I’m going to ignore Matt’s twitter-length rebuttal of my last post, and instead point to an excellent set of data that just appeared in my inbox. State Street Global Advisors publishes (as many firms do) a monthly report on the ETF industry. What grabbed me this time was the short-interest report.

It should come as no surprise that ETFs are heavily shorted. After all, one of the great things about ETFs is that phrase “exchange-traded.” It means you can fold, twist and mutilate an ETF just like you can any other stock, and that means that if you can find it to borrow, you can short it. And since many ETFs are phenomenally liquid, they can be pretty easy to locate for shorting.

Overall, short interest in ETFs as reported on Oct. 15 was 11.84 percent. This is substantially higher than the number for the market as a whole; NYSE short interest was 3.51 percent overall. It’s worth nothing that this is a fairly high historical level for the NYSE—it hovers a bit above 2 percent over the last 10 or so years. Given the recent rally in many segments of the market, I’d actually expect it to be high. But what I wasn’t expecting was the extraordinary short-interest levels in certain sectors of the market:

Let’s cut through the haze here a bit. The “Size: Large-Cap” means the S&P 500 SPDR (NYSEArca: SPY). It is—as of the end of October—the most heavily shorted issue on the NYSE, with some 287 million shares short at the end of October. With some 700 million shares outstanding, this explains the lion’s share of that line item. I was equally unsurprised to see the heavy short position in financials, a figure dominated by the sizable short interest in the Financial Select Sector SPDF (NYSEArca: XLF), or small-cap stocks (explained primarily by a huge short interest in iShares Russell 2000 ETF (NYSEArca: IWM), as they’re up nearly 75 percent from the March lows.

But consumer staples? Consumer staples, most easily tracked by the Select Sector SPDR of the same name (NYSEArca: XLP) or the competitive iShares product (NYSEArca: KXI), has been a laggard in the recent stock market rally. While consumer discretionary stocks have been on a tear, putting that sector up 43 percent in the last year, consumer staples—which includes stocks like Procter & Gamble and Wal-Mart—are up just over 10 percent. From the March lows, of course, all did better, but no matter how you slice it, staples have been a laggard, not a leader.

Granted, you can only call something that has rallied 40 percent a “laggard” with a bit of a wink, but compared with the near-double of consumer discretionary stocks? This surprising bearishness is completely borne out in the options market, where there are 12,611 puts outstanding for November, vs. just 2,759 calls (for a 4.5:1 put/call ratio). By contrast, in XLY, there are 19,471 November puts outstanding to 7,264 calls (or 2.7:1).

Personally, I don’t generally play around with rotating sectors, but this did come as a shock to me. Since ETF shares are destroyed and created based on trading and investment demand, the implication here is that three out of every four shares of XLP exist at the whim of people making negative bets on the sector (of course, those three shares also represent someone else’s long bet, since every short position has an offsetting long somewhere out there.

With all the daily blather about moving averages, double-tops and candlestick formations, this is one indicator I can put some faith in, because it’s a reasonable representation of real traders’ sentiment, and a substantial amount of pent-up purchasing should those shorts decide to cover.

Restaurant stock prices have doubled since their November lows, retested in March. The Zacks Restaurant Index has surged 211% from its 52-week lows, far outpacing both the Russell 2000 (up 63%) and the S&P 500 index (up 48%). The major indexes remain roughly 25% off their 52-week highs.

Valuation multiples have expanded from trough levels and the group now trades at roughly 15 times 2010 earnings. While there are pockets of opportunity in the sector, we think the recovery will be slower than anticipated by the market, weighed down by a consumer sobered by shriveling home values and retirement portfolios and record levels of debt.

Casual dining cooks up positive earnings surprises, but offers no sustenance

Driving the restaurant stock rally, was a slew of better-than-expected earnings reports Ð and upward earnings estimate revisions -- including those by Darden Restaurants (DRI), Brinker International (EAT), Ruby Tuesday (RT) and California Pizza Kitchen (CPKI).ÊWith the exception of Darden, however, the out-performance was driven by strong cost controls, decelerating commodity prices and conservative assumptions.

Darden was the only operator that saw customer traffic improve and had limited same-store sales declines to the low single-digits (down 3.2% in its latest quarter). The remaining three earnings out-performers saw same-store sales fall at a mid-to-high single digit rate in 1Q09, and those results were bolstered by menu price increases, masking steeper drops in customer traffic.

Highly-leveraged companies rocket as credit markets thaw

Some of the steepest stock price gains in the restaurant sector, as in the overall market, were made by those of highly leveraged companies at risk of covenant violations or bankruptcy as sales shrank. As the credit markets thawed and it appeared less likely that these companies were headed towards bankruptcy, this group soared, including Ruby Tuesday (+785%), OÕCharleyÕs (+776%), Dine Equity (+388%) and Einstein Noah (+319%).

Valuation multiples are not justified by fundamentals

Consensus estimates incorporate a 15% earnings growth in 2010 off expected growth of 33% in 2009 and almost no growth in 2008.

In the midst of what is expected to be a tepid recovery, we think 2010 earnings estimates may be challenging. There are three potential drivers of net income growth: unit expansion, improved same-store sales and cost cuts.

There seems little chance that upside will come from more aggressive unit expansion, as current development plans remain extremely light and restaurant development takes about 18 months from planning to opening.

The second driver, same-store sales growth, consists of price increases and revitalized customer traffic.ÊAny price increases, other than the most minimal, would likely serve only to drive value-conscious customers elsewhere in this fiercely-competitive environment. Likewise, a brisk resurgence in customer traffic in 2010 is anything but guaranteed, especially in the first half of the year.

The majority of economists expect unemployment to continue rising into the second half of 2010, after reaching levels not seen in decades. Consequently, it is more likely that this time around the consumerÕs recovery will be slower than in past recessions, because this one was deeper and longer.

When employment resumes, consumers will be saddled with debt -- which is currently at record levels. Without the subsidies from rocketing home values that consumers had come to rely on the last decade, a return to thrift may be in vogue.

Finally, some of the cost cuts achieved in the last two quarters will anniversary in 2010. These include labor savings from new scheduling systems and food waste savings from new kitchen technology. Commodities, however, seem set to continue decelerating with the economy, enabling some casual dining chains to lure cash-strapped diners with value menu offerings like the quick service operators have done so well. Brinker InternationalÕs three concepts Ð ChiliÕs, On The Border, and MaggianoÕs Ð have each launched their own value menus.

Casual Dining plagued by excess capacity

When the economy recovers, the casual dining industry will continue to suffer from an oversupply of capacity and lack of differentiation, particularly in the crowded bar and grill segment. To meet investorsÕ expectations for growth, publicly traded restaurant chains expanded faster than demand for years, and in the mid-1990Õs, began opening units in less-traffic locations when ÒAÓ sites became scarce.

As the recession eroded sales and tightened credit, most casual dining operators finally began curtailing unit growth and closing restaurants that were under-performing Ð for some, this is years after profitability began to sag. Independent restaurants and small franchisers with fewer resources to weather the recession are closing at a rapid clip.

But to date, most large chains have closed relatively small numbers of under-performing units. S&A Restaurant Corp., the parent of BenniganÕs and Steak & Ale restaurants filed for Chapter 7 bankruptcy last June, but many of the units remain in operation. Consequently, despite curtailed growth and a growing number of bankruptcies, industry capacity has not meaningfully shrunk the way it did in the quick service segment a few years ago.

Upscale Segment

Like the casual dining segment, upscale restaurants proliferated over the last decade as the economy thrived. The degree of upscale overcapacity appears less severe, however; in part we believe this is because the segment is not dominated by public chains but rather by smaller private chains (Roys, Flemings, Palm, etc.) and by slews of independent operators.

OPPORTUNITIES

Buy Best of Breed

For buying opportunities, we would look for pullbacks in companies with strong brands that offer good value propositions and have a history of superior profitability and shareholder returns. Companies able to contain costs will have the ability to offer a ÒvalueÓ menu without squeezing margins, thereby boosting sales without sacrificing profitability.

Darden Restaurants (DRI) is our best example. We would also be a buyer of Buffalo Wild Wings (BWLD) on a sharp pullback. The company offers investors the strongest growth (25% EPS growth expected in 2009) and same-store sales (+6.4 in 1Q09) in the industry and a history of superior ROE and ROIC.

The successful chainÕs Achilles heel is its high leverage to the price of chicken wings -- roughly 21% of sales -- which are volatile and have soared 40% since December to nearly $1.80 per pound in March (the latest data available at the time of this writing). Impressively, BWLD has contained food costs with menu price increases.

WEAKNESSES

Underweight Casual Dining and Upscale

We are maintaining our Sell ratings on casual dining growth chains that continue to grow, despite sub-par profitability. BJÕs Restaurants (BJRI) and Red Robin Gourmet Burgers (RRGB) are two examples.Zacks Investment Research

Restaurant stock prices have doubled since their November lows, retested in March. The Zacks Restaurant Index has surged 211% from its 52-week lows, far outpacing both the Russell 2000 (up 63%) and the S&P 500 index (up 48%). The major indexes remain roughly 25% off their 52-week highs.

Valuation multiples have expanded from trough levels and the group now trades at roughly 15 times 2010 earnings. While there are pockets of opportunity in the sector, we think the recovery will be slower than anticipated by the market, weighed down by a consumer sobered by shriveling home values and retirement portfolios and record levels of debt.

Casual dining cooks up positive earnings surprises, but offers no sustenance

Driving the restaurant stock rally, was a slew of better-than-expected earnings reports Ð and upward earnings estimate revisions -- including those by Darden Restaurants (DRI), Brinker International (EAT), Ruby Tuesday (RT) and California Pizza Kitchen (CPKI).ÊWith the exception of Darden, however, the out-performance was driven by strong cost controls, decelerating commodity prices and conservative assumptions.

Darden was the only operator that saw customer traffic improve and had limited same-store sales declines to the low single-digits (down 3.2% in its latest quarter). The remaining three earnings out-performers saw same-store sales fall at a mid-to-high single digit rate in 1Q09, and those results were bolstered by menu price increases, masking steeper drops in customer traffic.

