Thursday, November 6, 2008

The Kirk Report

The Kirk Report

10 Questions With David Fry

Posted: 06 Nov 2008 09:40 AM CST

David Fry
It's difficult to believe that it has been well over three years since our last Q&A with David Fry of The ETF Digest! So, we're long overdue for at least a quick update.

If you didn't read the previous Q&A, many of you know Dave from his Daily ETF blog in which he shares annotated charts of many popular ETFs along with his market musings. If you haven't visited his website, I highly recommend you do so!

10 Questions With David Fry

Kirk:  Since our last Q&A, what are some key developments in your area of expertise - i.e. exchange trade funds and their use in portfolio management?

David Fry:  It's been awhile since we did the last one and a lot has changed. Other than what is probably the tremendous growth of issues available and assets under management there have been some great new developments that we're thrilled about.

First is the arrival of many Alternative Investment, Inverse and Leveraged issues.

As some investors know, adding true uncorrelated assets to a conventional investment portfolio can reduce risk and increase overall returns. Therefore, having commodity and currency issues have been a major breakthrough. Previous to having commodity and currency ETFs, the only way for conventional investors to deal with them was either directly through trading expensive and highly leveraged futures contracts or in commodity limited partnerships.

As a former CTA [Commodity Trading Advisor] and CPO [Commodity Pool Operator] these pools traditionally involved high leverage, high minimum investments, expensive double digit fees, illiquidity and other negatives that turned-off mainstream investors.

ETFs have changed that considerably. Most of the previous negatives have been eliminated with ETFs linked to Commodity Tracking Indexes, gold, currencies, agricultural products, base metals, energy and so forth. If you want to use some leverage you can add a modest amount with some issues, liquidity is high and costs are comparatively much lower than previous vehicles.

Further, commodity markets are driven primarily by supply/demand issues. It's as likely to be long a commodity as short. And, in 2007 and 2008 we've benefited in both directions.

Currency investing has always been intriguing for most investors but was equally as difficult to participate in as commodity markets. Now, ETFs can be utilized for most major currency markets either for speculation or hedging without having to use the futures market or employ complex options strategies.

Inverse and leveraged issues covering US sectors, major market indexes, overseas sectors, and commodity and currency issues have been a great addition to the ETF Digest portfolio menu giving investors the opportunity to create some basic hedge fund like strategies.

Kirk:  Following what we've seen transpire especially over the past few months, what are some key things you're looking for as we finish up the year?

David Fry:  Given the lethal nature of market conditions taking positions is difficult given the wide intraweek and even intraday trading ranges we're witnessing. You expand your stops to very wide levels, invest with great conviction and courage or just stand aside in cash.

For us, the key to preserving wealth is risk management.

As they say, the first rule of investing is not to lose money. And, if you're down 40% or so, you'll need to make perhaps twice that amount just to get even.

Kirk:  Over the past couple of years we've seen our fair share of significant sector booms and busts. Where are you looking for the next boom to occur and which sectors do you think we'll see as leadership groups over the coming year or so?

David Fry:  The first task is to create portfolios with market sectors that are uncorrelated. Once those allocations have been made, I select a set of ETFs that exhibit the best trending characteristics and that work well historically with our systems.

But, we don't make forecasts. We only follow our systems which hopefully will lead us to the right trends within those allocated sectors.

Kirk:  A lot of investors have been burned by investing in overseas markets. Looking ahead are there any international ETFs that you think investors should continue to have on the radar screen? If so, why?

David Fry:  We were very overweight overseas sectors whether through BRICs [Brazil, Russia, India and China] or the regional issues like EEM [Emerging Market ETF], ILF [Latin American ETF] and EFA [EAFE ETF].

There was a lot of "talk" that these markets would decouple from US markets but that never happened. The only thing that did happen was the overseas markets rose and fell more in percentage terms than their US counterparts. The old expression, "when the US catches a cold the rest of the world catches the flu" was still operative.

Again, these markets exhibited good trends but did so in both directions. Therefore we were able to make good returns on the way up and the way down through the inverse issues that were available. I remember when we shorted Brazil in the summer through EWZ and that was thought heretical since the bullish theme was so ubiquitous.

I still like these themes but like the trending characteristics of them even better. I expect that to continue into the future no matter the direction.

Even though many investors are uncomfortable shorting, if our exit or shorting signals are sound, then just being on the sidelines is a smart and effective strategy.

