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Focus on Correlations When Using ETFs

Paul Justice, CFA

Paul Justice: Hi, I'm Paul Justice, director of North American exchange-traded fund research for Morningstar, coming to you live from the ETF Invest Conference in Chicago.

Today I'm joined by Rob Stein of Astor Asset Management, a practitioner, not a product provider within the ETF space, but building portfolios for advisors and individuals. Thank you for joining me.

Rob Stein: Thank you, Paul.

Justice: So as someone who actually uses the products and doesn't have really much to sell people, what do you think about using ETFs today and your overall market sentiment? What are you doing?

Stein: Right, so Paul, we are one of the oldest advisors that have exclusively used ETFs to manage client portfolios. We've been doing it for more than a decade, and we manage about $1.5 billion this way. So the ETF, we think, is one of the greatest financially created products since the put option. So we're really bullish on ETFs as a tool to manage client portfolios.

Justice: Sure, now you're not a deep value investor or anything like that. You've got your own unique strategies, and ETFs really lend themselves as good vehicles for using that. Could you talk about a little bit of your investment process?

Stein: Sure, so we're economists, and it's not typical to have an economist be a portfolio manager. We are not looking at earnings growth per se; we are looking at cycles of the economy. We believe that there are four distinct identifiable economic cycles: expansions, peaks, contractions, and troughs. And sectors experience those same cycles.

So for us it's more productive to identify an existing cycle that a sector is experiencing and invest in that sector through ETFs. If we can create enough diversification and rebalance based on correlation, we think that we can create a portfolio that generally goes up in economic expansions and not down too much, maybe up a little bit, during economic contractions.

Justice: Sure, talk a little bit more about your evaluation of correlations and how ETFs have really helped you round out those portfolios?

Stein: Sure. So, typically stocks go up and down based on what's happening in the broad market indexes, and you're trying to outperform. That's not truly a terrific objective in the long haul. So what we do is when we pick the sectors that we think are in an expansion or in a contraction, we then weight the portfolio based on correlation. If two sectors or two ETFs or two securities are too highly correlated regardless of what the fundamentals are behind it, we will reduce the exposure of that.

In 2008, our portfolios were up a couple of percentage points with the stock market; I think it was the worst fourth quarter in decades. The main reason was not the crystal ball that you think we have. It was because the correlation of the assets in the portfolio got too high, forcing us to reduce and invest more in one or two noncorrelating assets, which at the time I think was fixed income and I think the dollar through PowerShares DB US Dollar Index Bullish, ticker UUP. And today we're seeing similar correlation start to get a little high, and we're reducing exposure for that one reason alone.

Justice: Great. So you are actually taking some action now. You're seeing some warning signs, and I guess what's your overall outlook then on the market? I mean, is it a cautious approach?

Stein: So, we identified a market slowdown in the beginning of the third quarter and reduced exposure. We actually cut equity exposure in half. The market declined even with half of our equity exposure. We still got hurt a little bit, but not nearly as bad as if we had full equity exposure.

As the economic data has been evolving over the third quarter, it appears that things are not improving. They are actually deteriorating further and will become even more defensive as the quarter ends, and that includes possibly buying inverse ETFs. Inverse ETFs as you know go up when the market goes down.

Justice: Sure. That's a sobering tale in your view on the market right now.

Stein: Well, there is one piece of good news. We think if we do head into a declining or contraction recession, it will not be nearly as severe as the last recession in 2008.

Justice: Great. Well, thanks so much for joining me today, Rob.

Stein: Thank you, Paul.