At 6 minutes into the interview, he says that QE2 will impact interest rates but does not change the money supply (although he made a reference to currency in circulation…hmmm). It sounds like a Bill Clinton moment (“I did not have sex with that woman.” which I remember him saying that straight into the television camera.) I understand that the Treasury is the organization that actually applies ink to paper and calls it currency. But to pretend that money creating exercises like QE2, which is a specialized form of Open Market Operations, have no effect on the money supply stretches the truth a bit too far for me. Have a watch.

Cleaning up the tax code is a good idea. But, that feels like a bit of misdirection since it does not fall anywhere near the Federal Reserve’s mandate.

The Fund King System is all about promoting systematic investment as a way to reduce the emotional component of investing that so often ends up hurting out portfolio’s performance.

This week, in response to several users’ comments, I am going to outline how to construct an Asset Universe that will suit my needs and also work well in the Fund King System. I fully expect that someone else would follow the same process and come up with a different mix at the end of the process.

I approach the process in a top down manner because my role is to be the Asset Allocator for my investment funds. Other people are going to execute trades, hold the securities and decide which securities will meet their obligations to me. By leveraging off of that expertise (which I am already paying for in commissions, custodian charges and management fees), I can invest in a broad range of asset classes without having to visit a single factory.

To do “top down” correctly, I need to start broadly and then trim down my options to get a portfolio.

The first question to start with is: What do I know? Am I stronger in equities, bonds, commodities, currencies or real estate?

The second question is: What can I learn about? Are there any areas that I could expand into with a reasonable amount of effort?

Third, check for holes. Going forward it is reasonable to expect periods where developed market stocks and bonds may be stuck in a downtrend. At that point, I want to have some commodities, metals and/or currency opportunities to continue making money while more traditional asset classes sit on the sidelines.

This should give us a good list of sectors from which we can build up a shopping list of mutual funds, ETFs and/or ETNs.

Investing in what you know

Most of us have grown up with equity investment but some have cut their teeth on the bond market over the last three decades of almost uninterrupted bull market. Perhaps you have a strong feeling about precious metals as a hedge against paper money. You might think that the world is going to end up paying much more for foodstuffs or maybe you want to buy into real estate.

As an economic participant in the markets every day, you actually have access to a tremendous amount of information. Start building up your universe of investment opportunities with ones that you know well. If the universe starts to get too crowded or you find something more exciting in the next two steps, you can always substitute.

Try to keep things as broad as possible. You may be tempted to start picking individual ETFs or fund families but you will end up with a stronger universe and a better refresh process if you take the time to evaluate a broad spectrum of products, ideas and opportunities.

Investing in what you can learn about

It is unlikely that any one of us will possess enough information to feel equally comfortable with every asset class. However, since we are looking at funds (mutual funds and ETFs) a lot of the nitty gritty details are dealt with by the fund manager whom we are paying with a management fee.

This is where most of us have to step outside our comfort zone. But it is important to remember that we are not going to be auditing Eastern European bank balance sheets, Asian petrochemical refineries and South American airframe manufacturers. The idea here is to find assets that may grow in the coming few years. The emphasis is on “may”. If we pick one or two dud assets in our universe, it will not matter overly much because our trading system will keep us invested in the most promising assets. But we do not want to get too complacent. If we pick too many similar or underperforming assets, the system will just be choosing between mediocre investments. As any chef will tell you, no amount of culinary skill will make a great meal out of lousy ingredients.

If we have been primarily US bond investors, it is time to venture into equities (domestic and foreign), emerging market debt, commodities and perhaps even currencies.

What if I don’t like junk bonds?

I don’t like JNK…do I have to include it? No. In fact, decide to actively exclude it. What do I mean by actively? Just admit you don’t like JNK and move on. When your neighbor brags about how he made money one week in the future trading JNK on margin, you can nod politely and imagine all the loss making positions that he neglected to bring up with you. The idea is to make money on the whole portfolio. The actual assets are just tools towards that goal.

