By Kevin Kennedy

CoolcatReport.com Publisher

Exchange traded funds, or ETFs as they are better known, are dramatically growing in popularity. Assets invested in ETFs have surged in the past few years to almost $2 trillion, and there are now more than 1,500 ETFs for investors to choose from.

ETFs are similar to mutual funds, but are traded like stocks. They generally represent major stock indices, industry sectors or major international country indices. In other cases they will represent a basket of stocks with similar fundamental characteristics such as high dividend yields.

Unlike mutual funds, whose reporting of holdings can lag by months, the holdings and weightings of ETFs are generally updated daily, offering greater transparency.

These funds allow for greater diversification of your portfolio by allowing investors to invest quickly and easily in major market indexes, hot sectors, foreign countries and even commodities. You can track the S&P 500 index or the Dow, invest in small cap indexes or bet on the price of gold or oil going up or down.

BlackRock dominates the category with about 300 iShares ETFs. Most ETFs are traded on the New York Stock Exchange.

The Coolcat Report Approach to ETFs

While many investment newsletters are having trouble wading through this new alphabet soup to pick ETF winners, The Coolcat ETF Report has helped guide many investors as they learn how to use ETFs in their portfolios.

The dramatic outperformance of international ETFs was responsible for most of the Coolcat ETF Report’s gains in recent years. Here are some of the wins racked up by the report’s top performing ETFs:

* iShares Mexico Index Fund (AMEX: EWW), up 92.1% in 24 months .

* iShares Brazil Index Fund (AMEX: EWZ), up 86.0% in 14 months .

* S&P 500 Energy Sector (AMEX: XLE), up 84.4% in 20 months .

* iShares Emerging Markets Index Fund (AMEX: EEM), up 54.9% in 16 months .

Published regularly since June 2004, The Coolcat ETF Report includes two model portfolios. The newsletter, which has been featured in Investor’s Business Daily, Forbes.com and MarketWatch.com. is updated twice a month with occasional alerts between reports.

The ETF Portfolio is more actively traded with buy and sell signals and relies on picks from my as momentum-based rankings of the top-performing ETFs. I added the ETF Majors Long-Term Timing Portfolio at the end of 2014. It takes a longer view of 30 of the most important domestic, foreign and bond ETFs and is a great tool for investors with self-directed retirement accounts.

It’s useful to review my approach to stocks as outlined in The Coolcat Guide to Winning Stocks on my Strategies page. As with stocks, I use market timing to be more aggressive in strong markets. I then want to choose the top-performing ETFs and use solid money management rules to keep my losses small and let my winners run.

My goal is to narrow the universe of ETFs to a manageable number that includes the best prospects. To do that, I look for the best performing ETFs that also trade enough volume to ensure liquidity. I also want to identify the ETFs with higher-than-normal price volatility to increase the potential for big gains.

My first step is to require all ETFs to have an average daily trading volume during the past three months of at least 150,000. This indicates a solid level of acceptance among ETF investors and traders and ensures sufficient liquidity to avoid irregular price movements. Your position in an ETF should not represent more than 5% of the average daily volume to avoid influencing the price action of that ETF with your buys and sells.

Some of the ETFs that have been created have not gained acceptance because they focus on a narrow niche market. In other cases, an ETF may give investors essentially the same type of exposure as another, more popular ETF. We can generally eliminate more than 70% of the ETFs with our 150,000-volume requirement and get the number down to about 300 with that step alone.

My second step is to require at least a 1.25-to-1 ratio between their 52-week highs and lows to ensure some volatility. This again helps trim the field down to the best ETFs for consideration. It also keeps us from considering ETFs that are basically going nowhere fast. This generally includes larger index proxies like the QQQQs (Nasdaq 100 Trust) and the SPY (S&P 500) that simply don’t move as much as more aggressive international and sector ETFs.

The second step will generally cut the list down to about 100 ETFs or less. I then rank those ETFs by six-month percentage gain and eliminate those whose price is lower than it was six months ago.

I also require ETFs to have traded for at least six months, be priced above $5 and represent at least 10 stocks. I have also also eliminated leveraged ETFs from consideration as they are too volatile for most investors. I also don’t cover Merrill Lynch HOLDRs, which are investment vehicles that are very similar to ETFs.

This approach tends to narrow the list to a manageable number of ETFs to analyze further before making decisions on which ones to add to my portfolio.

Depending on the strength of the market, I will generally be left with a list of at least 50 ETFs ranked by six-month gain. I highlight new listings and current portfolio positions and discuss the significant changes in the list from the previous month.

I also provide some insight into my choices for the Coolcat ETF Portfolio. Many of the top-ranked ETFs will already be in the portfolio, so I will skip those. I’ll do the same thing with other ETFs which simply mirror the same investment objective as ETFs that are already in my portfolio.

Eliminating The Copycats

There are a lot of me-too ETFs out there, so it’s important to at least take a quick look at their investment objective and holdings. Many ETFs are almost identical, or close enough that you are not gaining any significant diversification by adding the second one.

