While mutual funds have long dominated the retirement savings landscape, in recent years many investors have turned to ETFs (exchange-traded funds) in an effort to add diversity and transparency to their portfolios. As the ETF industry grows, a new breed of mutual funds has emerged that incorporates the benefits of ETFs with the fundamental oversight that has made mutual funds an enduring investment approach.
For this interview, Fidelity Independent Adviser met with Paul Frank, portfolio manager of the ETF Market Opportunity Fund (ETFOX), formerly the Navigator Fund (NAVFX), to get an inside look at one of the top-rated ETF-comprised mutual funds available today. In the rapidly growing ETF industry, ETFOX will hit the five-year mark in spring 2009, and it recently garnered a five-star rating from Morningstar and the distinction of Lipper Leader for Preservation of Assets from Lipper Fund Services.
Frank, who steers the fund from a red barn in rural New York, designed ETFOX with the objective of capital appreciation for investors. Born in Quebec, Canada, Frank earned his B.A. in 1984 from Drew University and his M.B.A. in 1992 from Fordham University’s Graduate School of Business Administration, where he was valedictorian and earned the Dean’s Award for academic excellence. After graduation, Frank joined Signalert, a registered investment advisor, as an analyst and trader. In 1993, Frank founded Aviemore Asset Management, LLC, and he has been managing assets since that time.
Q: Why use ETFs in a mutual fund?
A: Combining the transparency of ETFs with a mutual fund helps investors tackle both security-specific and systematic risks, the two types of risk that ETFOX addresses. I am a student of Markowitz and the modern portfolio theory, which has helped me combat market risk. By using ETFs, I am also taking security-specific risk out of the equation. Investors will not be wiped out if a component of one of the ETFs suffers a loss.
Q: How do you choose which ETFs comprise the portfolio?
A: I employ a two-step process in selecting ETFs for the fund. The first step relies on mathematics and the Sharpe ratio to break down return per unit of risk. From there, I use two different time frames to show which ETFs are returning more than their longer-term average. This methodology allows you to measure the relative momentum of different ETFs against one another.
The second step, a fundamental filter, takes the fund beyond the numbers—a process that adds value and rationale to the decisions. I am a disciplined investor, and a close fundamental examination of the mathematical results allows me to stay invested and not go off on expensive tangents. Investors will get what they see in the prospectus—I’m not going to invest all their money in a passing trend.
Q: What kind of minimum standards do you apply for liquidity and market capitalization of the underlying funds? Are there any rules of thumb?
A: My goal is to get my orders filled without moving the market. I want to be able to unload any position in one day, so I won’t allow that position to be more than 10% of an ETF’s average daily trading volume. This has caused me to skip over some ETFs that have risen to the top of my rankings. Some of the smaller biotech ETFs were higher than IBB but had no volume or liquidity.
Q: Why do you think investors will be attracted to your fund at such a difficult time for the economy?
A: We are presently in a period of great turmoil in the asset management industry. Poor performance figures are being posted by previously stellar managers such as Bill Miller (Legg Mason). The rush into hedge fund investment vehicles has turned into a rush for the exits. Many investors are no longer willing to lock up their money for extended periods or to pay large management fees for average performance. I believe there will be a large amount of investor money looking for plain-vanilla investment vehicles that have managed the turmoil well. ETFOX has proven to be this type of fund, delivering positive alpha (above-average market returns) while taking below-average market risk. Personal service and market-beating returns are paramount concerns among investors today.
Q: The management fee for the fund is currently 1.75%. Is that typical for a fund of this type? What do investors get in return?
A: In any type of market conditions, it is important for investors to look at total return; focusing on just management fees can be a huge mistake in a difficult market. ETFOX is not an index fund like PowerShares QQQ (QQQQ); the fund’s beta, or market correlation, is 0.75, and I’m beating the S&P by more than 3% a year after fees.
Q: What kinds of “themes” has the fund taken historically? Has it leaned toward a particular sector over the past year? Which ETFs have risen to the top?
A: The fund’s main theme is large-growth U.S. equity ETFs. However, between 20% and 25% of the fund is placed in “opportunity” areas. Early in 2008, these areas were Brazil (NYSEARCA:EWZ) and gold (NYSEARCA:GLD). In the second half of 2008, I used two U.S. Treasury funds—TLT and SHY—to achieve both short- and long-term approaches. There was no place to hide in late 2008, and since ETFOX stays invested, we experienced losses along with the rest of the market. I’ve shied away from financials since summer 2007, which has meant a move away from the financial-heavy S&P 500 to overweight areas such as health care (NYSEARCA:IYH). As we moved into 2009, I reallocated assets into biotechnology (NASDAQ:IBB), high-yield corporate bonds (NYSEARCA:JNK), investment-grade corporate bonds (NYSEARCA:LQD) and inverse treasury bonds (NYSEARCA:TBT). This year has also seen me shift back from value toward growth, using VUG and QQQQ in the core holdings.
Q: What kind of investor would benefit most from your fund?
A: Historically, the fund has returned above-market returns while taking only 75% of the market’s risk. An investor who is seeking capital appreciation from U.S. equities and has a time horizon of longer than one year should consider investing in the fund. The disciplined, quantitative approach I use is designed to keep volatility to a minimum and tries to ensure that an investor is well-compensated for any risk ETFOX takes.