Burned by the Last Bear Market? Consider This ETF

It is well-known that a diversified portfolio will have a lower volatility and more consistent returns than a portfolio concentrated in only one asset class. But if volatility is as extreme as we saw in 2008, even a diversified portfolio will suffer large losses. For example, the Morningstar Moderate Target Risk Index, which has a 60% equity/40% bond allocation, suffered a loss of over 33% from October 2007 to March 2009. Losses of this size are likely to cause many people to sell out of the market completely--at exactly the wrong time. The strategy employed by  Cambria Global Tactical ETF  seeks to reduce the chance of large negative returns by selling out of the market early based on a systematic trend-following strategy. GTAA may be a good choice for investors who can't tolerate large losses in their investment portfolio.

Suitability
GTAA is an allocation fund for those with a moderate to aggressive risk tolerance who are interested in an actively managed absolute-return strategy. It is intended to serve as a core holding, either by itself or paired with other alpha-seeking active funds. For investors who do not have the time or inclination to research, monitor, and rebalance multiple funds, allocation funds like this provide a simple solution.

GTAA follows a unique investment strategy based on the research of portfolio manager Mebane Faber. The portfolio is designed to produce absolute returns by following a systematic trend-following strategy that employs very wide diversification of holdings. The fund will invest in U.S. stocks, international stocks, bonds, commodities, and foreign currencies all at the same time. The fund gains exposure to each asset class through narrowly focused exchange-traded funds. For example, instead of buying   iShares MSCI EAFE Index (EFA) for international exposure, the fund will instead buy each individual country ETF. This creates a very large portfolio of 50-100 ETFs owned at any one time. The broad multiasset diversification helps smooth out poor performance by any one asset class.

The trend-following component of GTAA seeks to invest only in funds that are appreciating and to avoid funds that are declining. It does so by using a fund's simple moving average, or SMA, as an indicator. For example, the 200-day SMA is a fund's average price over the past 200 trading days. A fund is in a positive trend when the market price of the fund is higher than the SMA value. A basic strategy is to own the fund when it is above its 200-day SMA and to hold cash when it is below. Research shows that such a strategy avoids large losses in market crashes but limits returns during market turning points. GTAA does not disclose exactly what SMAs it follows, but it likely uses multiple SMAs to allow it to scale into and out of positions. It is possible that GTAA could move its entire portfolio to cash in a market crash if all investments were trading below their SMA.

The final component of GTAA is a relative strength overlay to tactically overweight asset classes that are performing the best. Relative strength is the measure of how a fund is performing relative to other funds. GTAA will overweight asset classes that have strong relative strength. These tactical changes will increase or decrease each asset class' weight by a few percentage points and do not dramatically change the composition of the overall portfolio.

Fundamental View
GTAA was launched on Oct. 25, 2010, so there is not enough performance history for a star rating, but we can make some basic comparisons. Since inception, GTAA has returned a negative 3.25%. The most comparable benchmark would be the Morningstar Moderate Target Risk Index, which is up 10.28% over the same time period. Trend-following strategies like GTAA often underperform in periods where there is no clear direction for the market. In the fourth quarter of 2011, stock markets sold off because of the European debt crisis. Equity and commodity ETFs traded below their moving averages, and GTAA moved most of the portfolio to cash to protect capital. When the European Central Bank announced its bank lending program, the markets rebounded quickly and GTAA missed out because it was positioned in cash.

Research shows that a moving-average timing strategy is successful at avoiding the worst of bear markets. To avoid the risk of substantial capital loss seen in 2008 the portfolio will sometimes get caught in a large cash position when the market is rallying. An investor in GTAA needs to understand that its returns will deviate dramatically from major stock market indexes because of its broad diversification and market-timing strategy. The value of this fund will be seen over a full market cycle where it could produce equitylike returns with lower volatility.

Portfolio Construction
The fund is an active ETF that achieves its investment objective by primarily investing in other ETFs to create a very diverse portfolio. Assuming no tactical overweightings, the fund should hold approximately 16% U.S. stocks, 15% international stocks, 17% fixed income, 10% foreign currencies, 15% real estate, 14% commodities, and 13% cash. While not explicitly stated in the prospectus, the portfolio seems to equal-weight most positions. For example, the fund owns all of the sector ETFs that make up the S&P 500 in about the same percentage. Turnover will likely be more than 100% per year because of the relative-strength trend-following strategy that will move assets to cash in declining markets. GTAA also has the ability to own closed-end funds but has not done so yet.

GTAA's current allocation is 34% U.S. stocks, 9% international stocks, 0% commodities, 38% fixed income, 6% foreign currencies, and 13% cash.

Fees
With a fee of 1.42%, it is one of the more expensive ETFs on the market today. The fund will get a fee breakpoint when it crosses over $250 million in assets.

Alternatives
There are no ETFs that can be directly compared with GTAA because of its unique strategy. There are iShares allocation ETFs, which range from conservative to aggressive; these include  iShares S&P Conservative Allocation (AOK),  iShares S&P Moderate Allocation (AOM),  iShares S&P Growth Allocation (AOR), and  iShares S&P Aggressive Allocation (AOA). Each of these funds charges 0.11% on top of the fees charged by the underlying funds, but at different weightings to reflect their varying risk tolerance. These ETFs only invest in stocks and bonds and exclude commodities, foreign currencies, and cash. Although the trading volume in these allocation ETFs is relatively low, the underlying ETFs these funds invest in are liquid. Investors should get good execution, but when trading large dollar amounts, be sure to use limit orders and be patient.

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Disclosure: Morningstar, Inc. licenses its indexes to institutions for the creation of ETFs and ETNs. Morningstar receives fees that are mainly based on fund assets under management. AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Scottrade, and Van Eck currently license Morningstar Indexes. These ETFs and ETNs are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on the Morningstar Indexes.