Highly-leveraged companies rocket as credit markets thaw

Some of the steepest stock price gains in the restaurant sector, as in the overall market, were made by those of highly leveraged companies at risk of covenant violations or bankruptcy as sales shrank. As the credit markets thawed and it appeared less likely that these companies were headed towards bankruptcy, this group soared, including Ruby Tuesday (+785%), OÕCharleyÕs (+776%), Dine Equity (+388%) and Einstein Noah (+319%).

Valuation multiples are not justified by fundamentals

Consensus estimates incorporate a 15% earnings growth in 2010 off expected growth of 33% in 2009 and almost no growth in 2008.

In the midst of what is expected to be a tepid recovery, we think 2010 earnings estimates may be challenging. There are three potential drivers of net income growth: unit expansion, improved same-store sales and cost cuts.

There seems little chance that upside will come from more aggressive unit expansion, as current development plans remain extremely light and restaurant development takes about 18 months from planning to opening.

The second driver, same-store sales growth, consists of price increases and revitalized customer traffic.ÊAny price increases, other than the most minimal, would likely serve only to drive value-conscious customers elsewhere in this fiercely-competitive environment. Likewise, a brisk resurgence in customer traffic in 2010 is anything but guaranteed, especially in the first half of the year.

The majority of economists expect unemployment to continue rising into the second half of 2010, after reaching levels not seen in decades. Consequently, it is more likely that this time around the consumerÕs recovery will be slower than in past recessions, because this one was deeper and longer.

When employment resumes, consumers will be saddled with debt -- which is currently at record levels. Without the subsidies from rocketing home values that consumers had come to rely on the last decade, a return to thrift may be in vogue.

Finally, some of the cost cuts achieved in the last two quarters will anniversary in 2010. These include labor savings from new scheduling systems and food waste savings from new kitchen technology. Commodities, however, seem set to continue decelerating with the economy, enabling some casual dining chains to lure cash-strapped diners with value menu offerings like the quick service operators have done so well. Brinker InternationalÕs three concepts Ð ChiliÕs, On The Border, and MaggianoÕs Ð have each launched their own value menus.

Casual Dining plagued by excess capacity

When the economy recovers, the casual dining industry will continue to suffer from an oversupply of capacity and lack of differentiation, particularly in the crowded bar and grill segment. To meet investorsÕ expectations for growth, publicly traded restaurant chains expanded faster than demand for years, and in the mid-1990Õs, began opening units in less-traffic locations when ÒAÓ sites became scarce.

As the recession eroded sales and tightened credit, most casual dining operators finally began curtailing unit growth and closing restaurants that were under-performing Ð for some, this is years after profitability began to sag. Independent restaurants and small franchisers with fewer resources to weather the recession are closing at a rapid clip.

But to date, most large chains have closed relatively small numbers of under-performing units. S&A Restaurant Corp., the parent of BenniganÕs and Steak & Ale restaurants filed for Chapter 7 bankruptcy last June, but many of the units remain in operation. Consequently, despite curtailed growth and a growing number of bankruptcies, industry capacity has not meaningfully shrunk the way it did in the quick service segment a few years ago.

Upscale Segment

Like the casual dining segment, upscale restaurants proliferated over the last decade as the economy thrived. The degree of upscale overcapacity appears less severe, however; in part we believe this is because the segment is not dominated by public chains but rather by smaller private chains (Roys, Flemings, Palm, etc.) and by slews of independent operators.

OPPORTUNITIES

Buy Best of Breed

For buying opportunities, we would look for pullbacks in companies with strong brands that offer good value propositions and have a history of superior profitability and shareholder returns. Companies able to contain costs will have the ability to offer a ÒvalueÓ menu without squeezing margins, thereby boosting sales without sacrificing profitability.

Darden Restaurants (DRI) is our best example. We would also be a buyer of Buffalo Wild Wings (BWLD) on a sharp pullback. The company offers investors the strongest growth (25% EPS growth expected in 2009) and same-store sales (+6.4 in 1Q09) in the industry and a history of superior ROE and ROIC.

The successful chainÕs Achilles heel is its high leverage to the price of chicken wings -- roughly 21% of sales -- which are volatile and have soared 40% since December to nearly $1.80 per pound in March (the latest data available at the time of this writing). Impressively, BWLD has contained food costs with menu price increases.

WEAKNESSES

Underweight Casual Dining and Upscale

We are maintaining our Sell ratings on casual dining growth chains that continue to grow, despite sub-par profitability. BJÕs Restaurants (BJRI) and Red Robin Gourmet Burgers (RRGB) are two examples.Zacks Investment Research

Investors can find such funds by checking out the entire list of the Zacks #1 Rank Small-Cap Equity Funds.

3 Small Wonders

American Century Small Cap Value Inv (ASVIX) was incepted in July 1998. The investment seeks long-term capital growth with income as a secondary consideration.

The fund invests at least 80% of its assets in small capital companies that are undervalued. It is designed for investors who want way to diversify large-cap growth investments.

Benjamin Giele has been lead manager at the fund since its inception. Giele has worked in the financial industry since 1992 and before joining American Century, he was an investment analyst for USAA Investment Management.

Wasatch Small Cap Growth (WAAEX) seeks long-term capital growth. Income is a secondary consideration, but only when consistent with long-term growth of capital.

Unit holders have to make a minimum initial investment of $2,000 to enter this Zacks#1 Rank (“Strong Buy") fund. Dividends and capital gains, if any, are distributed annually.

O'Reilly Automotive Inc. (ORLY), Resources Global Professionals Inc. (RECN) and Techne Corp. (TECH) are among the fund’s key holdings.

TFS Small Cap (TFSSX) seeks long-term capital appreciation. In addition, it seeks to outperform the Russell 2000(R) index.

The fund invests primarily in common stocks of U.S. companies whose market capitalization dose not exceed those of the Russell 2000 index. It may continue to hold investments in companies whose market capitalizations appreciate or depreciate to levels outside of the range of the fund's investment focus.

The fund has topped the total returns of its benchmark index in the last 1- and 3-year periods. It has an expense ratio of 0.88%.

Discover Many More Funds

Learn more about the new Zacks Mutual Fund Rank and discover some of the best market-beating mutual funds by browsing our new mutual funds section. This part of Zacks.com offers a variety of tools, including mutual fund research, a new mutual fund screener, helpful answers to frequently asked questions and quick access to prospectuses and other information.

By applying the Zacks Rank to mutual funds, investors can find funds that not only outpaced the market in the past but are also expected to outperform going forward.

• More Banking Trouble: This could come in many forms. But if the government's stress tests were not adequate or there are more bad loan boogeymen looming about, then we are right back where we started with this mess.
• Accelerating Jobless Claims: Weekly report of new jobless claims starts growing again instead of shrinking as it is now. The unemployment rate looks like it will reach around 10-11% when given the current picture of the economy. It's not good a sign if we start shooting past that mark.
• Deflation: Meaning the cost for goods start getting cheaper. It sounds nice on the surface, but it's a deadly economic disease that took hold of the U.S. during the Great Depression. It also spelled disaster in Japan during the 1990's which they call the "Lost Decade".
• Runaway Inflation: The reason the government pumped in so much money was to fight off a deflationary spiral. The risk on the other side is that all that extra money creates runaway inflation. Normal inflation is around 2-3%. If you see it creeping up to 5%+ then that could signal things getting out of hand.
• General Economic Weakness: There are a number of key economic indicators to look out for. Since consumer activity accounts for 70% of the economy, then deteriorating retail sales is a very bad sign. Also watch manufacturing activity and sentiment indicators. If they continue to tick down instead of the recent modest improvements, then it spells trouble.

• Sell all small cap, aggressive or speculative stocks: These stocks go down first...and they go down the most.
• Short the Market: I believe the best way to do this is with inverse ETFs that allow you to profit as the market goes down. There are also "Ultra" inverse ETF's that can give you extra exposure to amplify your potential profits (and potential losses if you guess wrong). As noted above, small caps will fall more than the general market. Thus, you may want to use an ETF like the UltraShort Russell 2000 (TWM). Or you can just do the UltraShort S&P 500 (SDS).
• IF you are going to own any stocks, then they need to be the bluest of blue chips in defensive industries like food, healthcare, utilities etc.
• Nothing wrong with having a lot of cash on hand.

Investors can find such funds by checking out the entire list of Zacks #1 Rank Small Cap Equity Funds.

3 Strong Performers

Artisan Small Cap Value (ARTVX) seeks long-term capital growth. It uses a bottom-up investment process to construct a diversified portfolio of undervalued firms that have attractive business models.

The fund invests primarily in common stocks of small U.S. companies with market capitalizations less than three times the weighted average market cap of companies in the Russell 2000 index.

Maximus Inc. (MMS), Sanderson Farms Inc. (SAFM) and SPSS Inc. (SPSS) are among the fund's top holdings.

Conestoga Capital Advisor Small Cap (CCASX) seeks long-term capital growth through investments in equity securities of small-cap firms, including ADRs, convertible securities, foreign and domestic common and preferred stocks, rights and warrants.

The fund does not expect investment in foreign securities to exceed 20% of the total assets. As of December 2008, its portfolio turnover ratio was 23.12%.

William C. Martindale has been lead manager at the fund since its inception in October 2002. The fund has topped the total returns of its benchmark index in the last 1-, 3- and 5-year periods.

Royce Special Equity Fund (RYSEX) seeks long-term growth of capital using a disciplined value approach and is designed for investors looking at a long-term horizon of at least three years.

The fund focuses on companies with market capitalizations of less than $2.5 billion, focusing on inexpensive companies with high returns on invested capital and low leverage. Although it normally focuses on securities of U.S. companies, the fund may invest up to 5% of its assets in foreign securities.

Unit holders have to make a minimum initial investment of $2,000 to enter this Zacks #1 Rank ("Strong Buy") fund. It pays dividends and capital gains annually.

Discover Many More Funds

Learn more about the new Zacks Mutual Fund Rank and discover some of the best market-beating mutual funds by browsing our new mutual funds section. This part of Zacks.com offers a variety of tools, including mutual fund research, a new mutual fund screener, helpful answers to frequently asked questions and quick access to prospectuses and other information.

By applying the Zacks Rank to mutual funds, investors can find funds that not only outpaced the market in the past but are also expected to outperform going forward.