If you have a bag of preconceptions that you have brought to the investment process, this is the one place where you can unpack and use them. It may make sense for you to include Russian Equities or a soft commodity ETF in your universe from a pure asset allocation point of view. However, if the idea of dabbling in commodities or investing in Russia makes you uncomfortable for whatever reason (logical or otherwise), then it makes sense to exclude them from consideration at this point in the process.

As a live example, I included home builders (XHB) and Spain (EWP) in my universe as the Global Financial Crisis started on the logic that they would fall sharply and then have some sort of recovery. Both eventually staged rebounds significant enough to be ranked in my System. But because I had strong negative feelings about the underlying assets, I not once but twice (because the rebounds happened at different times) hesitated to buy when the signal came up, kicked myself and bought just as each was peaking and did not cut my losses immediately when they fell back into the general pool. As a result, I allowed my emotions to interfere with what was otherwise a pretty decent investment strategy designed to capture a meaningful rebound in two bombed out assets. After these two helpings of humble pie, I decided to eject the offending ETFs from my universe. There was nothing wrong with the ETFs or the way they performed. The problem was me. So, with plenty of other investment fish in the sea, I took my lumps and moved on.

Leveraged ETNs may be a good category to exclude in the beginning. The reason leveraged ETFs cause trouble is not because they are inherently bad investments but because most retail investors do not understand how to use them and do not have the time (or inclination) to watch them throughout the trading session.

Where are the holes?

We have all heard about diversification and its benefits. Those benefits exist but they were a bit oversold during the “Great Moderation” in the 80s and 90s when most asset classes were in a bull market. We approach diversification in a different way. Rather than holding a diverse basket of assets, we concentrate our investment dollars on the assets that look the most promising. However, to do that, we must consider a broad range of assets in the first place, rerank our universe regularly and invest according to the system (ie. do not let “gut feelings” intervene). Diversification for us means having enough different assets to prepare for the different market conditions that are likely to crop up over the medium term (3-5 years).

So, look for holes in your list of potential assets. You do not need to add a lot of currencies but if you are US based, why not add the Japanese Yen or Euro? You do not need to aspire to becoming a pit trader in Chicago to include some precious metals , industrial metals or a soft commodity basket. And, although you may fancy yourself as a risk taking equity person, there is no reason not to include some short and medium term government bond funds for those times when no one is making money in equities no matter how aggressive your trading stance. Also, you might want to consider some sector funds. While the market has been volatile, the overall direction has been neither particularly positive nor negative over the last decade. Investment flows have become “rotational” as professional investors seek to eke out performance by chasing down the next hot sector.

OK, now that you know where to look, how do you find the funds and ETFs that meet your criteria?

The first place to look is your online broker. TD Ameritrade, Schwab, Fidelity, Vanguard and all the other providers all have excellent tools which can help you zero in on funds and ETFs that match your shopping list.

You want to check beta vs. the index, and if you can see it, the top 10 holdings (just to make sure that what you read on the label of the fund is what you think should be inside). For ETFs, you should check the daily volume. If you are going to be a major (over 5% of daily volume) trader by placing a buy or sell order, you might want to look for a more liquid alternative. ETFs have a bid-ask spread which can get unacceptably wide if the Similarly, you should also make sure that any mutual fund you invest in has a decent amount of Assets under Management (AUM). You do not want AUM to drop to a point that the fund manager decides to close the fund or merge it with another. Nor do you want to be in a position where one large redemption will impact your interest.

ETNs have one more level of due diligence since they are senior obligations of the bank/sponsor that issues them. Whereas the assets in a fund belong to the share or unit holders even if the management company goes under, the assets of an ETN are part of the bank balance sheet that has to satisfy all creditors. If we had not just gone through the Global Financial Crisis, most people would not care about the difference. Now that we know better, just make sure that you are comfortable with the counter-party risk. If in doubt, leave the ETN on the cutting floor and move on.

How many assets to you want to watch?

Try to whittle the list down to 20. Why 20? Because this is an active process and trimming the list to just 20 assets will force you to think carefully about each one. What if you chose a mid cap value ETF over a mid cap growth? If the equity markets are not in a cooperative mood, the System will tell you not to hold either.

