Q&A With David Fry: July 15, 2005
Because of this, I thought it was the right time to bring in expert to provide some additional insight. While I know quite a bit about the use of exchange traded funds and find their use very important to my overall strategy (especially in my retirement accounts), David Fry has graciously agreed to take some questions from us.
Q: Welcome David. For readers who may be unfamiliar with you, can you please provide a quick background about yourself and your current performance numbers?
A: I've been in the investment business for 30 years. First as a bond dealer in 1975, mainly dealing in distressed securities (New York Bonds for example), then as a retail broker for Paine-Webber and Shearson Lehman Brothers where at both I became a Vice-President. In 1988, I formed Fry Financial Services which operated Fry & Co., a Broker/Dealer, Asia-Pacific Investment Management, a registered Investment Advisor, as well as two hedge funds. All in Honolulu, Hawaii. In 1997 I joined JWH Investment Management as Managing Director, Proprietary Investments, a subsidiary of John W. Henry & Company arguably the worlds largest Commodity Trading Advisor. In that capacity, I did something strange for John Henry--purchasing the Florida Marlins Baseball Team. When that was done, I moved back to Honolulu in 1999 and started planning the introduction of an investment newsletter that is today The ETF Digest. I am still registered with the NASD and NFA as an arbitrator.
Prior to 2002 we only covered the QQQQ and now we are covering over 50 different markets so it's hard to give you performance figures for so many different markets. We have placed some ETFs into three distinct portfolios that suit different investment styles - Aggressive ( +1.51% YTD), Growth (+2.27% YTD), and Growth and Income (+.35%). All have beaten Morningstar comparable indexes YTD.
Naturally, some sectors and ETFs have done quite well for us (Emerging Markets and REITs for example) while we've struggled with others, notably Japan. It's been a pretty difficult 2005 since trends have not been sustained and markets, at least for the first six months of the year, have been in trading ranges.
Q: Obviously you're well-positioned in the newsletter advisory business due to your focus on the fastest growing part of the investment business, exchange traded funds. Why do you think investors are gravitating toward this trend?
A: Retail investors know intuitively that their old conventional relationships with brokers was too costly and they weren't getting their money's worth. After a few years of losing money in their accounts with conventional firms and paying high fees, investors starting looking around. When trading scandals and other misdeeds occurred that was enough to cause an increased interest in ETFs. ETFs are the perfect companion for DIY (Do-it-Yourself) investors given their transparency, liquidity, and low expenses.
Q: In your research, do you think the average joe investor would be better off to focus entirely on exchange traded funds than stocks which is the focus of your newsletter?
A: Yes, for the "average Joe" it's much easier. In an upmarket, properly selected stocks will outperform any index. However, the average Joe just doesn't have the time to deal with that unless he's actively involved with online investing and using someone to guide him.
Q: Everyone knows the statistics that the overwhelming majority of individual investors and portfolio managers do not beat the market over long periods of time. Because of this, I've often told beginner investors to focus their time and energy on positioning their portfolio so they can at least match the market's performance. If an investor has that as their starting goal, what ETF(s) would you recommend to accomplish that goal and how would they go about it over various time frames (3 months, 6 months, 1 year for example).
A: Unfortunately there are now too many repetitive ETFs so choosing becomes more critical. We've grouped some together that we feel best match typical styles. Aggressive investors are more focused on tech sectors and Emerging Markets for example. In that category, we're using SMH (Semiconductor Holders), SWH (Software Holders), IGN (Networking ETF), IBB (Biotech ETF), EEM (Emerging Market ETF), EFA (Europe Asia and Far East ETF), and GLD (Gold ETF). Now there are some ETFs that are newer and could replace so many different issues from the same sector such as PWO (PowerShares Dynamic OTC ETF) or XLK (Technology Sector ETF) for example.
A typical growth investors might find QQQQ (Nasdaq 100 ETF), SPY (S&P 500 ETF), IWM (Russell 2000 Small Cap ETF), IEV (S&P Value ETF) mixed with previously mentioned EEM, EFA, and GLD. DVY (DJ Dividend Select ETF) and perhaps PEY (Mergent Dividend Achievers ETF). To make it easier and still cover all the bases, I would recommend VTI (Vanguard Total Market Vipers) and/or PWC (PowerShares Dynamic Market ETF) in lieu of the various sectors but still keeping dividend oriented issues.