The total-market Russell 3000 Index has seen some sizable changes in its sector weightings, although the top 10 remain very much the same. Figure 1 shows the new 2009 sector weightings according to the Russell sector classification system. Not surprisingly, financial services is no longer the largest sector: It now takes second place to technology, which is weighted at 16.19% versus financials at 15.27%. In 2008, those sectors were reversed, with financials at 17.24% and tech at 14.19%.

Health Care saw its weighting increase to 13.41% from 11.52%, popping it up to the third position from No. 5. It displaced energy, which fell from the third slot to the fourth, declining to 11.97% from 13.42%; presumably, declining oil prices had something to do with that. Consumer discretionary also fell: It was the fourth-largest sector after the 2008 rebalance, at 12.94%, but is now the fifth-largest, with a weighting of 11.86%. Producer durables, consumer staples, utilities and materials & processing maintained their same positions (six through 10, respectively).

The top 10 stocks in the Russell 3000 are by and large the same, except for one: ConocoPhillips was displaced by JPMorgan Chase & Co.—a financial company, of all things. Of course, JP Morgan did acquire two former giants in the field of finance last year: Bear Stearns and Washington Mutual. And it has been one of the least-scathed of the financial services companies.

While the other members of the top 10 remained largely the same, some of their positions did not. ExxonMobil is still at the top of the heap, like it was last year, but General Electric fell from the second-largest weighting in the Russell 3000 to the tenth-largest, with a weighting of 1.27%. Microsoft moved up from the third slot to the second, with a weighting of 1.87%. And Johnson & Johnson jumped to No. 3, befitting its strong performance.

Russell 2000

In the Russell 2000, financial services is still the top sector, increasing its weight to 21.10%. A surprising result, perhaps, but the sector was boosted by having hard-hit banks move out of the Russell 1000 and into the smaller index. Technology claims the second-largest slot, with a 16.75% weighting, displacing consumer discretionary, which falls to the No. 3 position, with a 14.68% weighting. That’s down from 17.65% in 2008. Energy only fell one spot, to No. 9, and saw its weighting nearly halved, falling from 8.60% to 4.52%, further emphasizing the differences between the large- and small-cap worlds.

RUSSELL INDEXES ARE CHANGING

1. S&P 500 BREAKS OUT: SO DO WE THROW A PARTY FOR THE REBELLIOUS TEENAGER?

Mike Bayer considers himself a contrarian investor.

In the past few months, as stock markets soared, that sort of go-against-the-grain approach has taken center stage.

The Toronto, Canada-based adviser and president of Strategic Analysis Capital Management says he prefers to buy exchange-traded funds and mutual funds from Dimensional Fund Advisors when they’re out of favor.

“The problem most investors have is that they tend to trade too frequently and make changes in the wrong direction. They’re buying high and selling low,” said Bayer, who works with individual and institutional clients in Canada and the United States.

Since early March, SACM has been taking advantage of the rally in stocks to rebalance client portfolios. Bayer has been trimming positions in the Vanguard Emerging Markets Stock ETF (NYSE: VWO).

“Emerging markets have had a big run-up in the past few months,” he said. “I’ve been carefully monitoring portfolios to make sure they stay within our asset allocation limits. In cases where VWO has exceeded those bands, we’ve sold positions and redeployed proceeds into mainly bond funds.”

The proceeds from selling VWO have been mainly going into buying more fixed-income ETFs and funds, says Bayer. Those include the iShares Barclays TIPS Bond ETF (NYSE: TIP) and the iShares Barclays 1-3 Year Credit Bond ETF (NYSE: CSJ). The firm has also been adding to positions in the DFA Five-Year Global Fixed-Income Fund (DFGBX).

Typically with fixed-income portfolios, Bayer will allocate about a third to DFGBX, another third to CSJ and the remainder in TIP.

“Usually, we’ll use a band of about 5% to determine when to make changes,” he said. “But that’s not a hard-and-fast rule. If someone’s in a taxable account, we’ll customize our rebalancing strategies so people can take advantage of tax-loss harvesting and reduce their overall tax liabilities.”

Taking A Cue From History

Bayer says he’s a big fan of simplicity in investing. He likes to stick with four to seven funds built around the long-term needs of each client. “The portfolios are built around broad diversification, but they don’t include commodities,” he added. “That asset class tends to add too much volatility. And over time, it doesn’t necessarily add any additional return.”

In a typical portfolio with 60% equities and 40% bonds, Bayer likes to keep around 45% of total stock assets in funds focused on the U.S. and Canada.

With a total stock market approach, he’ll use the Vanguard Total Stock Market ETF (NYSE: VTI) or the Vanguard Total World Stock ETF (NYSE: VT). In cases where VTI is implemented, at least 60% will go into that fund. Bayer also uses as core holdings the DFA U.S. Core Equity 1 (DFEOX) and the DFA U.S. Vector Equity Fund (DFVEX).

But with clients who don’t mind being a bit more aggressive, Bayer prefers to slice and dice allocations. He’ll put an equal percentage of U.S. stock allocations into the four corners of the market: large-cap value, large-cap blend as well as small-cap value and small-cap blend.

In a slice-and-dice portfolio, Bayer uses the iShares Russell 1000 Value Index (NYSE: IWD) and the Vanguard Value ETF (NYSE: VTV). He balances those with the iShares Russell 1000 (NYSE: IWB) or the Vanguard Total Stock Market ETF (NYSE: VTI).

“If you have a long time horizon and can handle the volatility, slicing and dicing the market can really provide some extra benefits,” said Bayer. “But a slice-and-dice strategy isn’t necessarily the easiest type of portfolio to hold. You need to remain very disciplined to make it work well over time.”

Nod To Small-Cap Value

Even with a more total-markets approach, the firm still likes to tilt allocations toward small-caps and value. On the small-cap side, it uses the iShares Russell 2000 Value Index (NYSE Arca: IWN) and the Vanguard Small Cap Value ETF (NYSE: VBR).

Whether slicing and dicing or total markets in design, Bayer says his portfolios avoid small-cap growth. “It just adds a lot of unneeded volatility and lower returns over time,” he said. “I’m a value investor. So even when a client is better-suited to a more total markets approach, I still like to tilt towards value.”

In those cases, he will add blended ETFs such as the iShares Russell 2000 Index (NYSE Arca: IWM) and the Vanguard Small Cap ETF (NYSE: VB).

“Usually, I’ll start by talking to clients about taking a total stock market fund and then adding IWN or VBR to tilt the portfolio a bit,” said Bayer. “Taking a total market approach appeals to a lot of people in terms of simplicity and slightly lower costs.”

A Global View Of Markets

In a global portfolio, Bayer leans toward about 55% in non-U.S. stocks. “I’m not trying to predict whether foreign markets are doing better than the U.S.,” he said. “But a 55% international tilt roughly follows the global market capitalization percentages of VT, which is a good barometer of the total world market.”

For international exposure, he’ll buy the iShares MSCI EAFE Index (NYSE: EFA) or the Vanguard Europe Pacific ETF (NYSE: VEA). Bayer also uses the Vanguard FTSE All-World ex-US ETF (NYSE: VEU) for some investors. In a standard portfolio, he’ll put about 10-15% into emerging markets of the stock portion of his global portfolios.

For international, Bayer also talks to clients about the DFA International Core Equity Fund (DFIEX) and the DFA Emerging Marktes Core Fund (DFVQX).

“In the U.S., DFA separates developed and emerging markets,” he added. “So if we use one of those funds, we’ll also include a dedicated emerging markets fund. In those cases, we like the DFA International Vector Equity Fund (DFCEX).”

His bent toward sticking with broad-based asset classes and a disciplined strategic allocation approach to investing has its roots in the tech boom. Bayer was managing accounts for a large technology distributor and watched investors rush into hot sectors and get crushed from 2000-2002.

“I’ve always been an index investor. But back then, there weren’t as many choices with ETFs, especially to gain international exposure. But I was an early adopter,” said Bayer, who began investing for himself as well as family and friends as a teenager.

He decided to work with individual investors in 2002 and joined a small local brokerage. “They were selling traditional high-fee mutual funds,” said Bayer. “My strong preference was to use ETFs and DFA funds, which are lower-costing and provide superior long-term risk-adjusted performance,” he said.

-- This report was submitted by IndexUniverse.com's Murray Coleman.

The second exchange-traded fund aiming to deliver hedging strategies at bargain-basement prices is set to launch on Tuesday.

The IQ Hedge Macro Strategy Tracker ETF (NYSE Arca: MCRO) is expected to hit the market taking a more specialized approach. Its sister IQ Hedge Multi-Strategy Tracker ETF (NYSE Arca: QAI) set the table in March for using ETFs to mimic hedge funds. But it takes a broad approach across six different types of hedging strategies. (See related story here.)

The new ETF will focus on combining two hedging strategies—global macro and emerging markets. According to IndexIQ, which created MCRO’s underlying benchmarks and serves as its sponsor, the fund will start with about a 75% allocation to emerging markets and 25% to more diversified global markets.

Just as with QAI, the new fund will come with an expense ratio of 0.75%.

As with the original QAI, the index for MCRO will use ETFs rather than stocks or other securities as constituents. The reasoning is that such a methodology reduces portfolio costs and improves tracking efficiencies. It’s important to note that hedge funds focusing on global macro and emerging markets typically buy everything from stocks and bonds to commodities and currencies.

The top constituents in the Macro Tracker ETF’s index heading into May were:

That left the composition at:

• International equities (32.51%)

• Short-Term Bonds (28.69%)

• Corporate Bonds (14.27%)

• U.S. Equity (6.05%)

• Commodity (5.76%)

• International Bonds (5.11%)

• Currency (3.87%)

• Inverse Real Estate (3.74%)

IndexIQ says that over time, the MCRO’s index has shown less volatility and stronger results than the MSCI Emerging Market Index, which is a long-only and fully invested stock-only traditional market-cap-sized index.

MCRO figures to be the next in a much bigger lineup planned by IndexIQ. In April, the firm filed to offer 15 more ETFs based on specific hedging strategies, including the Hedge Macro Strategy Tracker. (See related article here.)

The second exchange-traded fund aiming to deliver hedging strategies at bargain-basement prices is set to launch on Tuesday.

The IQ Hedge Macro Strategy Tracker ETF (NYSE Arca: MCRO) is expected to hit the market taking a more specialized approach. Its sister IQ Hedge Multi-Strategy Tracker ETF (NYSE Arca: QAI) set the table in March for using ETFs to mimic hedge funds. But it takes a broad approach across six different types of hedging strategies. (See related story here.)