Remember, more does not always equal better. If you have 5 tech funds in your universe, they will all move pretty much together relative to non-correlated assets like Silver or Treasuries.

If you are stuck for ideas, ETFdb.com has just put out a page with a number of useful sources that can help you. Check out this page of 50 free ETF tools.

So what is the final result?

For my “Seeking Alpha” Portfolio, I have come up with this. Is this the end of the process? Hardly. I plan to review this list once a quarter to fill holes and make sure that I have all of my investment bases covered. For example, I might want to drop one of my developed and one of my emerging markets and replace them with a Real Estate and another Fixed Income choice. That would add better balance to the universe.

Equities

Developed Markets
SPY – US Equity Market
FEZ – European Equity Market
EWH – Hong Kong Equity Market
EWY – Korean Equity Market
EWT – Taiwan Equity Market
Sectors
IXC – Global Energy Sector
IXG – Global Financial Sector
XPH – Pharmaceutical Sector
Emerging Markets
EWZ – Brazilian Equity Market
RSX – Russian Equity Market
EPI – Indian Equity Market
FXI – Chinese Equity Market
EWW – Mexican Equity Market
TUR – Turkish Equity Market

Fixed Income

TLT – 20+ Year US Treasuries

Currencies

FXY – Japanese Yen
FXE – European Euro
FXA – Australian Dollar

Commodities

DBA – Agricultural Futures
GLD – Gold

The Seeking Alpha Portfolio

As mentioned in last week’s post, we switched out of 370 shares of EPI (Indian Equities) to invest in 320 shares of DBA (Agricultural Commodities Basket). The EPI netted us $9190.25 (and a short term capital loss of $710.95) and we bought the DBA for $9371.15. Our cash balance falls to $345.95.

Last week, we participated in the general rebound to the tune of +4.11%. Overall, we are still down 3.53% from our starting point on November 15th.

There are no changes in the ranking this week so we will see how our portfolio of Hong Kong, Turkey and Agriculture fares in the choppy markets that seem destined to persist for the foreseeable future.

One final note

Just to follow up on an issue we explored earlier, it seems that hedge fund performance has generally not lived up to expectations (Bloomberg article). This might lead to some sell off in some of the favorite names. One of the biggest, AAPL, may be in for a bit of profit taking as the year closes and redemptions need to be paid out. We do not hold AAPL (long or short) nor are we suggesting that you should take any action. We are using the stock simply as an indication of the magnitude of the Hedge Fund redemptions.

We like to test market chatter with indicators. Talk really is cheap, but investors tend to be a bit more judicious with real investment dollars. The Fund King methodology is all about measuring what investors are actually buying and selling and comparing that with what people are saying.

As you can tell from the title, we are going to use Apple’s common equity as an indicator to test a market rumor for four reasons:

1. AAPL is well known.
2. It accounts for about 20% of the QQQQ.
3. It is one of the top holding of Hedge Funds.
4. Lackluster performance has kicked off rumors of big redemptions in the hedge fund space.

How does a hedge fund work?

The first thing to understand is how most hedge funds work. Almost all hedge funds are structured as partnerships. The fund manager is the General Partner (runs the partnership and gets the management and performance fees) and the investors are Limited Partners. Agreements vary from shop to shop but most only allow for redemptions twice to four times a year. To redeem your interest, you need to give advanced notice (say, 45 days).

The structure allows hedge fund operators to invest in more illiquid instruments and strategies because, unlike a mutual fund or an ETF, the chance having no cash to meet a sudden redemption is minimized. Investors are very wealthy individuals or increasingly institutions so the annual, semi-annual or quarterly cycles are seen as a small price to pay for access to “smart money.”

What does this have to do with AAPL?

