Outside the Box: How to profit from ETFs’ quarterly changes and outsmart the stock-market algos

Equal-weight ETFs can be attractive because of their focus on narrow market sectors.  Yet rather than choosing which ETF best embodies the niche of the economy most likely to thrive, intrepid investors can search the underlying stocks of thematic ETFs.  The strategy turns the unique structure of these ETFs as well as the market algorithms on themselves, giving investors a shot at outsized returns.  

Regarding ETF structure, equally weighted ETFs rebalance on a regular basis, usually quarterly (market cap-weighted ETFs do not rebalance holdings), and this date is disclosed in the fund’s prospectus. 

For example, Invesco Solar ETF’s
TAN,
-1.96%
most recent realignment took place on March 30 and brought with it substantial buying and selling of its portfolio. As March came to a close and Invesco Solar rebalanced, money chased Enphase Energy
ENPH,
-3.83%,
SolarEdge Technologies
SEDG,
-1.75%
and Daqo New Energy
DQ,
-1.83%,
among others. These stocks had enjoyed big runs during the first quarter and the ETF had to buy more of these shares to catch up.  For example, on March 29, pre-alignment, SolarEdge was trading at $257 and on April 1 its stock closed at $295.  During the same period, Enphase jumped to $169 from $141; Daqo shares went to $78 from $62.  

To capitalize on this trading, individual investors can stalk positions in the top three- to five price gainers in a targeted ETF’s basket about 10 days before a realignment occurs. When selecting stocks, it’s not just price appreciation that matters.  Fundamentals matter too, because if the realignment-driven buying does not move shares, you want to be left with fundamentally sound equities. I look for companies with market caps of at least $2 billion, high levels of liquidity, and at least 10% sales and earnings growth annualized over the past three years. 

Another element of this strategy is that momentum can be spiked by algorithms which are reacting to the rebalancing trade.  Remember, a trading algorithm is simply a set of pre-defined rules that guide the buying and selling of stocks. These pre-defined rules are highly sensitive to order flow, which means that in addition to ETFs buying these momentum stocks as they rebalance, the algos are tuning in as well.  

Using such a blunt tool to outsmart the algorithms might seem like a mismatch of intellects.  Investors who want to add a little rigor to their technical insights might consider using the MAPSignals Big Money Index, which tracks the flow of institutional money in and out of equities and provides marketwide buying and selling signals.  

Jason Bodner, the Big Money Index co-founder, says institutional money flows can provide a reality check for an ETF rebalancing strategy.  “Even if the fundamentals and the rebalancing suggest opportunity, I would still avoid these trades in the face of large outflows of institutional capital.” 

Since the rebalancing trade comes along every 90 days, there’s ample opportunity to watch and learn.  For June’s rebalances, here are several ETFs and some of their current underlying stocks that I am keeping an eye on:  

Savvy traders at this point might be retreating to their “no free lunch” instincts. After all, if the algos are so smart, why haven’t they figured out how to capitalize on a massive trading opportunity that comes along with rebalancing?    

Part of the answer is that algos react to trading activity as it occurs, not trading activity that will occur. The high-frequency-trading of other algos, along with robo-trading, currency dislocations and myriad other technical indicators all provoke algorithmic buying in near real-time. Two weeks to 90 days is an eternity for the algos.  The other part of the answer is that, quite frankly, I don’t know. I do know this strategy has worked ever since ETFs emerged in the early 2000s, and today’s investors — at least those with steel nerves — might want to dance at this party while the music is playing.  

Louis Navellier is founder and chief investment officer of Navellier & Associates, Inc. He owns shares of Enphase, SolarEdge and Daqo directly and through the managed accounts of Navellier & Associates. The firm and the Navellier family also own shares of Kroger (KR), JD.com (JD), Nvidia (NVDA), Boston Beer (SAM) and Zoom Video Communications (ZM).

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