The new ETF will focus on combining two hedging strategies—global macro and emerging markets. According to IndexIQ, which created MCRO’s underlying benchmarks and serves as its sponsor, the fund will start with about a 75% allocation to emerging markets and 25% to more diversified global markets.

Just as with QAI, the new fund will come with an expense ratio of 0.75%.

As with the original QAI, the index for MCRO will use ETFs rather than stocks or other securities as constituents. The reasoning is that such a methodology reduces portfolio costs and improves tracking efficiencies. It’s important to note that hedge funds focusing on global macro and emerging markets typically buy everything from stocks and bonds to commodities and currencies.

The top constituents in the Macro Tracker ETF’s index heading into May were:

That left the composition at:

• International equities (32.51%)

• Short-Term Bonds (28.69%)

• Corporate Bonds (14.27%)

• U.S. Equity (6.05%)

• Commodity (5.76%)

• International Bonds (5.11%)

• Currency (3.87%)

• Inverse Real Estate (3.74%)

IndexIQ says that over time, the MCRO’s index has shown less volatility and stronger results than the MSCI Emerging Market Index, which is a long-only and fully invested stock-only traditional market-cap-sized index.

MCRO figures to be the next in a much bigger lineup planned by IndexIQ. In April, the firm filed to offer 15 more ETFs based on specific hedging strategies, including the Hedge Macro Strategy Tracker. (See related article here.)

Investors can find such funds by checking out the entire list of the Zacks #1 Rank Small Cap Equity Funds.

3 Strong Performers

Artisan Small Cap Value (ARTVX) seeks long-term capital growth. It uses a bottom-up investment process to construct a diversified portfolio of undervalued firms that have attractive business economics.

The fund invests primarily in common stocks of small U.S. companies with market capitalizations less than three times the weighted average market cap of companies in the Russell 2000 index.

Maximus Inc. (MMS), Sanderson Farms Inc. (SAFM) and SPSS Inc. (SPSS) are among the fund's top holdings.

Conestoga Capital Advisor Small Cap (CCASX) seeks long-term capital growth through investments in equity securities of small-cap firms, including ADRs, convertible securities, foreign and domestic common and preferred stocks, rights and warrants.

The fund does not expect investment in foreign securities to exceed 20% of the total assets. As of December 2008, its portfolio turnover ratio was 23.12%.

William C. Martindale has been lead manager at the fund since its inception in October 2002. The fund has topped the total returns of its benchmark index in the last 1-, 3- and 5-year periods.

Royce Special Equity Fund (RYSEX) seeks long-term growth of capital using a disciplined value approach and is designed for investors looking at a long-term horizon of at least three years.

The fund focuses on companies with market capitalizations of less than $2.5 billion, attempting to find inexpensive companies with high returns on invested capital and low leverage. Although it normally focuses on the securities of U.S. companies, the fund may invest up to 5% of its assets in foreign securities.

Unit holders have to make a minimum initial investment of $2,000 to enter this Zacks#1 Rank ("Strong Buy") fund. It pays dividends and capital gains annually.

Discover Many More Funds

Learn more about the new Zacks Mutual Fund Rank and discover some of the best market-beating mutual funds by browsing our new mutual funds section. This part of Zacks.com offers a variety of tools, including mutual fund research, a new mutual fund screener, helpful answers to frequently asked questions and quick access to prospectuses and other information.

By applying the Zacks Rank to mutual funds, investors can find funds that not only outpaced the market in the past but are also expected to outperform going forward.

Manager known for its family of active mutual funds also uses ETFs and index funds in its model portfolios for advisers and private accounts.

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During the past few months, managers at Litman/Gregory Asset Management have been tweaking their index-only fund portfolios.

In particular, the Bay Area-based adviser and money manager has been building positions in high-yield bonds and emerging market stocks, hoping to capitalize on temporary inefficiencies in the market.

"The market is generally efficient. But there are times when prices get out-of-whack with fundamentals. In the case of high-yield bonds, they sold-off dramatically in the fall of 2008," said Alice Lowenstein, the firm's director of managed portfolios. "When an asset class is really beaten down, our process assesses whether it's overdone."

Litman/Gregory manages about $2 billion in assets for outside advisers. It also runs another $2 billion in private accounts and through its Masters' Select family of mutual funds. Besides offering actively managed portfolios, the firm also creates model portfolios which are index-based.

With its index-based portfolios, Litman/Gregory started raising positions in junk bond funds last October by 3-5%, depending on risk levels. In late November 2008 and mid-February 2009, they added to those positions. Both times, the firm's managers used proceeds from the sale of U.S. equities to bump up allocations in bonds to a high-point of 15% in the most aggressive portfolios.

"In most of the scenarios we can envision right now over the next three- to five-years, high-yield bonds as an asset class looks more attractive than even equities," said Lowenstein. "Of course, conditions can change very quickly in these types of conditions. But we continue to own high-yield bonds and believe their significant yields can offer a short-term cushion if the market falls."

With junk, the firm's 10-member analyst team builds scenarios to test the impact of factors such as how rising default rates and interest rates can impact yield spreads as well as longer-term performance.

"We don't try to predict any particular outcome. We simply try to build models of what we might see happen," said Lowenstein. "Baked into those scenarios are macroeconomic trends that could impact valuations and earnings growth for stocks, for example."

The firm's managers in May also shifted some stock assets into emerging markets, bumping those allocations to between 3-7%, says Lowenstein.  Such a tactical move was funded by taking assets from a combination of U.S. and developed international stock fund positions.

Lowenstein says that those kinds of tactical moves only come when analysts see "fat pitches" coming investors' way. "Unlike baseball, you don't have to swing if it isn't a great pitch," she said. "So we don't unless our confidence level is pretty high."

In a model index-based portfolio with a neutral target allocation of 60% stock and 40% bonds, Litman/Gregory currently has:

• 42.5% in investment-grade bonds through the iShares Barclays Aggregate Bond Index (NYSE: AGG).

• 12% in various junk bond mutual funds.

• 27.5% in large-cap domestic stocks through the iShares S&P 500 Index (NYSE: IVV) and the iShares S&P 100 Index (NYSE: OEF).

• 2% in small-cap stocks through the iShares Russell 2000 Index (NYSE Arca: IWM). That's about 8 percentage points less than the portfolio's neutral position---anunderweight position that has been in-place for awhile.

• 11% in international stocks . That's just 1 percentage point less than the portfolio's long-term neutral weighting. In that asset class, the firm prefers to use the Vanguard FTSE All-World ex-US ETF (NYSE: VEU).

• 5% in emerging market stocks, using the Vanguard Emerging Markets ETF (NYSE: VWO).

With 54.5% of the portfolio in bonds, it might seem that the portfolio is nearly 15% overweight fixed-income. But that's true only true when junk and investment grade bonds are grouped together. Studies have shown that junk as a group is more correlated to equities than most other types of bonds.

"In this case, we're not allocating our fixed-income assets (in investment-grade) to a more risky asset class (in junk bonds). Instead, we took some of our holdings in equities to fund bigger positions in high-yield," said Lowenstein.

Last year, asset class valuations and scenarios for potential longer-term returns were shaken dramatically by the market's huge fall, she added.

"Starting from mid-September of 2008 when the financial crisis really grew in scope, we made about five tactical changes through year's end. But that's very unusual," said Lowenstein. "Normally, we wouldn't see that much activity in a whole year."

According to Litman/Gregory's calculations, its index-based model 60/40 model portfolio has outperformed its benchmark by a significant amount over time. Since the portfolio's inception on Jan. 1, 2002, it had returned an average annualized 3.12% through April. That compared to its benchmark's total return of 2.14%.

The firm uses a benchmark for its 60/40 model, which it refers to as the balanced portfolio, consisting of the following:

• The Vanguard Total Bond Market Index Fund (VBMSX), 40%.

• The Vanguard 500 Index (VFINX), 40%.

• The iShares Russell 2000 Index (NYSE Arca: IWM), 8%.

• The Vanguard Total International Stock Index Fund (VGTSX), 12%.

"We primarily employ ETFs in our index-based portfolios," said Lowenstein. "But our benchmarks use a combination of index mutual funds and ETFs."

Either way, she says Litman/Gregory stresses low-priced and well-managed vehicles of both types. "We recommend that advisers take a common sense approach in applying factors such as account sizes, trading costs and investment strategies when choosing between ETFs and index mutual funds in individual portfolios," said Lowenstein.

-- This report was submitted by IndexUniverse.com's Murray Coleman.

The fund primarily invests in the stocks of companies with market capitalizations within the range of those consisted in the Russell 2000 Value Index at the time of purchase. It may invest in equity securities of both U.S. and foreign issuers, including those purchased in initial public offerings.

Macrovision Solutions Corp. (MVSN), First Cash Financial Services Inc. (FCFS) and Advance Auto Parts Inc. (AAP) are among the fund's top holdings.

Dreyfus Midcap Value A (DMCVX) seeks to surpass the performance of the Russell Midcap Value Index. The fund normally invests at least 80% of its assets in mid-cap stocks with market capitalizations between $1 billion and $25 billion at the time of purchase.

The fund may, but is not required to, use derivatives, such as, options, futures and options on futures, forward contracts and swaps, as a substitute for investing directly in an underlying asset, to increase returns, or as part of a hedging strategy. It may also engage in short-selling.

Unit holders have to make a minimum initial investment of $1,000 to enter the fund. It distributes dividends and capital gains annually.

Dreyfus U.S. Treasury Intermediate Term (DRGIX) seeks to maximize total return, consisting of capital appreciation and current income, by investing at least 80% of its assets in U.S. Treasury securities.

The fund also may invest in other securities issued or guaranteed by the U.S. government or its agencies or instrumentalities (including inflation-indexed bonds), and may enter into repurchase agreements. Under normal market conditions, it maintains an effective duration between 2.5 and 6 years, and a dollar-weighted average portfolio maturity between 3 and 10 years.

Robert M. Bayston has been the fund's manager since May 2008. The fund has outperformed the total annual returns of its benchmark index in the last 1-, 3- and 5-year periods.