If you are thinking in terms of iPad sales this holiday season, not that much, directly. But, one of the ways we like to use the Fund King Method is to verify or debunk what we are hearing in the marketplace. While we may hear rumors that hedge funds have in general not lived up to expectations this year and may be facing big redemptions, it is hard to collect solid evidence of either postulation in time to position one’s portfolio. The reason we do not have hard evidence is not due to some sort of conspiracy. Hedge funds are private companies and they have a right to keep their positions and trading intentions to themselves. The information will eventually be disclosed but, by then it will have little commercial value.

When hedge funds receive notice (30-45 days) of redemptions, they are compelled to sell assets to meet those redemptions (which are met primarily in US dollars). Since hedge funds often invest in illiquid assets (private equity deals, complex swap arrangements, custom built derivatives, funny stocks in foreign markets and so on…), they tend to sell down the most liquid assets first.

This could be part of the reason we are seeing money coming out of the “riskier” assets and “popular” trades around the world, and a subsequent rebound of the US dollar…or maybe not. What we need is a clearer indication of what is going on. That’s where a big, favorite holding like AAPL comes in.

Is AAPL a perfect indicator?

Unfortunately, there is no such thing. AAPL has had a tremendous run in terms of both its products and its stock price…so some year-end profit taking is probably inevitable (just in case the Bush tax cuts don’t get renewed). But, since we should see a fair number of iPads under the tree this year, a big drop might be a confirmation that the hedge fund redemption story has temporarily swamped AAPL’s fundamentals.

How can we play?

Since most of the money being redeemed will be repositioned with other firms, the net effect over a three month view will be negligible. However, we may see some downside in risky assets (and upside in safer assets) in December with a reversal in January (perhaps a pronounced “January Effect” coming up). Expect a lot of “disinformation” which may take the form of this attempt to tout a growth stock with deep value methodology, but do not let the buzz distract you from the price action. If hedge funds are under pressure and need to sell down a big stock like Apple, you do not want to stand in the way of that or other top performing, liquid assets. But, also, you do not want to be overly gun shy when these assets are being offered at a post-holiday discount in the early days of January. Keep your eye on Apple…the stock price may be telling you some valuable information about the short term state of the markets. And you may even get a chance to pick some up at a good price.

P.S. Don’t settle for a lump of coal in your stocking

When I was researching AAPL and hedge fund holdings, I came across this post from MarketFolly.com. I had to read it several times because I could not believe that someone of David Einhorn’s stature and reputation could make such a dopey statement about Apple (AAPL). If you watch the whole interview, he comes across as sensible but the Apple section is still a shocker.

Of his AAPL position Einhorn says, “Looking at Apple today, the stock is about $310, or $320 a share. There’s about $45 a share in cash. So you’re paying about $265 for the business. I think they’re going to earn well over $20 a share in the next year, so you’re looking at a PE net of the cash in the low teens, which is below a market multiple.”

Source: MarketFolly.com

If he thinks AAPL can earn $20 a share and presumably more in years to come, then 15-16x earnings is probably not an outlandish price to pay. If you agree with his thinking, fine.

But, he chose to engage in a bit of deep value flim-flammery by deducting the cash from the stock for the purpose of comparing it to the market and trying to dress up the stock as “cheap” relative to a market full of corporations that are also sitting on huge piles of cash (over US$1 trillion by some reports).

This method of analysis is common in deep value situations. Someone might come across a company trading at $60 with $45 of cash on the books and conclude that one is getting a good value because you are only really paying $15 for the business. But, the P/E always includes the cash portion of the balance sheet because the cash is part of the earnings potential of the company (for better or worse).

Applying this sort of deep value thinking to a growth stock trading at nearly 4x book would get you “dope-slapped” before you could finish the sentence as a first year analyst. Why? Because that $45 represents half the balance sheet and is actually a drag on earnings (and bad for shareholders) rather than a positive. Slicing it away to pretty up a P/E ratio in the current low interest rate environment is a shocking attempt to “apply lipstick to the pig”. For someone who has made his reputation by showing which emperors were parading around without clothes, the irony is rich.

AAPL may be the greatest stock in the world but not because you can trim $45 from the $310 “P” to get a somewhat lower P/E ratio.

Disclosure: neither long nor short AAPL…just watching.