More conservative investors would focus on previously mentioned DVY, PEY, IEV, VTI, XLU (Utilities Sector ETF), TLT (Lehman 20-year Treasury Bond ETF), IEF (Lehman 7-10 year Treasury Bond ETF) and GLD.
Q: Those are helpful guidepoints David. But, I think your answer also shows the complexity that still remains. I know from my conversations with all investors that they desire simple, low-cost, market-beating options. And, from your answer, I think what you're also indicating that at a basic level all investors really have to obtain a firm understanding of their own risk tolerance, time horizon, and investment objectives. Would you agree with that?
A: If investors want "market-beating options" they must sacrifice simplicity. In other words, just dealing with the major ETFs (SPY, QQQQ, VTI for example) means if you merely "bought" those, you're not going to "beat" the general market. However, choosing better performing individual sectors within the markets (for example--IYR, real estate; XLE, energy; and SMH, semiconductors) beat the overall averages at least during the first six months of 2005.
Certainly investors need to make the evaluations you mentioned to ascertain how best ETFs fit with their overall goals and personalities. Assembling a well-conceived and dynmaic mixture of ETFs to meet typical investor goals is a major part of our job.
Q: One question I receive quite frequently is how to go about analyzing exchange traded funds. Do you have any guidelines or recommendations on how to go about this? I know from reading your newsletter that your rely a great deal on technical analysis.
A: The first thing I look for is the related index. Is there one? How much data is there? And, how long is the history? Since I approach the markets on a technical basis, how does that ETF or security fit in with how I approach the markets? If back-testing the related index works well with what I do, then great, it will pass that test. If not, I won't and I'll stop there.
The next hurdle is liquidity. As I mentioned previously, there's a lot of "me too" repetitive ETF issues. The ETF market is quirky in the sense that once an issue becomes the accepted standard, a copy-cat will find attracting volume difficult. For example, SMH (Semiconductor Holders) is the most higly traded issue that sector despite the fact that it's structured as a "Holder" versus an ETF. (A holder is a trust and can't add new issues and can only be traded in 100 share lots). One would assume an ETF issue would attract more investors, but IGW (GS Semiconductor ETF) while performing similarly doesn't have the same following. So institutional investors are creatures of habit and the ETF market is dominated by this type of phenomena.
The next important feature is whether that market is highly correlated with the rest of the market. In other words, is it merely trending in the same direction as everything else? Does it add value? The less correlated the better. Unfortunately, most ETF issues today are highly correlated.
Finally, if all these factors meet my tests, I'll happily include that issue.
Q: Very interesting. I think that gives us a good outline of your approach and I appreciate you sharing it with us. I suspect that I also fall trap to only wanting to trade or own ETFs that have become the "accepted standard." I'm curious also to know from a contrarian's perspective if you find that unpopular ETFs in the same area outperform or underperform their peers. Have you seen any correlation one way or the other or just does it come down to basic liquidity?
A: There's exceptions to every rule. Recently we added a new ETF, RSP (Rydex Equal Weight S&P ETF). Volume has been relatively light, but the approach is significantly different from the traditional SPY. My testing has revealed significant out-performance using RSP versus SPY and, despite the low volume, I've included it. I believe over time, volume will build as this benefit becomes more widely known. I've done much the same with several new PowerShare ETFs (PEY, Mergent Dividend Achievers Index; and PGJ, Halter USX China ETF). Once again, back-testing these indexes against my trading system has proven effective and, fundamentally, I believed these two areas will attract investment interest.
Q: I tend to utilize exchange trade funds to invest in certain areas of the market where I'm not an expert (like biotech). Do you think that is one of the reasons driving the trend toward sector specific ETFs that are all the rage at the moment?
A: Yes, biotech is a great example where it's all about the "future" as opposed to current "earnings". In that regard this is a sector where an ETF is most suitable since when stocks in this sector go out of favor given a bad clinical trial or other reason, there's hell to pay. I would say the same for Emerging Markets and international investing in general.