Chicago, IL - April 23, 2009 - Zacks.com announces the latest Industry Outlook. Today's outlook from Zacks Equity Research analyst Ann Northrop discusses the Restaurant sector. Highlighted stocks include: Darden Restaurants (DRI), Brinker International (EAT), Ruby Tuesday (RT) and California Pizza Kitchen (CPKI).

Here is the latest on the Restaurant sector:

Casual dining restaurant stocks are sizzling. The Zacks Casual Dining Restaurant Index has surged 218% from its November lows, far outpacing both the Russell 2000 (up 37%) and the S&P 500 index (up 28%). The Russell 2000 and the S&P index both remain roughly 40% off their 52-week highs. And although the Zacks Casual Dining index is 30% from its high, there appears to be more downside risk than upside potential.

The chief catalysts in the recent restaurant stock rally were better-than-expected earnings reports by Darden Restaurants (DRI), Brinker International (EAT), Ruby Tuesday (RT) and California Pizza Kitchen (CPKI). With the exception of Darden, however, the out-performance was driven by strong cost controls, decelerating commodity prices and conservative assumptions.

Darden was the only operator that saw customer traffic improve in January and February -- though two months during milder-than-normal weather does not a trend make -- and that limited same-store sales declines to the low single-digits (down 3.2% in its latest quarter). The remaining three earnings out-performers saw same-store sales fall at a mid-to-high single digit rate in 1Q09, and those results were bolstered by menu price increases, masking steeper drops in customer traffic.

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Restaurant stocks sizzle

Casual dining cooks up positive earnings surprises but offers no sustenance

The chief catalysts in the recent restaurant stock rally were better-than-expected earnings reports by Darden Restaurants (AKS), Brinker International (EAT), Ruby Tuesday (RT) and California Pizza Kitchen (CPKI). With the exception of Darden, however, the out-performance was driven by strong cost controls, decelerating commodity prices and conservative assumptions.

Darden was the only operator that saw customer traffic improve in January and February -- though two months during milder-than-normal weather does not a trend make -- and that limited same-store sales declines to the low single-digits (down 3.2% in its latest quarter). The remaining three earnings out-performers saw same-store sales fall at a mid-to-high single digit rate in 1Q09, and those results were bolstered by menu price increases, masking steeper drops in customer traffic.

Valuation multiples are not justified by fundamentals

The surge in stock prices has expanded the casual dining group's valuation multiples to about 17.4x 2010 consensus EPS estimates -- while 2010 estimates remain at levels equating to just 10-12% year-over-year growth. To be sure, we think 2010 industry earnings won't exceed 2008 levels.

While there is little visibility to 2010 earnings and ample time for positive estimate revisions, upside surprise is unlikely. There are three potential drivers of net income growth: unit expansion, improved same-store sales and cost cuts.

There seems little chance that upside will come from more aggressive unit expansion, as current development plans remain extremely light and restaurant development takes about 18 months from planning to opening.

The second driver, same-store sales growth, consists of price increases and revitalized customer traffic. Any price increases, other than the most minimal, would likely serve only to drive value-conscious customers elsewhere in this fiercely-competitive environment. Likewise, a brisk resurgence in customer traffic in 2010 is anything but guaranteed, especially in the first half of the year.

The majority of economists expect unemployment to continue rising into the second half of 2010, after reaching levels not seen in decades. Consequently, it is more likely that this time around the consumer's recovery will be slower than in past recessions, because this one was deeper and longer. When employment resumes, consumers will be saddled with debt -- which is currently at record levels. Without the subsidies from rocketing home values that consumers had come to rely on the last decade, a return to thrift may be in vogue.

Finally, some of the cost cuts achieved in the last two quarters will anniversary in 2010. These include labor savings from new scheduling systems and food waste savings from new kitchen technology. Commodities, however, seem set to continue decelerating with the economy, enabling some casual dining chains to lure cash-strapped diners with value menu offerings like the quick service operators have done so well. Brinker International's three concepts -- Chili's, On The Border and Maggiano's -- have each launched their own value menus.

Excess industry capacity looms

When the economy recovers, the casual dining industry will continue to suffer from an oversupply of capacity and lack of differentiation, particularly in the crowded bar and grill segment. To meet investors' expectations for growth, publicly traded restaurant chains expanded faster than demand for years, and in the mid-1990's, began opening units in less-traffic locations when "A" sites became scarce.

As the recession eroded sales and tightened credit, most casual dining operators finally began curtailing unit growth and closing those that were under-performing -- for some, this is years after profitability began to sag. Independent restaurants and small franchisers with fewer resources to weather the recession are closing at a rapid clip.

But to date, most large chains have closed relatively small numbers of under-performing units. S&A Restaurant Corp., the parent of Bennigan's and Steak & Ale restaurants, filed for Chapter 7 bankruptcy last June, but many of the units remain in operation. Consequently, despite curtailed growth and a growing number of bankruptcies, industry capacity has not meaningfully shrunk the way it did in the quick service segment a few years ago.

WEAKNESSES

Casual dining underweight recommended

We are maintaining our Sell ratings on casual dining growth chains that continue to grow, despite sub-par profitability. BJ's Restaurants (BJRI) and Red Robin Gourmet Burgers (RRGB) are two examples.

OPPORTUNITIES

Buy "best of breed"

Darden Restaurants (DRI) is our best example. We would also be a buyer of Buffalo Wild Wings (BWLD) on a sharp pullback. The company offers investors the strongest growth (25% EPS growth expected in 2009) and same-store sales (+4.5 in 4Q08) in the industry and a history of superior ROE and ROIC. However, the company is highly levered to the price of chicken wings (roughly 21% of sales), which has soared 39% since December, leaving estimates particularly vulnerable and too much risk in the stock at the current valuation of 18x the 2010 consensus EPS estimate. Zacks Investment Research

Restaurant stocks sizzle

Casual dining cooks up positive earnings surprises but offers no sustenance

The chief catalysts in the recent restaurant stock rally were better-than-expected earnings reports by Darden Restaurants (AKS), Brinker International (EAT), Ruby Tuesday (RT) and California Pizza Kitchen (CPKI). With the exception of Darden, however, the out-performance was driven by strong cost controls, decelerating commodity prices and conservative assumptions.

Darden was the only operator that saw customer traffic improve in January and February -- though two months during milder-than-normal weather does not a trend make -- and that limited same-store sales declines to the low single-digits (down 3.2% in its latest quarter). The remaining three earnings out-performers saw same-store sales fall at a mid-to-high single digit rate in 1Q09, and those results were bolstered by menu price increases, masking steeper drops in customer traffic.

Valuation multiples are not justified by fundamentals

The surge in stock prices has expanded the casual dining group's valuation multiples to about 17.4x 2010 consensus EPS estimates -- while 2010 estimates remain at levels equating to just 10-12% year-over-year growth. To be sure, we think 2010 industry earnings won't exceed 2008 levels.

While there is little visibility to 2010 earnings and ample time for positive estimate revisions, upside surprise is unlikely. There are three potential drivers of net income growth: unit expansion, improved same-store sales and cost cuts.

There seems little chance that upside will come from more aggressive unit expansion, as current development plans remain extremely light and restaurant development takes about 18 months from planning to opening.

The second driver, same-store sales growth, consists of price increases and revitalized customer traffic. Any price increases, other than the most minimal, would likely serve only to drive value-conscious customers elsewhere in this fiercely-competitive environment. Likewise, a brisk resurgence in customer traffic in 2010 is anything but guaranteed, especially in the first half of the year.

The majority of economists expect unemployment to continue rising into the second half of 2010, after reaching levels not seen in decades. Consequently, it is more likely that this time around the consumer's recovery will be slower than in past recessions, because this one was deeper and longer. When employment resumes, consumers will be saddled with debt -- which is currently at record levels. Without the subsidies from rocketing home values that consumers had come to rely on the last decade, a return to thrift may be in vogue.

Finally, some of the cost cuts achieved in the last two quarters will anniversary in 2010. These include labor savings from new scheduling systems and food waste savings from new kitchen technology. Commodities, however, seem set to continue decelerating with the economy, enabling some casual dining chains to lure cash-strapped diners with value menu offerings like the quick service operators have done so well. Brinker International's three concepts -- Chili's, On The Border and Maggiano's -- have each launched their own value menus.

Excess industry capacity looms

When the economy recovers, the casual dining industry will continue to suffer from an oversupply of capacity and lack of differentiation, particularly in the crowded bar and grill segment. To meet investors' expectations for growth, publicly traded restaurant chains expanded faster than demand for years, and in the mid-1990's, began opening units in less-traffic locations when "A" sites became scarce.

As the recession eroded sales and tightened credit, most casual dining operators finally began curtailing unit growth and closing those that were under-performing -- for some, this is years after profitability began to sag. Independent restaurants and small franchisers with fewer resources to weather the recession are closing at a rapid clip.

But to date, most large chains have closed relatively small numbers of under-performing units. S&A Restaurant Corp., the parent of Bennigan's and Steak & Ale restaurants, filed for Chapter 7 bankruptcy last June, but many of the units remain in operation. Consequently, despite curtailed growth and a growing number of bankruptcies, industry capacity has not meaningfully shrunk the way it did in the quick service segment a few years ago.

WEAKNESSES

Casual dining underweight recommended

We are maintaining our Sell ratings on casual dining growth chains that continue to grow, despite sub-par profitability. BJ's Restaurants (BJRI) and Red Robin Gourmet Burgers (RRGB) are two examples.

OPPORTUNITIES

Buy "best of breed"

Darden Restaurants (DRI) is our best example. We would also be a buyer of Buffalo Wild Wings (BWLD) on a sharp pullback. The company offers investors the strongest growth (25% EPS growth expected in 2009) and same-store sales (+4.5 in 4Q08) in the industry and a history of superior ROE and ROIC. However, the company is highly levered to the price of chicken wings (roughly 21% of sales), which has soared 39% since December, leaving estimates particularly vulnerable and too much risk in the stock at the current valuation of 18x the 2010 consensus EPS estimate. Zacks Investment Research

David Kreinces is a portfolio manager with ETF Portfolio Management. Before founding the Newbury Park, Calif.-based firm in 2007, he was a portfolio manager in Merrill Lynch's global private client group, specializing in absolute return strategies using exchange-traded funds.

Kreinces is one of a growing number of independent portfolio advisers offering all-ETF portfolios that implement hedging strategies.To find out more about his unique quantitative-based methodology, IndexUniverse.com's Managing Editor Murray Coleman recently caught up with him at ETF Portfolio Management's southern California headquarters.

