Large-Cap Stocks and Covered Calls Are Key to 2010 Outperformance - Fund Manager Tyler Vernon

by: Tyler Vernon

Tyler Vernon is a Principal and Portfolio Manager at Princeton, NJ based Biltmore Capital Advisors.

We had the opportunity to ask Tyler how he's allocating among different asset classes in this environment, and what his overall strategy is for outperformance in 2010.

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Seeking Alpha (SA): In your portfolio currently, how are you allocating among different asset classes?

Tyler Vernon (TV): We believe diversification is the key to protecting assets and compounding returns over the long term. While correlation of asset classes was dramatically high in 2008 and 2009, we believe 2010 will be much different. As such, to determine over and underweightings of portfolios, the investment committee of Biltmore Capital Advisors takes a macro view of the economy and looks at valuations of various asset classes relative to economic realities that we see over the next 12-24 months.

While we think the stock market is properly valued as a whole, there are still undervalued areas of the market where returns can be made. In particular, the riskier, smaller companies with higher P/Es and lower dividends outperformed last year, keeping the larger, higher dividend yielding companies at fairly attractive current prices. We believe that individuals should focus on these larger multinational companies as they will capitalize on deriving a large majority of their revenue from the faster recovering economies.

Additionally, we believe that the “risk trade" will end over the next 12 months as investors grow more concerned about a tightening Federal Reserve and that investors will flock to safety at that point.

Our strategy focuses on not only diversifying by size, style, and sector, but also on employing covered call strategies on approximately 50-60 percent of our long equity positions. Coming off a 55 percent increase from market lows, we feel that the economy needs to show signs of improvement and corporate profits will need to see top line revenue growth before this market regains momentum. As such, we feel that the market will trade in a range for a considerable period of time and covered call strategies will outperform.

For income oriented investors, if we can target large companies issuing 3 percent dividend yields, and collect a 10 percent annualized yield from call writing, we are accomplishing their income goals without taking interest rate risk inherent in the current bond market. Even for total return investors, if we can collect a 9-12 percent dividend and income stream in flat markets using these strategies, we believe people will be better off over the long haul than owning the S&P outright.

When viewing market investments, we believe risk management is more important than ever and that professionals and individual investors alike don’t accurately understand the risk inherent in portfolios. Biltmore Capital believes it’s important to purchase out-of-the-money protective puts on at least 50 percent of the equity portfolio in attempt to protect against another black swan event. While there is obviously an expense to purchase these out-of-the-money puts, only a small portion of the covered call premium is used to buy this protection.

We also practice risk management by employing a 15 percent allocation to structured notes. These investments, generally principal protected by an underlying bond or CD, give our clients the ability to profit by making directional views of currency, domestic and international markets, metals, and other commodities. Our investment committee will customize these investments according to long term themes we see materializing in the economy. Generally, the investor gives up some upside in their returns in exchange for the principal protection inherent in these investments.

We believe that 20 percent should continue to be in alternative investments. Within this space, 30 percent should be allocated to managed futures and the rest to macro and event driven hedge fund strategies. We believe that managed futures should be able to capitalize on any shock to the economy such as inflation, dollar crisis, or market turmoil and perform the way they did in 2008.

Additionally, we believe that low to non-correlated alternative investment strategies are key to diversification within a portfolio. Having the ability to go long, or short almost any asset class including currency, energy, metals, commodities, international and domestic equity markets as well as bond markets gives this strategy flexibility to capitalize on any trend that develops while properly hedging downside. After the robust run up in the equity markets over the past 11 months, we feel that a focus on alternative investments is more important than ever.

Fixed income is always a vital part of any portfolio but we feel it’s prudent to be underweight that asset class after historical inflows. Additionally, we at Biltmore Capital have been shortening duration on our fixed income portfolios to mitigate interest rate risk. We believe a 30 percent allocation to this asset group is still warranted.

SA: Which single asset class do you think will perform best in 2010? What stocks or ETF would you choose to capture that?

TV: We believe a combination of covered call strategies and managed futures should perform well in 2010. Since they historically aren’t correlated to each other, overweightings in these areas make sense.

At Biltmore, we customize our own covered call portfolios for clients as they generally have larger asset bases giving us proper capital to diversify. For the average investor, there are such ETFs as the Madison/Claymore Covered Call & Equity Strategy Fund (NYSE:MCN) that employ covered call strategies. It is important to note though that an ETF like MCN does not trade at NAV like a customized portfolio of stocks and options, so volatility can be much greater than owning the underlying positions. For this reason, we prefer customized covered call portfolios for our clients, but other options do exist.

SA: What instruments do you generally use to capture particular asset classes?

TV: We are fortunate to be able to work with individuals with established wealth of between $3-$40 million in investable assets. Because of this, we can produce customized portfolios for individuals using in house and outside institutional managers and don’t need to purchase tax unfriendly and high fee mutual funds. We can seek out institutional quality managers to manage separate pieces of client portfolios, ones who have proven track records of success in the strategy.

The alternative investments are generally the toughest to access, with lower minimums and fee structure. Having said this, funds have popped up over the past 5 years that give qualified investors access to managed futures at minimums as low at $10,000 as well as access to reputable hedge funds.

SA: Have any new instruments emerged in the past few years that you've adopted in your portfolio construction?

TV: There have been two major developments in the past few years that have made it easier for individuals to enter sectors of the markets as well as alternative investments.

First, funds have opened up all over with lower minimums to quality alternative investment managers such as managed futures and hedge funds. Qualified investors can access these funds for as little as $10,000 where in the past one would need a minimum investment of a million dollars. This has been a major win for individual investors as these asset classes have the ability to perform very well when markets fall, thus providing a vital element of risk management.

Second, ETFs have been the other major development over the last couple of years. We have made strategic allocations to these investments to capitalize on specific views of our investment committee. We at Biltmore have made allocations to ETFs such as GLD, TBT and others, enabling us to capitalize on leveraged directional views of bond prices and metals.

Seeking Alpha: Thank you very much for sharing your current process, Tyler.

TV: Happy to participate.

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