Q: As you know, all investors have a bad habit of chasing performance, especially near the end or top of key cycles. What steps can investors take to avoid that trap? And, likewise, how do you spot value in the market in under performing sectors?
A: Since I approach the markets on a technical basis, I'm not looking for value as much as I am trying to correctly discover emerging trends. If I'm right, I'll try to ride the trend for as long as possible-hopefully many months. But, like anyone, we make mistakes. Being systematic and disciplined will minimize losses when you do get "trapped" or are simply wrong. I approach it like a business and try not to make emotional or value judgments.
Q: Can you lend any insight on the lack of shorting capability in most of the new ETFs for individual investors?
A: The simple answer is that issuance of new ETFs has exceeded brokerage loan departments ability to keep up. It costs them money to hold stocks for lending. Sponsors like Barclay's IShares, State Street, and PowerShares for example have no financial incentive to aid retail investors short. They only make fee income when more shares are issued--not when the same shares in float are shorted. So, they don't want small investors to short. Institutions on the other hand can go to them and have new shares issued in 50-100K denominations and the sponsors love that because there's new shares and more fee income. The small investor looking to short even 1K shares is scoffed at. The exchanges want you to trade options since that's more lucrative to them, so they have little incentive either to assist.
The rub of course is that all of them "promote" shorting as a feature and benefit. So the appearance is one of misleading promises and two levels of service--one for institutions while retail gets the short shaft.
Investors wishing to short ETFs will have to confine their activity to the top half dozen or so until "inverse" ETFs are issued. These are in the works and should solve the problem depending on the adequacy of these issues.
Q: I've been a long-term student of sentiment indicators and one of those indicators tracks the movement of traders in and out of exchange traded funds. For example, when investors seek more risk, you'll frequently see a shift to own more individual stocks vs. exchange traded funds. Do you follow these sentiment indicators when evaluating the market and/or your positions?
A: Not really. Most institutional investors, especially mutual funds, use ETFs to get invested in a sector quickly and will then buy the appropriate stocks and sell the acquired ETFs as time passes.
Q: So, in your experience, a dramatic shift to a specific sector ETF often is a leading indicator for stocks in that sector as well? If that is the case, even stock-only investors would be smart to also keep an eye on which ETFs are performing well or which ones make notable trend changes. Would you agree?
A: That's right. We cover over 50 different markets and of those, almost half deal with sectors. But, as I've mentioned, sometimes stock weightings within each sector index play a significant role. We've seen that recently in Biotech where BBH (Biotech Holders) took off owing to its heavy weighting in DNA (Genentech) while IBB (Biotech Ishare was restricted to Nasdaq and had no DNA). Recently IBB rose because of its 17% weighting in AMGN (Amgen). I study the components of each linked index to understand weightings that may drive prices one way or another.
Q: There seems to be a lot of new exchange traded funds and it is rare that I don't hear of a new one almost on a weekly basis. Are there any ETFs in the pipeline now that you're very interested in?
A: I think the following are needed and seem to be in the pipeline: Currency ETFs, Crude Oil ETFs, & Inverse ETFs.
These three sectors will, once issued, allow individual investors the opportunity to add more uncorrelated sectors to their portfolios. Having all these in place will allow an individual the opportunity to create their own hedge fund using ETFs. This is where its all going in my opinion.
Next are actively managed ETFs. I won't use them since they will just be mutual funds in an ETF structure. Technically oriented investors like myself won't be able to use them since there is no index to anchor them to. PowerShares on the other hand, has brought to market some interesting ETFs which I'm beginning to incorporate that are more actively managed "but" have an index link. These ETFs have potential from my perspective to bring performance levels to that of higher Beta stock funds.
There are other holes that need some filling:
1. Internet ETF--Google for example isn't included in HHH (Internet Holders) and can't be added owing to its trust structure.
Q: In my trading account, I'm currently sitting on a fairly sizeable cash position due to my view of the market in the short-term. Where do you put cash while trading trading your ETF portfolios?
A: I just leave it in the money-market fund with my broker. It's an interesting question since I've maintained long periods this year and last year in cash. You must maintain a short duration money-market fund so that when you need to move you can.