IU.com: How do you implement ETFs in absolute return strategies?

Kreinces: Our strategies are built around quantitative, rules-based models. And they don't use leverage at all. That's an important point. By not using leverage, we feel like our ability to limit volatility and control portfolio risk is greatly enhanced. But this has been an unusual period. In the past 18 months, we've had record activity in terms of shifting positions. During this time, it has been rare for us to hold funds for more than a few weeks at a time. But this isn't designed as a short-term trading strategy.

IU.com: What's your fee structure for your various strategies?

Kreinces: Our core passive portfolios have no advisory fees. We offer three of these. One follows the basic recommendations for an all-ETF portfolio created by David Swensen, the manager of Yale University's endowment program. It basically follows the strategy described in his book, "Unconventional Success."

The second passive core portfolio is designed for novice investors and takes a more basic approach to diversification. A third passive portfolio takes a more diversified approach by not discriminating as much against emerging markets and commodities. Again, all three are passively managed buy-and-hold strategies using ETFs where our clients don't pay advisory fees.

IU.com: How do you make money then?

Kreinces: We make money because most clients, after seeing the results of our absolute return strategies, put at least a portion of their assets into those portfolios. After 2008, when the buy-and-hold strategy hit a pothole, about 90% of our client assets have moved into absolute return strategies.

IU.com: How much do you charge for those strategies?

Kreinces: Last year, we charged 50 basis points for our global growth model and 100 basis points for our long-short strategy and aggressive growth strategy. This year, they're all charging 200 basis points. That's because all of the strategies outperformed strongly in 2008. And we don't charge a performance fee.

IU.com: Can you provide a recent example of how you achieve positive returns in a down market?

Kreinces: Our global growth model in 2008 went into cash and stayed in cash for a large part of the year. When the model moved into equities, it was very selective about which ETFs it picked. Probably the broadly diversified ETFs we traded most often last year were the iShares MSCI Emerging Markets Index (NYSE: EEM), the iShares Russell 2000 Value Index (NYSE: IWN) and the iShares MidCap 400 Index (NYSE: IJH).

IU.com: What are you doing this year?

Kreinces: The global growth model is a long-only strategy. This year, it's long in large-cap growth. And what is driving that part of the market is technology. We use ETFs such as the PowerShares QQQ (Nasdaq: QQQQ) to capture large-growth with a tilt towards technology. We're also investing in emerging markets through EEM and the Vanguard Emerging Markets ETF (NYSE: VWO). But we continue to be very greatly invested in cash in the diversified global growth strategy.

IU.com: What are you doing in your aggressive growth strategy?

Kreinces: It's also a long-only absolute return strategy and rotates between sectors. Right now, it still has about a third of total assets in cash. In this model, we do have the ability to use more broad ETFs when the environment calls for it. That's the case now. We're using EEM with a heavy weighting on Brazil through the iShares MSCI Brazil Index (NYSE: EWZ). In this portfolio, we've also traded the Internet HOLDRS (NYSE: HHH). We don't hold them now, but our theme currently is to emphasize emerging markets and technology. We've traded SPDR Gold Shares (NYSE: GLD) and the iShares Silver Trust (NYSE: SLV) in this model as well. But we don't hold either of those right now.

IU.com: What about your long-short portfolio?

Kreinces: It invests in concentrated countries and sectors as well as commodities. It also has the capacity to step back and go into broader ETFs. This model can go 100% long or 100% short. Right now, it's 100% long. We're not holding any individual commodity ETFs right now, preferring to gain that exposure through Brazil and other emerging markets that are strongly influenced by natural resources.

IU.com: What has made you turn so bullish in that strategy?

Kreinces: When the market is trending upward as strongly as it has been, we try to capture as much of that as possible. So our long-short model hasn't been in cash during the past five weeks. We're very much trying to listen to what the market is telling us. The nature of our long-short model—along with the other models—is that it doesn't try to outguess markets. We're clearly in an uptrend and that pattern hasn't broken enough to send us back to cash yet.

IU.com: You also have an overlay for your models based on your own views, don't you?

Kreinces: Yes, but that overlay is implemented only when markets are at extreme levels. Right now, our more subjective judgments are being used to override our objective, rules-based quantitative processes only to a very limited degree.

IU.com: Why is that?

Kreinces: Our goal is to follow our rules-based methodology as much as possible. But when the markets shock our models, we don't want to get whipsawed around—that's expensive. So part of our risk controls are to allow for some sort of logical override to prevent severe losses of capital. We've got limitations on our threshold for pain. If our models aren't able to keep risks within a certain range, then we'll step in. Lately, we've been overriding the models in our core alpha strategy to try to stay out of the markets.

IU.com: How defensive are you in those types of composite portfolios?

Kreinces: Right now, we're about 85% long in our core alpha model, which equal-weights the other three strategies into a single, blended portfolio. The effort to fight the current rally reflects the fact that we were down in the mid-single digits in the first quarter in the core alpha strategy. That's a big drawdown for us. So as markets started rallying, we've participated in a very conservative fashion. The core alpha strategy is down slightly for the year. So we've eaten away at the drawdown, which is giving us a progressively bigger risk appetite.

David Kreinces is a portfolio manager with ETF Portfolio Management. Before founding the Newbury Park, Calif.-based firm in 2007, he was a portfolio manager in Merrill Lynch's global private client group, specializing in absolute return strategies using exchange-traded funds.

Kreinces is one of a growing number of independent portfolio advisers offering all-ETF portfolios that implement hedging strategies.To find out more about his unique quantitative-based methodology, IndexUniverse.com's Managing Editor Murray Coleman recently caught up with him at ETF Portfolio Management's southern California headquarters.

IU.com: How do you implement ETFs in absolute return strategies?

Kreinces: Our strategies are built around quantitative, rules-based models. And they don't use leverage at all. That's an important point. By not using leverage, we feel like our ability to limit volatility and control portfolio risk is greatly enhanced. But this has been an unusual period. In the past 18 months, we've had record activity in terms of shifting positions. During this time, it has been rare for us to hold funds for more than a few weeks at a time. But this isn't designed as a short-term trading strategy.

IU.com: What's your fee structure for your various strategies?

Kreinces: Our core passive portfolios have no advisory fees. We offer three of these. One follows the basic recommendations for an all-ETF portfolio created by David Swensen, the manager of Yale University's endowment program. It basically follows the strategy described in his book, "Unconventional Success."

The second passive core portfolio is designed for novice investors and takes a more basic approach to diversification. A third passive portfolio takes a more diversified approach by not discriminating as much against emerging markets and commodities. Again, all three are passively managed buy-and-hold strategies using ETFs where our clients don't pay advisory fees.

IU.com: How do you make money then?

Kreinces: We make money because most clients, after seeing the results of our absolute return strategies, put at least a portion of their assets into those portfolios. After 2008, when the buy-and-hold strategy hit a pothole, about 90% of our client assets have moved into absolute return strategies.

IU.com: How much do you charge for those strategies?

Kreinces: Last year, we charged 50 basis points for our global growth model and 100 basis points for our long-short strategy and aggressive growth strategy. This year, they're all charging 200 basis points. That's because all of the strategies outperformed strongly in 2008. And we don't charge a performance fee.

IU.com: Can you provide a recent example of how you achieve positive returns in a down market?

Kreinces: Our global growth model in 2008 went into cash and stayed in cash for a large part of the year. When the model moved into equities, it was very selective about which ETFs it picked. Probably the broadly diversified ETFs we traded most often last year were the iShares MSCI Emerging Markets Index (NYSE: EEM), the iShares Russell 2000 Value Index (NYSE: IWN) and the iShares MidCap 400 Index (NYSE: IJH).

IU.com: What are you doing this year?

Kreinces: The global growth model is a long-only strategy. This year, it's long in large-cap growth. And what is driving that part of the market is technology. We use ETFs such as the PowerShares QQQ (Nasdaq: QQQQ) to capture large-growth with a tilt towards technology. We're also investing in emerging markets through EEM and the Vanguard Emerging Markets ETF (NYSE: VWO). But we continue to be very greatly invested in cash in the diversified global growth strategy.

IU.com: What are you doing in your aggressive growth strategy?

Kreinces: It's also a long-only absolute return strategy and rotates between sectors. Right now, it still has about a third of total assets in cash. In this model, we do have the ability to use more broad ETFs when the environment calls for it. That's the case now. We're using EEM with a heavy weighting on Brazil through the iShares MSCI Brazil Index (NYSE: EWZ). In this portfolio, we've also traded the Internet HOLDRS (NYSE: HHH). We don't hold them now, but our theme currently is to emphasize emerging markets and technology. We've traded SPDR Gold Shares (NYSE: GLD) and the iShares Silver Trust (NYSE: SLV) in this model as well. But we don't hold either of those right now.

IU.com: What about your long-short portfolio?

Kreinces: It invests in concentrated countries and sectors as well as commodities. It also has the capacity to step back and go into broader ETFs. This model can go 100% long or 100% short. Right now, it's 100% long. We're not holding any individual commodity ETFs right now, preferring to gain that exposure through Brazil and other emerging markets that are strongly influenced by natural resources.

IU.com: What has made you turn so bullish in that strategy?

Kreinces: When the market is trending upward as strongly as it has been, we try to capture as much of that as possible. So our long-short model hasn't been in cash during the past five weeks. We're very much trying to listen to what the market is telling us. The nature of our long-short model—along with the other models—is that it doesn't try to outguess markets. We're clearly in an uptrend and that pattern hasn't broken enough to send us back to cash yet.

IU.com: You also have an overlay for your models based on your own views, don't you?

Kreinces: Yes, but that overlay is implemented only when markets are at extreme levels. Right now, our more subjective judgments are being used to override our objective, rules-based quantitative processes only to a very limited degree.

IU.com: Why is that?

Kreinces: Our goal is to follow our rules-based methodology as much as possible. But when the markets shock our models, we don't want to get whipsawed around—that's expensive. So part of our risk controls are to allow for some sort of logical override to prevent severe losses of capital. We've got limitations on our threshold for pain. If our models aren't able to keep risks within a certain range, then we'll step in. Lately, we've been overriding the models in our core alpha strategy to try to stay out of the markets.

