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Paul M. Frank is the president of Aviemore Asset Management, LLC, and the portfolio manager of the ETF Market Opportunity Fund (ETFOX), which has earned five stars from Morningstar for three-year, five-year and overall performance. ETFOX currently has nearly $75 million in assets under management.

Seeking Alpha's Jonathan Liss recently spoke with Mr. Frank to find out how he planned to position his ETFOX mutual fund in 2011 in light of his understanding of how a range of macro-economic trends were likely to unfold in the coming year:

Seeking Alpha (SA): Welcome back, Paul. How did your predictions for 2010 play out, and how did the fund do?

Paul Frank (PF): Thank you for inviting me back to share my ideas with Seeking Alpha. My predictions for 2010 were mid caps and a turn in the US dollar weakness trades. I was correct on the mid caps (ETFOX owned MDY and RWK). I didn't foresee the steps we'd take to undermine the US dollar, but was quick to take advantage of it.

The Fund's goal is to beat the S&P 500 return with lower volatility. Many funds reduce volatility by simply doing an equity/bond mix. I reduce volatility and increase alpha by a more detailed process. Most funds that did well in 2008 haven't kept up for the last two years. ETFOX has beaten the S&P 500 for each of the last three years. As of today, ETFOX is beating the S&P 500 by approximately 3.5% a year with a beta of 0.87 for the last five years. The Fund has been achieving the goal I set for it.

SA: Looking back at 2010, which ETF investments worked out particularly well, and which were a bust?

PF: The Market Vectors Indonesia fund (IDX) and iShares Silver (SLV) are two of the Fund's best performers this year. They were both added to the portfolio in 2009 and continued to generate alpha in 2010, while decreasing the Fund's volatility because of their low correlation to domestic equities. Their weightings were trimmed recently, but none of my quantitative work has turned bearish. iShares US Transport (IYT) didn't work out as desired. A small profit turned into a small loss in August and the money was rotated into First Trust Micro Cap (FDM), which has performed very well.

Seeking Alpha (SA): What methodology are you using to position yourself with ETFs for 2011?

PF: The first step in the Fund's investment process is to rank all of the ETFs quantitatively. I calculate each ETF's Sharpe Ratio using two different time frames. This allows me to compare them on the basis of units of risk. I then do some Fundamental and Modern Portfolio calculations in order to build the portfolio closest to the Efficient Frontier at the level of risk I want to take.

SA: And the results are?

PF: This has me increasing positions in Small Caps (VBK, VB, FDM), Metals & Mining (XME, REMX), Oil (VDE) and opening new positions in Financial (KBE).

SA: Despite predictions of a dip in equities amid slow global growth in 2010, stocks were clearly the better choice than bonds in 2010, especially in Q4 where bonds sold off almost across the board whereas stock returns remained robust. What's your view of bonds going into 2011?

PF: The only fixed income position in the Fund is TBF, which is ProShares' Inverse 20+ Year Treasury. So my bond allocation is negative. Many people don't understand the risks involved in buying and holding long-term Treasuries. All of my work shows continued weakness in the fixed income ETFs. I like seeking alpha because of its emphasis on mathematics. People need to concentrate on the relationship between asset classes and position their investments accordingly. I believe fixed income will underperform ETFOX.

SA: What would you say to people who own munis? Will a government bailout ultimately be necessary to backstop state debt as defaults pile up? Do the significant tax benefits of municipal bonds still outweigh the possible downside of one or more states defaulting?

PF: Who is going to backstop the Feds? I met with an advisor/newsletter writer this past spring and explained to him the beauty of betting against munis. To be nice, I'll just say he didn't agree. Shorting munis is very difficult, but some of the issues have credit default swaps available. Many of the CDS have doubled in price since my meeting (ETFOX doesn't own any CDS). Having said that, munis are a very fractured market. If you own a NY muni based on cigarette revenues, I would get out while you can. If you own a PA muni based on toll road revenues, I wouldn't worry too much.

SA: To what extent are you bearish on bonds because you expect inflation? In November the Fed implemented another round of quantitative easing (QE). Will we get a third round of fiscal stimulus in 2011?

JL: To steal a phrase: "I've learned what Quantitative Easing is, but now I don't what the meaning of Money is." Just about everything measured by dollars is going up. If we measure them in terms of purchasing power, I'm not so sure. I couldn't believe they did QE II, so I guess I shouldn't be surprised if we see QE III and beyond. I don't do any "seat of the pants" trading, but my work seems to be pointing in the direction of sectors that do well during periods of currency debasement. I believe inflation is coming, although I don't know if it will hit hard in 2011. Often extraneous events cause inflationary spikes and it is necessary to keep up with events across the globe.

SA: Does that lead you to owning commodities and precious metals?

PF: The Fund's only direct commodity holding is iShares Silver (SLV). I get exposure to the metals through the mining companies (XME, REMX) because I like the balance sheet leverage they have to the actual metals. The agricultural ETFs are climbing in my rankings and may be added to the portfolio in 2011.

SA: Let's move on to some specific issues that will affect equity returns in 2011 and beyond. How does the incoming Republican House majority affect the economic outlook for the next two years? Is gridlock ultimately good or bad for equity returns?

PF: In the past gridlock has been good for equity returns. I think it will be detrimental going forward. If some regulations/laws are not reversed, and if the size of government borrowing/spending continues at the present pace, we will see lower growth. Much of this is simple Economics 101. People need incentives. If you lengthen unemployment payments for over 2 years you can't expect the unemployment rate to decrease.

SA: Meanwhile, the U.S. housing market seems to be in the midst of another prolonged leg down.

PF: I like markets that aren't manipulated. Our government held the flame under the housing caldron for far too long. Everyone knows that prices went too high, so why are we now trying to prop up those high prices. The housing market should have been allowed to completely correct and I'm not going to bet on it happening anytime soon.

SA: How about the situation in the EU? Have you lightened up on European stock/bond exposure in client portfolios as a result of continuing contagion there? Are there any bright spots you'd focus on in terms of European equity allocation?

PF: Presently the Fund doesn't own any European ETFs. Some of the Fund's holdings (Industrial Select Spyder (XLI)) have exposure to Europe, but IDX is my only pure International holding. If an ETF rises in my quantitative rankings, I calculate its co-variance to my present holdings. It will be added if the calculations show that it makes sense. I don't have any bias against Europe, but they haven't earned a place in my Fund.

SA: That's remarkable - your only pure foreign holding is Indonesia. Why not China or India, or broad exposure to emerging markets with EEM or VWO?

PF: Indonesia is the 3rd largest democracy in the world, and their internal fundamentals are phenomenal. Indonesia has an open capital account and its economy isn't as reliant on exports as China. Another reason I own IDX is because it is the least correlated to the US markets. India is also a great story but I think China isn't their equal. As everyone knows capital flows are the boon and bane of emerging markets. Presently there is a tsunami of capital hitting these economies, and just about all boats are rising. If the capital starts moving in the other direction, they are in trouble. At one point this year the Fund had 11% in IDX, presently it has about a 4% allocation.

SA: Thanks Paul, and good luck for 2011.

PF: Thank you Jonathan and I hope you and all your readers have a profitable 2011.

Source: Paul Frank: Cautious on Emerging Markets, Bullish on Commodity Producers