I will generally go with the ETF with the better recent performance and higher trading volume when looking at ETFs with a similar focus. Once I have eliminated the ETFs already in my portfolio and the copycats, I will generally buy from the top of the ranked list .

Portfolio Size

I will generally hold about 10-12 positions in the ETF Portfolio when market conditions are strong. I will be more cautious in weak market conditions and hold more cash. I may restrict my buys to half-positions and focus on more defensive sectors. I may at times establish some short positions when the markets are in retreat.

Money Management

I try to use a stop loss of 10% or less on all new positions. I generally use stops just below a recent key low.

I also might sell:

* If I have a better-performing ETF I want to add.

* If I become too overloaded in a certain area and want to diversify.

* If one of my positions gains more than 10% in a month after gaining more than 30-50% while in my portfolio.

* If a position is too extended from a key recent low in a declining market.

I was very pleased to introduce some changes to The Coolcat ETF Report at the end of 2014 that I will hope will have a big impact on the results investors achieve in their retirement accounts.

For years I have heard mutual fund salesmen say that buy and hold is the only approach that can work for the long-term investor. They say you cant time the market, so long-term investors are taught to grin and bear it when a significant bear market occurs, like we saw in 2000-2002 and again in 2008-2009.

They trot out statistics that say if you jump in and out of the market, you will miss some of the biggest one-day gains. Naturally they dont mention that you will also miss some of the biggest one-day losses.

I say theyre wrong, and I will try to prove it with the ETF Majors Long-Term Timing Portfolio, which uses a long-term approach based solely on market timing signals that will keep you in cash when the bears are roaming around and have you more fully invested in bullish conditions.

The portfolio focuses on 30 ETFs I have carefully selected based on a combination of their assets invested, their average daily trading volume and their importance in modern-day retirement accounts. Here they are, rated from most to least relevant in each category:

* SPDR S&P 500 (SPY)

* PowerShares QQQ (QQQ)

* iShares Russell 2000 (IWM)

* SPDR Dow Jones Industrial Average (DIA)

* SPDR S&P MidCap 400 (MDY)

* iShares MSCI Emerging Markets (EEM)

* iShares MSCI EAFE (EFA)

* iShares MSCI Japan (EWJ)

* Vanguard FTSE Europe (VGK)

* iShares China Large Cap (FXI)

* iShares MSCI Brazil (EWZ)

SECTOR ETFs-SPDRs

* Financial Select Sector SPDR (XLF)

* Energy Select Sector SPDR (XLE)

* Health Care Select Sector SPDR (XLV)

* PowerShares DB Commodity Tracking (DBC)

* SPDR Gold Shares (GLD)

* iShares iBoxx $ High Yield Corporate Bond (HYG)

* Vanguard Total Bond Market (BND)

* iShares iBoxx $ Investment Grade Corporate Bond (LQD)

* iShares 20+ Year Treasury Bond (TLT) BUY

These ETFs are divided into five categories representing the areas that most retirement experts agree should play a major role in your retirement planning: domestic stocks, foreign stocks, sector stocks, commodities and bonds. I am using a portfolio of 30 ETFs not to say investors should hold that many, but to offer guidance to a wide range of investors even if they are only investing in 3-5 of these ETFs.

I think there is also value in looking at this group of core holdings to get a quick snapshot of whats working and whats not in the current market.

Lets take a quick look at this approach as it applies to one of the most popular ETFs, the PowerShares QQQ ETF, which tracks the Nasdaq 100. The ETF began trading in March 1999 and the first buy signal came in September of that year. It lasted slightly more than a year and rose 45% during that time. It then remained in cash for almost 28 months, including all of 2001 and 2002. It ended with a loss of less than 1% in 2000. Meanwhile, heres what the Nasdaq 100 did to investors in those three years:

* 2000: MINUS 36%.

* 2001: MINUS 33%.

* 2002: MINUS 37%

Thats three straight terrible years in which the Nasdaq 100 lost MORE THAN 73% overall, while my approach stayed on the sidelines for the most part and lost less than 1%.

The current BUY signal kicked in on Nov. 30, 2012, more than two years ago. The Nasdaq 100 has gained almost 64% since then. Overall, the approach would have turned $10,000 into more than $44,000 at the end of 2014, or a gain of better than 340% — all while being in cash for most of the most painful market freefalls.

It wasnt perfect, though there was a bad patch in 2011 where it lost 21% in 16 weeks. It lost about 10% two other times. But that was by far the worst of it.

A buy-and-hold approach, meanwhile, trudged to just an 80% rise in the same 14-year-plus stretch. And thats if those investors could stomach the big drops and not do what a lot of folks do when the going gets rough bail out of the market altogether.

I Welcome Your Questions and Comments

If you have any questions or comments about the newsletter and its approaches, please feel free to email me. However, I can’t and won’t make specific recommendations about your portfolio or investments.

I wish you all the best of luck in your investing.

Kevin Kennedy

* The Coolcat Explosive Small Cap Growth Stock Report