IU.com: How defensive are you in those types of composite portfolios?

Kreinces: Right now, we're about 85% long in our core alpha model, which equal-weights the other three strategies into a single, blended portfolio. The effort to fight the current rally reflects the fact that we were down in the mid-single digits in the first quarter in the core alpha strategy. That's a big drawdown for us. So as markets started rallying, we've participated in a very conservative fashion. The core alpha strategy is down slightly for the year. So we've eaten away at the drawdown, which is giving us a progressively bigger risk appetite.

Sounds too easy, right? But take a look. Using data as of March 31, the 10 largest ETFs by assets were:

If you took an equal position in each of those ETFs, you'd have a nice, balanced portfolio: 60% stocks, 30% bonds and 10% gold.

Not only is that a reasonably well-diversified portfolio, it includes a number of twists and tilts that I find pretty appealing right now.

Starting in equities, both growth and large-caps have been performing relatively well, as they often do in difficult economic environments. Similarly, the tilt toward Technology via the QQQs captures one of the best-performing sectors in the market. And while the portfolio is light on international exposure, its strong relative weight in emerging markets is appealing.

In the fixed-income market, it is almost dead-on. If you split out the exposure in AGG, the fund is 16% corporate, 10% TIPS and 4% Treasuries. Considering that most experts think that Treasuries are at least fully valued, and corporate undervalued, that's just about right. 

Finally, the addition of significant (20%) exposure to inflation-hedging assets like gold and TIPS is very appealing in the current environment, where many of us (even Jim) expect a major uptick in inflation.

Another approach would be to create a portfolio weighted by the size of assets held in each ETF. That portfolio is slightly more aggressive, with 68% equities, 16% bonds and 16% gold.

As good as these portfolios seem to be, I'm tempted to look a bit further down the tables to see what other ETFs are on the edge of being added to the mix.

Looking through that list, there are a few tempting funds. I love the Vanguard MSCI Total Market ETF (NYSE Arca: VTI), the cheapest way to gain access to the total market. And I'd be very tempted to elevate the iShares FTSE/Xinhua China 25 ETF (NYSE Arca: FXI) into the mix, as I think China is underweight in global benchmarks and is positioned well to perform.

Still, that's all happening on the edges. You don't really have to go much further than the top 10. As it turns out, ETF investors are a pretty smart lot. So much for the madness of the crowds.

3 Solid Samples

ProFunds UltraBear Inv (URPIX) seeks daily investment results that match twice the inverse of the performance of the S&P 500 Index. It provides leveraged exposure to the S&P 500 Index.

URPIX primarily focuses on futures contracts, options on futures contracts, options contracts, swaps, forward contracts and other financial instruments rather than investing in securities like common stock of companies.

Unit holders have to make a minimum initial investment of $15,000 to enter this nondiversified fund. The Zacks#1 Rank ("Strong buy") fund distributes dividends and capital gains annually. It had outdone 1055.96% of its peers in terms of annual return in 2008.

UltraShort International ProFund (UXPIX) seeks daily investment results, before fees and expenses, that are twice the inverse of the daily performance of the MSCI EAFE index. It may use leveraged investment techniques to attain its objective.

The fund invests assets which are not invested in equity securities or financial instruments in debt instruments or money market instruments. It is nondiversified and has an expense ratio of 1.62%.

Erik Benke has been the lead manager at UXPIX since its inception in April 2006. Prior to joining the company, Benke was a trader at AIM Investments and an associate at Goldman Sachs Hill Group. The Zacks#1 Rank ("Strong buy") fund has outstripped the S&P 500 index by 884.15% in terms of annual returns in 2008.

ProFunds UltraShort Small-Cap Svc (UCPSX) seeks daily investment results that correspond to twice the inverse of the daily performance of the Russell 2000 index. The fund normally invests at least 80% of its assets in financial instruments with economic characteristics that inverse that of the index.

Elisa Petit has been the lead manager at the fund since its inception in January 2004. Before joining ProFund Advisors, she managed equity funds for Banque Populaire Group in Paris, France.

The fund is nondiversified and distributes dividends annually. Its annual returns beat 596.81% of UCPSX peers in 2008.

Discover Many More Funds

Learn more about the new Zacks Mutual Fund Rank and discover some of the best market-beating mutual funds by browsing our new mutual funds section. This part of Zacks.com offers a variety of tools, including mutual fund research, a new mutual fund screener, helpful answers to frequently asked questions and quick access to prospectuses and other information.

By applying the Zacks Rank to mutual funds, investors can find funds that not only outpaced the market in the past but are also expected to outperform going forward.

The fund, which aims to synthetically replicate the performance of hedge fund strategies, launched yesterday on NYSE Arca. Judging by early trading volume, the new fund is going to be a hit: QAI looks like it will trade more than 100,000 shares today, an impressive performance for just its second day on the market.

The idea of providing access to hedge fund-like returns through an ETF is hugely attractive. The best investors in the world---endowments like Harvard and Yale---hold enormous investments in hedge funds for a reason: They deliver returns with low correlations to the broader market. If QAI can make those returns available to all investors in a low-cost wrapper, it'll be big news.

As I said yesterday on CNBC, however, the proof will be in the pudding: Can QAI actually deliver on its promises?

It's important to understand that this ETF doesn't actually invest in hedge funds; rather, it uses factor-based analysis to determine the performance characteristics of hedge funds in general, and then builds a portfolio (using other ETFs) that it thinks will replicate that performance.

Over the past few days, a lot of people have told me that this idea sounds crazy. I disagree. Too many people have a near-mythical conception of hedge funds; they think they are run by high-paid geniuses who make either spectacular or spectacularly bad investments. The truth is more mundane: While some hedge funds ARE run by geniuses, most are run by normal guys who use pretty standard strategies to generate a certain kind of return. They do a reasonable job, and are paid absurdly well to do it.

The idea of synthetically replicating that performance at lower costs is well-established both in academia and the real world. Both Goldman Sachs, and IndexIQ itself, for example, have been running synthetic hedge fund mutual funds since last summer. Generally speaking, they've done pretty well: The Goldman Sachs fund is down about 15% since July 2008, while the IndexIQ fund is down about 12%; that compares to the S&P 500, which is down about 38%. That's a good relative performance. Most hedge funds are down over that span too, in line with the synthetic products.

The question now is whether these funds will be able to perform well as the market recovers. Although both funds have well-documented methodologies, they are nonetheless largely black box strategies; the concept behind the funds make sense, but you have to have faith that the quant-engine driving them is going to work.

One advantage of the new ETF is that you can watch the holdings on a daily basis and see for yourself if they make sense. As of yesterday's close, here's what QAI was holding:

If you drill down, the portfolio is fairly simple. The fund's positions include:

• 72.79% fixed income, including

            o 32.73% in broad-based bond indexes

            o 27.71% in short-term Treasuries            

            o 10.54% in junk bonds            

            o 1.81% in TIPS

• 13.33% in emerging market stocks, the only long equity position
• 9.47% in commodities and currencies
• 4.41% in various inverse funds

That's a fairly defensive portfolio. The question is, how will this portfolio perform if the market recovers? How will it adapt and change over time?

It's worth watching.

Investars calculated that Zacks Equity Research's buy-recommended stocks rose 23.9% over the past 5 years, nearly 200% better than the Russell 2000.

To put this performance in perspective, let's look at how Investars says other firms performed. Following the buy recommendations from Goldman Sachs, Standard & Poor's, Deutsche Bank, Citigroup, Piper Jaffray, Raymond James, BMO Capital Markets and Ameriprise would have lost you money. Not a single one of those well-known brokerage firms had a positive return.

At the same time, Zacks Equity Research did a great job of telling you which stocks to avoid, or even short. According to Investars, Zacks' sell-recommended stocks fell 50% more than the Russell 2000. In other words, not only did Zacks warn you about the bad stocks, we helped keep you out of the worst of the worst - the ones that wreck your portfolio.

The Secret Behind Our Strong Performance

What's our secret? Combining our powerful quantitative model with the expertise of seasoned analysts.

Zacks harnesses the power of earnings estimate revisions to create two quantitative models: a short-term (1-3 month) indicator - the Zacks Rank - and a long-term (6+ months) indicator - the Zacks Recommendation. The Zacks Recommendation is an extension of the Zacks Rank and is designed specifically for long-term investors. Both models are applied to approximately 4400 stocks.

In addition, we employ a staff of 50 analysts with expertise in the specific industries they cover. Since there are often factors such as valuation, business conditions and management effectiveness that can be better spotted by a trained investment professional, we allow our analysts to override the quantitative model when they feel it is necessary.

Since our analysts cannot cover every stock, subscribers to Zacks Premium have access to 2 types of reports: analyst reports and snapshot reports.

Analyst Reports contain the analysts' recommendations as well as their in-depth written description on the company. These reports can range from 5 to 20 pages on the individual stock. Or simply, as many pages as necessary to impart to you why to buy, hold or sell the stock. These reports are available for the 1,150 stocks covered by our analyst team.

Snapshot Reports contain the quantitative recommendations and a quick overview of the key fundamental drivers behind the recommendation. This is contained in a 1-page document for approximately 3,250 stocks not covered by analysts.

The Best of Both Worlds

There are many stocks with a long-term buy recommendation that are also on the short-term Zacks #1 Rank and Zacks #2 Rank lists. Combining both rating systems is a profitable strategy, and one I use for finding candidates for the Zacks Elite Focus List.

Here are 5 stocks that are buy-rated from both a short- and long-term perspective:

• Autozone Inc. (AZO)
• Salesforce.com (CRM)
• Hot Topic (HOTT)
• ISIS Pharmaceutical (OSIR)
• Tesoro Corporation (TSO)

Zacks Premium subscribers can view the full list of Zacks Equity Research's buy-recommended stocks. In addition, subscribers can also screen for stocks that are buy-rated from both a short- and long-term perspective with the Custom Screener.

Click here for more information about Zacks Premium, including how to get a free trial.

Zacks Investment Research

The bulk of the outflows can be laid at the feet of a single fund, the S&P 500 SPDRs (NYSE Arca: SPY), which saw $13.6 billion in net outflows.