Q: Within my own long-term retirement accounts, I've put together what is known as a "lazy man's portfolio" which is basically a set allocation of mutual funds and exchange traded funds that I only adjust two times per year, if at all. Because I'm actively trying to time the market in my trading account, that works pretty well for me. Do you think an average part-time investor would be well-served with a similar approach, or one based primarily on market-timing of etfs as you advocate in your newsletter?
A: One of my "Sacred Cows" advises "to respect the methods of others". Everyone "times" the market in one way or another. Warren Buffett sits on $43B in cash yet claims to not "time" the market--yet by any other name it's timing.
You adjust your portfolio twice a year and trade actively the balance. Nothing wrong with that. I just believe that there's a time to be in, a time to be out, and a time to be short. If investors had just gotten out in 2000 when I did, they would not have received a "long" signal until the spring of 2003. They could then have resumed a "long" position with a larger base. If they had "shorted" when we did in 2000-2002, the base would have been even larger.
Everyone has their own way to get to heaven.
Q: Well put. And, that's a good point about Buffett that many investors fail to understand. I appreciate you pointing that out and I think others will as well.
Q: Earlier this year, Paul Farrell at Marketwatch posted an interesting article suggesting that no load index funds, particularly from Vanguard, are better than many exchange-traded fund offerings if you're an investor, rather than a trader. What is your opinion about this article and the use of no load index funds versus etfs particular for the buy and hold investor?
A: I would agree with Farrell if you were maintaining an account at a high cost brokerage firm. If you're investing at an online discount firm and paying only $10 per transaction, then the math boils down to how large a portfolio you have and what are the percentages.
Q: There seems to be a cost war going on in the industry as firms compete for the lion share of available dollars. Is there a good way to keep informed of these changes, or should cost be not a primary concern?
A: I assume you mean management "fees." You can keep up by just following the four major issuers of ETFs like Barclay's, State Street, PowerShares, and Vanguard. Fees are being squeezed. The more exotic the ETF, the higher the fee.
Q: Like most people, I suspect there will be a big demand for commodity ETFs. Do you agree with that view? And, if so, what effect will that have on the equity market itself, if any as equities compete for investment dollars?
A: That's true. XLE (Energy ETF) and IGE (Natural Resource ETF, which I don't cover because it's 75% energy making it redundant) have been big successes. As I said, I think the primary winners will be gold (GLD), and crude oil should it be issued. Silver will be issued soon and I suspect someone will want to issue a Commodity Index Fund. Since I was a Commodity Trading Advisor at one time I'm familiar with the area.
Q: I've read articles talking about new "actively managed" ETFs that are just mutual funds masked by an ETF structure. Is this just another way for Wall Street to find a way to make a buck or will these new breed of ETFs be something to actually consider?
A: Yes it is, and I would avoid them with the exception of PowerShares.
Q: Other than your website, where should investors go for more information on ETFs? Have there been any decent books written about the subject that you would also highly recommend?
A: Well, I'm writing one now. But, ETF Zone and ETF Connect are good sources of information.
Now for some questions from members of The Kirk Report:
Q from David: Most of the volume in the ETF's continues to be at un-tradeable low levels e.g. never over 500k shares per day and many never over 100k. It seems the original HOLDRS and SPDRS are the only ones with any tradeable volume. I appreciate your views on this as many more ETF's are being created (Vipers, Powershares,etc.) in a field that already looks too crowded.
A: You're right. That's why we only cover those that have volume. But, what constitutes good volume. When I was younger 50K shares was adequate. Today 500K? My threshold is 100K shares since my audience is primarily retail.
Q from Guruprasad: Are there any ETF funds at present or in the future being planned that mimic or come close to Dimensional Funds International Small Cap Value Fund (DISVX)?
A: It wouldn't surprise me, but I haven't heard that yet. Micro-caps are coming.
Q from Tim: I would like help with identifying the high beta ETFs. For example, if I felt strongly that the DOW or S&P were about to make a big move to the upside, and I did not want to purchase calls, is there an ETF that I could purchase that would be equal to 2x or 3x the DJIA? Likewise, if I wanted to put my money on a move to the downside, are there any ETFs that have a high-beta, negative correlation to the DJIA, S&P or Nasdaq?
