in relatively weak markets.

Often you find energy or health related funds doing quite well in periods of overall market weakness, so to get completely out of the market instead of using sector rotation when there are pockets of strength in some sectors is not the best approach we’ve found when testing our systems. As we cover in this article, it seems there’s always a strong sector somewhere.

Next we will go into more detail on how we measure relative strength.