Tom Lydon Positions For 2013: An ETF Trend-Following Strategy For All Seasons

by: Tom Lydon

This is the eleventh piece in Seeking Alpha's Positioning for 2013 series. This year we have taken a slightly different approach, asking experts on a range of different asset classes and investing strategies to offer their vision for the coming year and beyond.

Tom Lydon is editor and publisher of ETF Trends, a website with daily news and commentary about the fast-changing trends in the ETF industry. Mr. Lydon is also CEO of Global Trends Investments, an investment advisory firm specializing in the creation of customized portfolios for high-net worth individuals. He has been involved in money management for more than 25 years. Mr. Lydon serves on the Board of Directors for U.S. Global Investors, Inc. and Guggenheim Investments. In early 2010, Mr. Lydon helped create the CNBC Model ETF Portfolios. Mr. Lydon is the author of The ETF Trend Following Playbook, as well as iMoney: Profitable Exchange-Traded Fund Strategies for Every Investor. He is Co-Founder of Virtual Summits, educational virtual events for financial advisors.

Seeking Alpha's Jonathan Liss recently spoke with Tom to discuss his plans for client portfolios in 2013 and how the famous 'trend-follower' uses momentum strategies to manage risk.

Jonathan Liss (JL): How would you describe your investing style/philosophy?

Tom Lydon (TL): We use technical trading strategies based around the 200 day-moving-average and other indicators, which help mitigate risk. Specifically, we keep an eye on the moving averages, both 50-day and the 200-day and never chase after under-performing markets.

Trend following is a long-term and dependable strategy that helps eliminate the emotions that causes erratic investment decisions. By following a pre-defined strategy before jumping into any investment, an investor is more likely to keep a focused attitude toward investing, instead of trading sporadically or placing bets on gut feelings. While there are general buy indicators out there, we also look for momentum off lows.

It should be noted that these trend-following strategies are not signals for buy-and-forget type investments. If investments should begin to dip below their trend lines, investors should not stubbornly hold onto them. Instead, try to set up some kind of stop-loss order to help provide a suitable exit point.

JL: How about trading costs as a result of momentum – how much of a factor are those?

TL: Trading costs used to be a factor, but today based on the size of your account, trading is very inexpensive. If you have an account under $5,000, then it may make sense to buy and hold in those types of accounts. Our minimum is $500,000 and trading costs are a tiny fraction.

JL: Speaking of costs, how much more difficult does strict trend-following make tax managing non tax-deferred client accounts? Are there ever times when you will hold a profitable position despite it triggering a clear sell signal because you want to avoid a large taxable event at year’s end?

TL: For the last 10 years, investors have been much more concerned with downside risk and preserving principal than tax exposure. You should invest money to make money and keep money, not to avoid paying taxes. When a long position triggers a sell signal, maintain that discipline. The amount of money you would save in avoiding taxes can eat away at principal pretty quickly.

JL: Over the last few years, there have been several well-received academic papers touting the ability of momentum-based investing strategies to deliver higher risk-adjusted returns. To your mind, what is the logical explanation for this phenomenon? As more investors migrate to this strategy, isn’t there a significant risk the market will ultimately take away this ‘free lunch’?

TL: There have been two historic bear markets in past 12 years. Having a trend-based strategy with clear exit strategies allowed you to preserve principal when the market was declining, allowing you to have more to put to work when the market ultimately rebounded. We’ve had a 10-year period when most developed markets have had zero returns. As investors look down the road and are fearful the next 10 years could perform like the last 10, they’re looking for strategies that may produce greater return. The main benefit of trend-following the past years was not participating in big bull markets, but avoiding big bear markets.

The markets are going to do what they want. If momentum works during a period, then great. If more people are following it, will it not work anymore? If you stick to the math, over time, this strategy works. It requires a discipline. This is key and critical. If people don’t have discipline to stick with it month in and month out, ultimately they won’t reap the benefits. Some investors switch mid-stream because a strategy isn’t working.

JL: As we begin 2013, are you bullish or bearish?

TL: Our positioning has to be bullish heading into 2013. Despite building pessimism the fiscal cliff was eventually worked out. The focus will now go back to the European debt crisis. Europe continues to hang in there and hopefully time will heal the debt wounds. As time goes on hopefully Europe will need less stimulus 'medicine' as economies improve. The wild card is if Europe slips into recession. But if that is avoided then there are reasons to be optimistic.

In the U.S., earnings have been slowing down recently but the compromise on the fiscal cliff will help. Some sectors that worked in 2012 should work again next year. For example, dividend stocks as corporations are more fiscally responsible. They’re waiting to hire, they’re getting more out of workers and technology. Companies remain profitable, they’re paying healthy dividends and dividends will continue to be popular despite likely higher taxes, which should only hit certain income levels.

Housing is improving and homebuilder ETFs were one of the best-performing sectors in 2012. This bodes well for confidence. We also like the technology sector. Global economic growth is positive and emerging markets are attractive. U.S. investors are underinvested overseas where many markets are posting GDP growth of between 3% and 6%.

JL: Which asset classes are you overweight? Which are you underweight? Why?

TL: In fixed-income, we’re overweight high-yield bonds, and underweight Treasuries. We’re looking for better yields and worried about the potential impact of rising Treasury rates. In equities we’re overweight financials, tech and consumer discretionary. We want to be in the more cyclical areas of the market.

JL: What is your highest conviction pick heading into the new year and why?