A: Not yet. Rydex and ProFunds have leveraged indexed linked mutual funds. I suspect that one or both of them will be issuing these in ETF formats.
Q from Kevin: I desire to put together a long-term retirement account with a 10 year horizon using ETFs with a 10%-15% annual return with minimum risk. What are your suggestions?
A: You're may be more aggressive than what may be available. You'll have to focus on technology, emerging markets, and commodity issues.
Q from Lisa: Do the same rules of supply and demand apply to ETFs? I know that they represent baskets of stocks and usually don't trade at a premium and discount because of the arbitrage process. What is the best type of technical analysis techniques to use in my analysis? I use them sparingly in my portfolio, mostly because I have a difficult time understanding how to analyze them.
A: The benefit of ETFs is their transparency to the linked index. So there should be little variation. The more exotic (like overseas linked ETFs) the more variation.
Q from Larry: I'm curious to hear what you think about the apparent inability to short an ETF, and if the inverse ETFs are a reasonable substitute for shorting individual stocks. Even if there are ETF shares to short and/or an inverse ETF to buy, we still have the issue of liquidity, right? Don't we currently have the majority of ETF shares trading in a handful of ETFs and wouldn't this make shorting and/or inverse ETFs more risky?
A: Inverse ETFs may be the only solution. Think about it for a minute, inverse ETFs open the door for retirement plans to buy and be short. That's a pretty big market. But, time will tell.
Q from Gautam: Does investing in ETFs make sense for long term investors who traditionally have invested in index funds employing a buy and hold strategy? Please comment on operating expenses, tax efficiency, and dividend reinvestment.
A: Sure. ETFs are cheaper than most index funds period. Dividend reinvestment is not available yet.
Q from Dave: Journalists and investment salespeople treat ETFs as if they are a new concept, but I don't see any significant way in which they differ from old-fashioned closed-end trusts, which have been around for decades. A closed-end trust can consist of an actively-managed portfolio of investments or a portfolio intended to passively mirror an index. Could you outline for me the differences between the "new" ETFs and the old closed-end funds that have been around since the 70s and 80s?
A: Nate Most created the first ETF (SPY) in the early 1990's. The mutual fund scandal triggered their rapid growth. Remember, most ETFs are linked to an index period. As the index changes the ETF reflects that as well.
Q from Fred: Is there a Precious Metals ETF that can compete with the Vanguard Fund (VGPMX)?
A: They're working on it. When the Gold Bugs ETF comes out, you'll have a competitive product.
Q from Mark: Do ETF's trade at premiums/discounts or at NAV (like a mutual fund)?
A: As I mentioned earlier, the more exotic the ETF the more potential for variation from the index. There isn't that much inefficiency to concern yourself with.
Q from Mary: The inability of the retail investor to consistently and reliably short ETFs, despite the ETFs documented claims that they are able to be shorted, is both frustrating and unfair. When should we expect to see "inverse ETFs" hit the market?
A: Good question. I know who's working on them and that they're in registration with the SEC. For competitive reasons these issuers won't say and I don't want to violate their confidence.
Q from James: I look for the healthcare sector to be one of the better performing sectors for the next 6-12 months. I specifically like biotech & believe that's where the most growth will be. I think I am better off with an ETF rather than picking individual stocks and I am looking at investing in IBB. However, I also see that Powershares just came out with PBE. What do you think of these two ETFs & would one of them be a better selection?
A: Your choices just grew with the new PowerShares Dynamic Biotech ETF. I haven't made a decision on it yet. The weird thing about biotech is that IBB only includes "NASDAQ" biotech stocks so DNA (Genentech) is excluded. IBB is 17% weighted to AMGN. BBH on the other hand is heavily weighted by DNA, so the trick is to trade both. It's frustrating for me because I dropped BBH because every subscriber wanted IBB. Then DNA and BBH takes off while IBB just sits there. Now AMGN is on the move.
Q from Paiboon: Mr. Greenspan keeps raising the Fed's rate. What would it be the impact to ICF, ILF and EEM funds. I am a swing trader (I keep the stocks/fund until its characters changed from uptrend to downtrend), what indicator/sign should I watch for, so I know when to sell the funds?
