Paul Frank Positions for Q2: Long Crude; Emerging Markets Now Totally Gone From ETFOX

|
Includes: BNO, IDX, SLV, TBF, VBK, VDE, XLI, XME
by: Paul Frank

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 $85 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 the second quarter 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. Obviously no fund or investment should be judged on a single quarter of performance but I have to ask anyway. How have your predictions for 2011 played out so far, and how did ETFOX do?

Paul Frank (PF): Thank you for having me back Jonathan.

One quarter is a very short time period, so first I’ll go over my choice of SPDR Metals & Mining ETF (NYSEARCA:XME) as my “Just One ETF” pick from November 2010. The very next day [11.05.2010] XME closed at $60.70. It closed at $74.29 on March 31, 2011. Hopefully some of your readers were able to profit along with ETFOX’s shareholders.

Now back to the first quarter of 2011, in which ETFOX returned 6.59%. The Fund’s holdings from December 31, 2010 changed quite a bit in the first quarter. The following ETFs were eliminated from the portfolio: XLI [Industrial SPDR], KBE [Regional Banks], and IDX [Market Vectors Indonesia] and existing positions in VBK [Vanguard Small Cap Growth] and VDE [Vanguard Energy] were increased. A new position in BNO [US Brent Oil] was added. The Fund’s holdings are posted on its website every quarter.

Below are the holdings as of March 31, 2011:

Exchange Traded Fund (ETF)

Ticker
% of Portfolio

VANGUARD SMALL CAP GROWTH

17.7%

VANGUARD ENERGY

15.0%

US BRENT OIL FUND

11.0%

VANGUARD SMALL CAP

10.1%

VANGUARD GROWTH

9.7%

POWERSHARES QQQ

7.7%

SPDR S&P METALS & MINING

7.6%

PROSHARES SHORT 20+ YR US TREAS

6.8%
FIRST TRUST MICROCAP
6.5%

MARKET VECTORS RARE EARTH

4.0%

iSHARES SILVER

2.8%

VANGUARD MATERIALS

0.9%

CASH & MISCELLANEOUS

0.2%
100.0%
Click to enlarge

I try not to make predictions, but I do remember saying that inflationary spikes are often caused by unforeseen events. There weren’t too many people predicting an uprising across most of the Muslim world or a 15 meter wave to hit Japan. The only way to be prepared for such events is by investing in a well-built portfolio, and that is what I try to offer people with ETFOX.

SA: As you just alluded to, this has been an extremely eventful quarter with many geopolitical events driving global markets. But before we get down to specifics, how would you characterize your general approach to portfolio building and asset allocation strategies in your ETFOX mutual fund?

PF: Aviemore Asset Management, LLC uses both quantitative and fundamental analysis to build ETFOX’s portfolio. ETFs are ranked on a risk adjusted basis and the portfolio is built using Modern Portfolio Theory (MPT). The Fund’s benchmark is the S&P 500 and its goal is to beat the benchmark’s return with lower price volatility. The Fund’s fact sheet (pdf) shows that it is achieving this goal.

SA: Where would you plot U.S. equities as an asset class on the risk curve right now?

PF: U.S. equities aren’t as far out on the risk curve as many people think. Historically equity returns are more volatile than fixed-income, but I don’t believe that makes them less risky going forward. By understanding and using MPT I’ve been able to lower the volatility of the Fund by adding minimally correlated volatile ETFs.

SA: When we last spoke at the start of the new year, you had mentioned two high powered holdings from 2010: SLV and IDX. Obviously SLV was extremely strong in Q1, IDX less so. As you mentioned earlier, you have continued holding SLV but have closed your position in IDX? Are you expecting mean reversion to begin creeping into SLV in Q2? Was it the protests in the Middle East made you rethink your exposure to IDX?

PF: SLV [iShares Silver] and IDX [Market Vectors Indonesia] were two of the Fund’s work horses in 2010. However, by December 31, 2010 the fund had reduced its holdings to 4.4% in SLV and 3.5% in IDX. Presently the Fund has 2.8% of its assets in SLV and no longer owns IDX.