TL: We like the technology sector. Recently tech has been a little beaten up due to the impact of one huge stock: Apple (NASDAQ:AAPL). One way to invest in the tech sector with ETFs without putting so much in Apple is Guggenheim S&P 500 Equal Weight Technology ETF (NYSEARCA:RYT). It puts an equal amount into every tech stock in the portfolio.

JL: So for all intents and purposes you’re overweight small and mid cap tech stocks. Why are you positive on Tech above and beyond other sectors? Please give us some of the specific thinking that leads you to this conclusion.

TL: Apple could be a buying opportunity because it has had such a big correction. If you look at major tech firms, from an earnings standpoint, they are doing quite well, they’re sitting on a bunch of cash, being innovative. M&A is gaining steam in the space. During times of economic recovery, technology tends to outperform. Anticipating we’ll get out of the financial hangover, owning not just tech but small and mid size companies should be the right thing to do.

JL: Where have you been having retirees turn for income in this record low rate environment? How have changes to the tax code affected your assessment of interest-paying investments?

TL: We’ve been moving up the yield curve, and moving away from munis and Treasuries. We’ve moved into corporates and high-yield. Also, we're more concentrated overseas bonds and international debt, including emerging market dividend stocks. The tax status of muni income isn't in danger. The compromise on the fiscal cliff didn't include any change on muni tax status. There’s just too much money in that market. The dividend tax rose for big earners but dividend stocks are paying more than Treasury yields. There is more risk in Treasuries over the next three to five years than equities. We will see higher Treasury yields, which will negatively impact principal.

JL: Doesn’t moving up the yield curve expose you to interest rate risk in the longer term view, or does trend-following protect you from that?

TL: We meant to say we’re moving into the traditionally “riskier” sectors of fixed-income such as corporates, high-yield and overseas. We’re moving away from Treasuries and munis. We didn’t mean to imply we’re going longer maturity.

JL: Which are your preferred ETFs in each of these spaces?

TL: Investment grade corporates: iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA:LQD). High yield: SPDR Barclays Capital High Yield Bond ETF (NYSEARCA:JNK) and iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA:HYG). Emerging market bonds and international: iShares JP Morgan USD Emerging Market Bond ETF (NYSEARCA:EMB), Market Vectors International High Yield Bond ETF (NYSEARCA:IHY) and iShares Emerging Markets High Yield Bond ETF (BATS:EMHY).

JL: Turning to younger investors, what is the ideal asset allocation for someone with a long-term horizon (greater than a decade) and no need to touch their investments? Can investors continue to rely on stocks for the bulk of their capital appreciation?

TL: Actually, the time horizon for “younger” investors should be much longer than a decade. Bonds have outperformed stocks these last 10 years, but we’ll probably see the reverse happen over the next decade. Global markets will gain traction after paying for the hangover of the financial crisis. We’ve had 30 years of declining interest rates - yields will rise in the coming decade which will be negative for bonds.

It makes sense for younger investors to have a higher percentage of equities in their portfolio. Also, emerging market economies will do well and outperform developed markets over the next 10 years. Accounting practices are improving in emerging markets. Younger investors need to think about having more allocated outside the U.S. and to emerging markets specifically.

JL: Which is your go-to emerging market equity fund? Any consideration on your part of including Frontier markets in the mix for clients willing to take on additional risk?

TL: For emerging markets, we prefer iShares MSCI Emerging Markets Index ETF (NYSEARCA:EEM). I would say 'no' on the second part of the question. Frontier markets are so small and potentially illiquid, we're avoiding them for now.

JL: Which global issue is most likely to adversely affect U.S. markets in the coming year? Issues which feature prominently in our minds at present include continued Eurozone contagion risks; the Iranian nuclear threat/potential disruption to global energy markets; a Chinese economic slowdown; and accelerated climate change and weather-related events.

TL: We’re actually most worried about investor confidence. Looking abroad, now that we're past the fiscal cliff, the focus will go back to Europe. Will Europe go into recession in 2013 and what is the systemic risk there? There are always outliers like the Iranian threat, but that’s tough to factor in on a short-term basis. China may slow down and not see the huge growth numbers like the past decade, but growth will still be good.

Getting back to the 'confidence' issue, small businesses in the U.S. and individual investors continue to be risk-averse. Some resolution of European debt issues would obviously help. However, when everyone is confident, if you’re still on the sidelines then you’ve already missed the big market move to the upside.

The biggest concern in the next 3-5 years for investors will not be equity risk, but interest rate risk. Understanding how higher rates can have a negative effect on bond prices will be critical to protecting principal in the next 3-5 years.

JL: Do you believe gold and other precious metals are a genuine hedge in uncertain markets? If so, how much exposure do you have? If not, where are you turning for potential downside diversification?

TL: Both physical metals and miners are in a position to help people hedge against inflation and provide a safe haven from uncertainty going forward. However today, both spot gold and gold ETFs and miner ETFs (which we feel at one point will outperform gold) are under their 200-day averages. Look for all to have greater strength in 2013, and use moves above the 200-day average as buying opportunities.

JL: When you do buy back in, which funds will you be looking at specifically?

TL: For physical gold, SPDR Gold Trust ETF (NYSEARCA:GLD). For a basket of precious metals, ETFS Precious Metal Basket Trust ETF (NYSEARCA:GLTR). In regards to the miners, Market Vectors Gold Miners ETF (NYSEARCA:GDX) and Market Vectors Junior Gold Miners ETF (NYSEARCA:GDXJ).

Disclosure: Tom Lydon’s clients own EMB, IHY, EMHY, EEM, GLD, JNK, HYG and LQD.

To read other pieces from Seeking Alpha's Positioning for 2013 series, click here.