A: Higher interest rates are bad news for Emerging markets generally. However the demand for raw materials from these countries makes for growth opportunities there. We're long EEM , ILF and IYR. One would think higher rates would be a negative, but I don't fight the tape.
Q from Gan: I have a full time job with no time to study trading, but I desire to buy a good ETF with which I could possibly put my monthly saved or annual retirement-oriented money to it. Any suggestions?
A: I suppose VTI in a general way might work.
Q from Paul: I've been told there is a way to create your own hedge fund using nothing but ETFs. Is this true?
A: Not yet. Please see prior comments.
Q from Fred: For index ETFs, would you choose the ones based on the Russell indexes, e.g., IWF,IWD,IWM,IWO,IWN or those based on the Barra indexes, e.g., IVW, IVE, IJR, IJT, IJS or a mix?
A: I'd go where the most volume is. For example, why use IJR when IWM does the same with more liquidity?
Q from Doreen: Would you please explain the in's and out's of the type of ETF that is suitable for each type of account (IRA or regular). I am also interested in your views on the EWO and EWZ.
A: Suitability is a personal evaluation. Some people are more aggressive than others. We're long EWZ and would recommend ILF as a better alternative. EWO is too thin. IEV would be a better choice for Europe.
Q from Jack: I own the Total Stock Market VIPERs (VTI), but I've been hearing good things about the Rydex S&P Equal Weighted Index (RSP)? If you had to choose between the two, which one would you go with?
A: Well, we're long both.
Q from Tom: To gain foreign exposure, I've been a holder of the iShares MSCI EAFE (EFA). Do you have any better recommendations at this time?
A: We're long EFA and EEM.
Q from Christina: In a flat to sideways market, are there any ETFs in your research that generally outperform all others beyond the sector-specific ETFs?
A: Well, Christina, that really depends on the economic climate. Some things may move well in a sideways stock market. REITs for example have done well in this climate...maybe too well.
Q from Vicky: The utilities sector looks ripe for a decline. Are there any shorting opportunities in exchange traded funds to play it?
A: If you can, XLU should work.
Q from George: I've owned the MidCap SPDR Trust (MDY) for several years and it has been one of my better holdings. Do you have any alternative recommendations in this area?
A: We're long MDY as well. You're doing well, why look for something else? Do you wish to diversify? Is that the idea?
Q from Carolyn: What is your opinion on the offerings by Powershares? I'm particularly interested in their semiconductor (PSI) and media (PBS) etfs? I find it difficult to figure out a good entry point in these type of new offerings. Can you offer some suggestions on how to overcome this hurdle?
A: I'm studying these right now. I'm concerned that they advertise 5 years of related index history, but unfortunately the AMEX where the indexes reside is only transmitting the last six weeks of data. Therefore, I can make no judgement until PowerShares and the AMEX get their act together. I like many PowerShares offerings and am interested to study them further. Remember, no index history, no interest.
Q from Travis: What three exchange traded funds do you see leading the pack in terms of performance over the next 6 months and why?
A: I have my own opinions, but I just follow the trends. Forecasting is for economists. As the famous economist once offered: "If you must forecast, forecast often". That's my motto.
But, IF YOU REALLY REALLY want to know, I personally am interested in the new PowerShares offerings, currency ETFs, commodity ETFs and Emerging Markets. Now, I'm not telling today if this is from the long or short side.
Aloha.
Thank you David. We do appreciate your time and effort to respond to all of these questions. I personally learned a few things and I'm sure those who read this will as well. For more information about David Fry and his newsletter, please visit his website at ETFDigest. In my opinion, David is one of the good guys in this business.
I'm privileged to bring you the first Q&A where I and other members have submitted questions to an outside expert in the investment field. While I generally use the monthly Q&A format to answer questions you send me about the market and/or stocks, many of the questions I've been receiving of late have been focused on the use of ETFs or exchange traded funds.
2. India ETF--Everyone's waiting for this.
3. Russia and/or Eastern Europe ETFs--are other markets where there's strong demand.
4. Gold Bugs ETF--I believe this is in the works and offers more upside than GLD alone. I would use it as a "long" position in lieu of GLD and when "short", I'd use GLD. I would act in the same manner with XLE (Energy Sector ETF) when "long" and short the Crude Oil ETF when "short".
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