SLV’s performance has been stellar and I’ve continued to trim its holdings and take profits out of the position because of its mean reversion to the historical Gold/Silver ratio.

The protests in the Middle East are primarily pro-democracy movements. Indonesia is the 3rd largest democracy on the planet, so massive civil unrest is pretty low on my Indonesian worry list. Emerging Markets fell out of favor in my quantitative ranking system which caused me to take profits on IDX and move entirely out of the sector. Emerging markets aren’t represented in ETFOX because I believe they are not in a position to lower volatility and raise returns at present.

SA: It's impossible to discuss the Middle East without touching on oil. How high is it heading and how are you planning to play? Will rising crude prices significantly impede the economic recovery, or will it not be as bad as feared? Did you end up increasing your oil producer holdings via VDE as you indicated you would at the start of the year?

PF: ETFOX ended the year with 8% in VDE [Vanguard Energy]. Today the percentage in VDE is 15% and the Fund has an 11% position in BNO [US Brent Oil]. My work is very bullish on oil, but the Fund has the position on a short leash. So far the pundits don’t believe the price spike in oil has reduced recovery expectations. Perhaps it hasn’t reduced “expectations” but there is no way it hasn’t hindered the recovery.

SA: In the wake of the triple disaster there, are Japanese equities undervalued right now?

PF: There are no direct Japanese holdings in ETFOX. Some segments of their market have probably been oversold, but I’m not going to jump in with my clients’ assets to bet that they will turn that around anytime soon. Japan’s debt ratio is very high, and it will have to get bigger in order to rebuild. Japan’s quake and tsunami killed approximately 20,000 people. I’m assuming the third disaster you mention is the nuclear plants problem. If that plays out as I expect, the only death it will cause is that of the nuclear power industry.

The large story everyone is missing in Japan is the resilience of their society. Immediately after Katrina U.S. citizens were calling for government rescue; it seems the Japanese people realize they need to rely on themselves.

SA: How are you positioning with regard to the situation in the EU? Do European equities remain a bad bet right now? How much are we in the U.S. at risk of contagion from the situation in the eurozone? Are there particular sectors you are avoiding?

PF: ETFOX hasn’t had any direct European equity ownership in 2011. My work has shown the European bourses to correlate highly with the U.S. market and the volatility added by currency moves hasn’t improved any of these ETFs' rankings in my system. Contagions have the ability to travel easily, and our over-indebted economy is fertile ground for a “debt bomb”. It now seems the next victims may be Spain or Italy, and I’m obviously staying away from all government debt as a result.

SA: Continuing with the topic of fixed income, you mentioned your only bond allocation heading into Q1 was TBF, which is ProShares' Inverse 20+ Year Treasury, meaning you had a negative bond allocation. Has that changed? How do you view the fundamental case for U.S. Govt. Bonds heading into Q2? Are there other parts of the fixed income market you're currently looking on more favorably?

PF: My view on the fixed income sector hasn’t changed and ETFOX has approximately 7% of its assets in TBF. This short U.S. Government bond position was purchased while the Federal Reserve was buying massive amounts of U.S. Treasuries and the position is slightly profitable. I look forward to reviewing the position after the Fed stops its QE II asset purchases in Q2. There are too many forces pushing against passive fixed income ownership and even the high-yield corporate sector hasn’t risen in my rankings.

SA: Name one ETF investment that worked out particularly well during Q1 and one that did not.

PF: As I mentioned earlier, VDE [Vanguard Energy] has been a great performer for ETFOX. It was Vanguard’s [my favorite ETF provider] top ETF for the quarter, and earned a larger allocation in the portfolio.

XLI [Industrial Select SPDR] showed extreme weakness in February and the position was sold before the profit could become a loss.

Note from Paul Frank to prospective investors in ETFOX: Please read the Fund’s prospectus (pdf) before you even consider investing in ETFOX.