Kirk:  Average spreads on ETFs have widened substantially over the past year. Do you consider this to be a problem, and if so, what recommendations do you have for investors?

David Fry:  Spreads were a serious problem when large market makers like Bear Stearns and Lehman Bros disappeared from the scene. Then risk aversion was extreme among remaining firms which led to poor market making and arbitrage for firms. Their credit lines were squeezed and things became inefficient. Further, hedge funds and mutual funds were awash in redemption and margin call issues which created fast market conditions.

When the SEC imposed restrictions on shorting, a large portion of important stocks hurt market making and caused further problems. Many restricted financial stocks crossed-over to major market indexes and that exacerbated inefficiencies.

Kirk:  You've said that "it's more important in a changing global economy to internationalize a portfolio and add uncorrelated assets." The latter - uncorrelated assets - has become quite a challenge. For someone who has a typical exposure to the market using both stocks and bonds, what suggestions would you recommend for those seeking to add uncorrelated assets to their portfolio?

David Fry:  Correlations are extremely important. On occasion you may see an important index generating a sell signal not supported by some of the lesser but highly correlated indexes or subsectors. It can often be important to trade off that one clue versus waiting for all the dominoes to fall in place.

Uncorrelated assets fall into the Alternative Investment category which includes commodity and currency issues. In most market environments and in this one in particular, you are doing yourself a great disservice by not being involved.

With the advent of ETFs whether leveraged or not, the opportunity finally exists for typical investors to get involved with these powerful effective sectors without destroying their portfolio with high leverage, fees and personal stress.

Kirk:  Tell us more about your "aggressive growth portfolio." Why do you think this represents a good model for investors and how has its performance been holding up this year?

David Fry:  You can see how allocations crossed into international and alternative investments with those sectors having heavier weightings [70%] than is typical. But, it's important to remember that we're now in November and next month the allocations will be changed again. It's too early to say how this will be done, but it will happen and we're working on it.

The Aggressive Growth ETF Hedge Fund Portfolio is up over +6% through the end of October and naturally has done well when compared to its peers. The portfolio went to cash over a month ago.

More exciting for us has been the evolution of Dave's Special Portfolio [DSP] which pursues a "Multi-Strategy Hedge Fund" approach. The allocations there are 15% Leveraged International ETFs, 10% International Special Situations, 25% US Special Situations, 25% US sectors leveraged long/short, and 25% Alternative Investments [Commodities and Currencies]. The DSP is up over +9% through October 31st and is also primarily in cash.

There's a favorable aspect of using leveraged issues that suit our style. Since we utilize primarily "weekly" charts to enter fresh positions given our trend-following style we can be late to new positions. Whether long or short, the leveraged issues allow us to make-up ground fast. And, if we've identified the trend correctly, these will allow us to beat the indexes ultimately.

Our oldest ETF covered is QQQQ which goes back to the beginning of 2001 when the newsletter began. We covered that alone for the first few years before adding new issues one or two at a time and ultimately portfolios in 2004. So, it's helpful for investors to analyze our track record for QQQQ.

From inception, the QQQQs using ETF Digest signals returned +19.95% annualized from 2001-2007 versus a buy and hold approach for the same period of -11.69%. But, what investors will notice is that most of the gains were made in the first few years. Since that period, we've underperformed the index. Nevertheless, the growth of a dollar over this 7-year period went from $1 to $2.45 versus buy and hold which declined from $1 to roughly $.48.

There are two points to make:

First, it's always better to restart into trends from a high level than trying to make-up ground from major declines. This is the case with our record since we started back on the long side of the market from a high dollar level.

Secondly, as I stated previously, with the advent of leveraged issues we can make-up ground fast and ultimately beat the index even if we're late, assuming our trend identification is correct.

Leveraged issues aren't for everyone. But here's a strategy tip: If you're not interested in being leveraged but still wish to hedge yourself or short modestly, use a half position and you'll still be able to achieve your goal without the leverage.

I believe these issues to be far superior for mainstream investors than the use of options and I say this as a former Options Principal. After all, there aren't any complex strategies or other considerations like: time premiums, strike prices, expiration considerations, deltas, collars, ratio writing, strips, straps, straddles and so forth.

But, using leveraged issues still requires you to be disciplined and systematic. There are too many investors who think a certain sector is going to make a move and they just throw an order in and lose money.

