No. of Recommendations: 2
Fixed-Income ETF's & CEF's

This is turning out to be an interesting investment problem.

There are only 6 fixed-income ETF's, and not that many fixed-income CEF's, all of which have been nicely collected and categorized by the Closed-End Fund Center.

Of the open-end mutual funds that allow frequent trading, ProFunds has five offerings; Potomac Funds has five offerings; and Rydex has a couple. (Due to their preference for esoteric names, it's hard to tell at a glance exactly what Rydex is offering. But in any case, as with the funds from any family, finding the prospectus and actually reading is where you start.)

At this point, which is still survey work, I don't wan to touch on all of the factors to be considered in moving from the idea that bond mutual funds might be traded toward the building of an actual trading system. So let me just do a quickie with the 6 bond ETF's, 4 of which can be dismissed immediately from further consideration.

#1 Anyone who knows enough about TIP (which is the ticker for the fund that holds TIPS as its underlying) to want to trade it is probably already buying his or her own TIPS, holding them to maturity, and doing just fine. In fact, it doesn't make much sense to me to try to trade TIP, which seems to be an institutional gig and better left to the institutionals.

#2 I'd say the same of SHY, IEF, and TLT, which are the funds that hold 1-3, 7-10, and 20+ year Treasuries as their underlying. If you know enough about these funds to want to trade them, you are likely already buying your own Treasuries directly, or else you are trading the futures contracts on them. Additionally, I foresee this problem (although it's been a while since I've done the exercise). By their volume numbers alone, the funds seem passably liquid. However, when you pull 1-minute charts for them, what you see is long periods of trading inactivity, which is “Not-A-Good-Thing”. My guess is that the volumes reported for these funds come from institutionals doing block trades. Chris is absolutely right that good money can be made by front-running the instituationals, but that is a more sophisticated game than I think is appropriate for the “average fixed-income investor”, who really is my target audience, especially when the tradables have such narrow daily, weekly, monthly price ranges. There's just not enough room for mistakes.

An aside: Futures can be traded in IRA accounts, and by “trading” I don't mean zipping in and out of positions. “To trade” is to have a disciplined method of getting into a position, and a disciplined method of getting out. You get in, and you get out. That's a trade, which says nothing about the time-frame in which that trade happens. “In-and-out” is a complete trade. Getting in is just half a trade, and the least important part of the whole process, a point that experienced traders like to make to newbies by posing the following problem:

“You and a monkey are going to be trading partners. One you will do all of the buying, and one of you will do all of the selling. Which job do you want?”

MORAL: “Always assume that a monkey did your buying for you.” It is your job as a trader to manage that position, which includes getting out immediately, with as small a loss as possible, if the position proves to be wrong.”

OK, back to the two remaining, fixed-income EFT's, AGG and LQD. AGG is a fund based on the Lehman Aggregate Bond Index, and you'll find beaucoup information about it when you Google the term. I haven't yet done the same with LQD, which is Goldman Sachs' Bond Index, but I suspect it includes some junk bonds (in contrast to AGG's solely investment-grade holdings) because when I do price chart overlays, LQD is seen to be more volatile. The two track each other closely (and just how closely could be determined by running data sets through Excel and applying the relevant formulas from their stats package). But just by eyeball (which is often as much as is needed), LQD can be seem to swing higher and swing lower than AGG, which suggests that they might be traded as a complementary pair or individually.

A further aside: every time you have enough data to make a comparison or contrast, also make guesses about why you are seeing what you are seeing, and then go looking for confirmation. Don't wait for someone to tell you what to look for. Look yourself, make a guess, and then check it out with other opinions. (And if you think you are right, have the courage of your convictions.) Investing and trading consists in evaluating partial or ambiguous information and making good guesses. If you can be absolutely sure about something, you can also be sure that everyone is sure and there's little profit to be gained. The market doesn't pay for information it already knows. Reward is directly proportional to risk. Risk is inversely proportional to information. Nobody pays you for something they already know.

Another point. AGG is a fund based on an index of investment-grade bonds. The Closed-End Fund Center just happens to have a fund category they call “Corporate Investment Grade” (which they abbreviate as CIG), and they list 5 funds: BDF, LND, ICB, PCN, VBF. When price chart overlays are done and AGG is used as the comparison symbols, you'll see that some of the funds track it quite closely and some do what amounts to their own thing, all of which sets up yet more trading possibilities to consider. (But I'm also running out of time.)

A final consideration. Instant diversification is touted as a reason to buy mutual funds, especially open-end mutual funds, which raises two sorts of problems.

#1 Defining what is meant by 'diversification” is something I know that few investors can do for themselves in any meaningful way. Therefore, they are committing an act of faith that they are, in fact, achieving “diversification” when they buy a fund. “Diversification” is a more sophisticated thing than merely owning a lot of what seem to be different things. But it also needn't be. Diversification is a tool for managing risk. It isn't the only tool, or necessarily the best tool. Therefore, before you do the trade, you need to identify all of your potential risks and all your potential risk-management tools. Sometimes, doing the equivalent of “putting all of your eggs in one basket and watching that basket carefully” is the lesser risk than putative “diversification”, which such an immanent investor as Buffet scoffs at, saying “Diversification is an excuse for ignorance.”

#2 Due to the minimalist reporting requirements that fund investors tolerate, no investor can truly know what she or he supposedly owns. Funds are only required to report their schedule of holdings twice a year, and the reporting can be several months late. (If I'm not mistaken.) So, yes, as of many, many months ago, the fund did own such-and-such-number of such-and–such securities, but who knows what they owned as of yesterday's market close? They know, because they have to mark themselves to market each day within 90 minutes (or whatever it is ) of the market's close. But they won't disclose their most current schedule of holdings to you if you ask them as a shareholder. So, to buy a fund is to make an act of faith, unless it truly is an index fund that holds each component of the index in the exact proportion as the index, which is also almost never the case. (Which is yet another story, but not necessarily “A-Bad-Thing”.) Furthermore, I'd claim that trying to game the index on the basis of the behavior of its components is beyond the abilities or needs of “the average fixed-income investor”. The hedgies, and some heavy-duty traders do it, but they play a different game. There are easier, more sensible ways for an average, small investor to protect and appreciate capital than to try to do things they really have no need to be attempting.

OK, I've gone into more detail than I intended, because I wanted to make some incidental points along the way about the general process of trading. I genuinely believe that the average small investor would be hugely benefited by taking a “traderly attitude” toward her investing, which means getting into her positions in a disciplined fashion and getting out of them in a disciplined fashion. She has no obligation to trade both sides of the market, nor to do her trades quickly. But if, for example, she can look at a chart and immediately see that what is touted to her by her advisor or friends as a “Screaming Buy” is actually a better short, she can protect capital by keeping herself out of trouble in the first place. That's what a lot of trading boils down to, “Chart Smarts” and following a game plan. And in subsequent Chautauquas, which this is turning out to be (shades of ZEN AND THE ART OF MOTORCYCLE MAINTENANCE, right?), I'll talk some more about those game plans as they might be applied to bond funds. (But I'm going to do so in smaller pieces. 1,565 words is almost too big a chunk of text to post or to read.)

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