Kirk:  In the charts you provide at your blog, typically you provide two indicators - the RSI and the MACD and both the 50 day and 200 day moving averages. Why are all of these so important in your analysis? I've also noticed more weekly charts at your blog. Do you think weekly charts should take priority over daily charts in this environment?

David Fry:  Basically I have two presentations, one for the public and one for members. This isn't duplicitous since the audience is different as are the objectives.

With the public blog, I use StockCharts default presentations which happens to include the indicators you mentioned. The indicator I value on those charts is the "weekly" Relative Strength Indicator [RSI]. I then try to annotate the charts with pithy comments and lines of support and resistance. Needless to say, I like to have fun with the blog as well. I do this to give public readers what I see as market possibilities and little else. Based on feedback, most folks seem to like the both the humor and the analysis.

For members, I utilize much more in the way of detailed technical indicators which I value and from which signals are indicated. For example we've integrated complex DeMark Indicators to our system and these seem effective since implementation.

Kirk:  I know from reading you these many years that you practice and encourage strong risk management. When using ETFs, do you have any suggestions or recommendations on how to set stops and generally manage portfolio risk?

David Fry:  It's not unusual for us to carry a lot of cash. That in itself reduces risk. For example we're nearly 100% in cash and have been the past few weeks.

Remember, we don't have a requirement (and most individual investors don't either) to be fully invested 100% of the time. We're not running a large mutual fund which often has such a requirement or approach. For them, when money comes in, they just chuck it in there as any portfolio manager with a large cash position might be fired. While that seems harsh it happens to be a fact of life since mutual fund management believes investors are making a conscious choice to be "invested" in that fund strategy.

As indicated previously when using leveraged issues I have a much different approach to our trading. With basic ETF positions we utilize straightforward stop management techniques but we don't publish stops for many reasons. The most important reason is that they're changing everyday. So changing them frequently is quite a task beyond blogging and analyzing over 150 different markets. I definitely don't like to use resting stops in this type of market which can especially lead to a lot of unproductive trading.

As one insight, I'm more interested in what linked indexes are doing rather than ETFs and generally base my stops on that versus the security.

Kirk:  Beyond your own website, what online tools/website do you find particularly helpful to research and monitor the hundreds of ETFs now available to investors?

David Fry:  Reading the Kirk Report gives me good links to topical stories of the day and you've done a great job of sorting through all the noise to pick out meaningful stories.

One good thing about the bear market is that it's slowed new ETF issuance down although some of the commodity, currency and leveraged folks have a lot in registration waiting to come to market. But the SEC, with all its problems, has slowed things down in that as well. Nevertheless, a person in my position must stay abreast of new issue developments by staying in contact with ETF sponsor companies and with that it's important to have good communications with individuals within these organizations. Therefore we visit them and do podcast interviews with these market veterans. Also, my weekly podcast of the market conditions with co-host Greg Newton is made available to the public on Sundays.

Index Universe does a good job at research and keeping everyone abreast of new issues coming to market.

The Emerging Markets Monitor in London has been a great source for us to stay abreast of developments in important global markets. We do a quarterly podcast interview with the principals and they've been very good with fundamental research and market forecasts as any.

I do pay attention to conversation in various bear chat rooms since occasionally they offer links to good articles describing current conditions.

Don Coxe with BMO group has a very good podcast regarding commodity markets.

Greg Newton's Naked Shorts blog is always interesting and a fun read since he offers articles and comments from an experienced insiders view regarding hedge funds and many other investment issues.

You'll find many research links to other sites at ETF Digest.

Thank you David. We appreciate the update and wish you well in your market adventures!

More Negative Data

Posted: 06 Nov 2008 08:30 AM CST

Good morning. There's a ton of data out on the economy this morning and none of it very positive.

We have more mixed earnings reports and disappointing guidance, higher than expected jobless claims and a poor reading in the Monster Employment Index, news of more Wall Street layoffs, and weak same store sales reports. In addition, it appears by the losses in overseas markets that rate cuts by England and the ECB are not serving as a positive catalyst as many had hoped.



We have quite a large trading range to deal with between Tuesday's high at 1005 in the S&P and 849 on October 27th. For today, I'd keep a watch on the 10 day moving average (around 930) and see if we can hold around those levels prior to tomorrow's jobs report. In addition, I would also watch for how the market reacts to any new stimulus package chatter that we're likely to hear a lot about in the coming days.

Have a terrific Thursday!