That gigantic move overwhelmed the positive flows into funds like the SPDR Equity Gold ETF (NYSE Arca: GLD), which  led all ETFs with $5.6 billion in inflows; GLD closed the month with $31.5 billion in assets. The Market Vectors - Gold Miners (NYSE Arca: GDX was second, with $1.1 billion in inflows, followed by the U.S. Oil Fund (NYSE Arca: USO) at $924 million. Other funds to make the top ten on inflows were the iShares Barclays TIPS ETF (NYSE Arca: TIP) at $840 million and three leveraged funds: the ProShares Ultra S&P 500 (NYSE Arca: SSO), ProShares Ultra DJ Financials (NYSE Arca: UYG) and the Direxion Financials Bull 3x (NYSE Arca: FAS).  The trend of inflows into leveraged bull market ETFs suggest a number of investors positioning themselves for a bottom in a these beaten-down markets.

ETFs suffering outflows were led by large established ETFS like the aforementioned SPDRs and the iShares MSCI EAFE ETF (NYSE Arca: EFA). Investors also pulled money out of a handful of inverse ETFs designed to go up when the market goes down.

Investors pulled nearly $6 billion out of exchange-traded funds in February, the first time ETF fund flows have been negative in nearly a year.

The new data, compiled by the National Stock Exchange and published on Wednesday, reversed the strong trend seen in January 2009 and December 2008. That's when investors poured more than $80 billion into ETFs.

The bulk of the outflows can be laid at the feet of a single fund, the S&P 500 SPDRs (NYSE Arca: SPY), which saw $13.6 billion in net outflows.

That's not unusual, either. Stripping out SPY and another heavily traded fund used by institutional investors, the PowerShares QQQ (Nasdaq: QQQQ), ETFs as a whole have generated 78 straight months of net inflows. 

"Those two are so heavily traded by institutions for so many temporary different reasons -- to replenish cash reserves, tax purposes and as an intermediate way to switch around positions within the same asset classes -- that they're really like outlying funds separate from the other ETFs," said Michael Traynor, the NSX's chief strategy officer.

In February, the QQQ's had net outflow of $724 million. 

"There's no telling what institutions are doing from one month's worth of data. This happens so frequently, however, reading too much into the trading volatility of SPY and QQQQ probably won't lead to many sound conclusions," said Traynor. 

That gigantic move overwhelmed the positive flows into funds like the SPDR Equity Gold ETF (NYSE Arca: GLD), which led all ETFs with $5.6 billion in inflows; GLD closed the month with $31.5 billion in assets. The Market Vectors - Gold Miners (NYSE Arca: GDX was second, with $1.1 billion in inflows, followed by the U.S. Oil Fund (NYSE Arca: USO) at $924 million. Other funds to make the top 10 on inflows were the iShares Barclays TIPS ETF (NYSE Arca: TIP) at $840 million and three leveraged funds: the ProShares Ultra S&P 500 (NYSE Arca: SSO), ProShares Ultra DJ Financials (NYSE Arca: UYG) and the Direxion Financials Bull 3x (NYSE Arca: FAS). The trend of inflows into leveraged bull market ETFs suggest a number of investors positioning themselves for a bottom in these beaten-down markets.

ETFs suffering outflows were led by large established ETFS like the aforementioned SPDRs and the iShares MSCI EAFE ETF (NYSE Arca: EFA). Investors also pulled money out of a handful of inverse ETFs designed to go up when the market goes down.

Jim Herrell considers himself a nontraditional index investor.

The chief investment officer at Partnervest Financial Group says his contrarian investing strategies take a more proactive approach to exchange-traded funds.

"We view volatility as an asset class unto itself that's negatively correlated with equity indexes," said Herrell.

The Santa Barbara, Calif.-based Partnervest manages portfolios for advisors across the country. It's part of a growing number of asset managers acting as outsourcers to independent planning firms.

Demand for such specialists is growing rapidly, according to industry statistics, as other aspects of financial planning—such as estate, health care and tax issues—are becoming more complex.

Partnervest was founded nearly seven years ago by ex-executives of a large asset manager based in Scottsdale, Ariz., that focused on serving high net worth clients and institutions in the health care industry. Herrell is a former longtime hedge fund manager.

Efficiency In An Inefficient World

"We believe markets are efficient, but traditional asset-class investing is inefficient," he said. "We're investing with the goal of achieving high absolute returns independent of the market's direction."

Before joining Partnervest last July, Herrell was a manager at Santa Barbara Quantitative Strategies for about five years. He was also a partner at Strome Investment Management, a global macro-hedge fund.

Herrell, age 42, started using ETFs with his hedging strategies in 2003. "Not only are they more flexible and transparent than mutual funds," he said, "but many ETFs have listed options."

That's important since some of the most sophisticated hedging approaches utilized by Partnervest rely heavily on options.

"Structured targeted-return strategies that used to be the purview of hedge funds and big institutions have been democratized by the rise of ETFs," said Herrell. "Now, almost any investor can access strategies similar to those used by Harvard and Yale and other large institutions in an all-ETF format."

An approach that simply invests in long positions with ETFs is just too risky in his view. "One bad year's worth of volatility can destroy several years' worth of accumulated returns," said Herrell. "No matter how you slice and dice it, traditional asset class investing provides way too much risk for the amount of return it can provide."

Partnervest's managers say they don't try to predict market movements. "The only predictive element in our strategy is that volatility is a constant," said Herrell.  "And our portfolios are built to take advantage of that uncertainty."

The firm employs a mix of strategies using ETFs. The simplest tries to maximize alpha. For example, the firm uses the SPDR S&P 500 (NYSE: SPY). Herrell says the ETF is added into the mix with the expectation that its underlying index will show long-term volatility of at least 20% a year.

In the firm's alpha strategy, that range is split in half to target 10% price movements in any given six-month period. "Instead of buying SPY, we structure an options call spread on the ETF at current prices," said Herrell.

The process involves taking advantage of gains made from initial strike prices on those option calls. (A strike price is simply the point at which an investor is going to start making profits. If SPY is selling for $85 per share, for example, and someone buys a call option on the ETF at that level, then an investor makes money on any price gains.)

"It's like leasing an ETF for a certain period," said Herrell.

While it still provides upside participation, using call spreads reduces downside risk, he says, "because you're risking fewer dollars since the cost of the options is much less than buying the ETF itself."

Herrell adds that even in a worst-case scenario, "the most you can lose is the cost of the spread" using such a strategy.

The firm also sells short-dated options. In terms of buying activity, Herrell sticks to purchasing only longer-dated options.

Self-Funding Approach 

"Even if the market doesn't go anywhere, the shorter-term options expire, and you'll make at least a little money," said Herrell. "The net result is that as time passes, this sort of time-decay pays for the upside participation. So it's a self-funding approach which limits your downside but participates in a market advance."

The other aspect of his portfolio strategy actually involves purchasing shares of ETFs outright. Currently, besides owning SPY, some of Partnervest's portfolios include: iShares Russell 2000 Index (NYSE Arca: IWM); iShares MSCI EAFE Index (NYSE: EFA); iShares MSCI Emerging Markets Index (NYSE: EEM) and iShares Dow Jones U.S. Real Estate (NYSE: IYR).

Owning actual shares of the ETFs is part of his Volatility Enhanced Global Appreciation strategy, or VEGA. In such a portfolio, Herrell will also sell call options on a portion of those ETFs to lock in returns.

"We're swapping a potential return for a fixed return," he said.

Partnervest has developed algorithms and built its own quantitative modeling system for constructing portfolios along those lines.

"It tells us how much of an ETF to buy and when to buy and sell options and at what prices," said Herrell. "Rather than guess, we have the model that dynamically adjusts to changing market conditions based on historical volatility patterns and returns."

-- This article was submitted by IU.com's Murray Coleman.

Tim Courtney admits that financial markets do tend to break down from time to time.

A prime example, says the Oklahoma City, Okla.-based portfolio manager, is what's going on today in markets across the globe.

"But markets have proven to be efficient enough over the longer-term to dissuade us from trying to time a recovery or squeeze any possible excess losses by using individual stocks," said the chief investment officer for Burns Advisory Group, which is headquartered in Oklahoma but has offices in California and Connecticut as well.

Courtney used to work with large institutional investors at Fidelity Investments on developing retirement plans and asset allocation requirements. He joined John Burns, who started the business and serves as its chief executive, in 1997.

These days, Courtney is a dedicate portfolio developer for the company's advisors across the country. He doesn't engage in individual stock analysts, but instead relies on the techniques and strategies of managers at Dimensional Fund Advisors. He also likes to sprinkle Vanguard Group index mutual funds and exchange-traded funds into allocations for high net worth and institutional client portfolios.

Preserving Capital Is Key

As the year comes to an end, he's making sure money set aside in more conservative investments remain fully funded according to long-term allocation requirements.

"A lot of people are really focused on yields so they've got enough interest to live on," said Courtney. "But we don't really look at just interest and yields. We're more focused on total returns and overall growth in a portfolio."

Rather than rebalancing back to a static stock-to-bond allocation, he prefers to take profits from stock positions when markets are doing well and use those proceeds to shore-up bond positions. "We don't rebalance back to static allocations. Our ultimate concern is that we don't have to sell stocks when they're way down, like what we're going through now," said Courtney.

Investors who came to the firm a year ago and set up portfolios primarily leaning towards stocks would've seen their fixed-income positions being sold in 2008. "We didn't sell any stock positions this year," said Courtney. "And the reason we didn't is because we set aside enough in our clients' income reserves (through bonds) so we would not need to sell stocks at the wrong time."

He doesn't believe in rebalancing by calendar dates. "We prefer to rebalance based on asset cycles," said Courtney. "We want to make sure that there's enough set aside in a client's income reserves to meet their needs. The fastest way to deplete those reserves over time is by selling stocks at the wrong time."

As a result, portfolio weightings between stocks and bonds can be dynamic. "We don't really see huge swings from year-to-year," said Courtney. "And in most years, we don't even come close to using up someone's income reserves."

During the bear market of 2000-2002, he didn't sell stocks. "We lived off the income of bonds. And if that wasn't enough, we sold shares of the bond funds as a last resort," said Courtney. "There were areas of the market that were doing well, such as real estate, where we were also able to take profits to live on."

The same situation has taken place this year. Courtney has been selling shares of the Vanguard Total Bond Market Index Fund (VBMFX), the DFA Five-Year Government Fund (DFFGX) and the DFA Five-Year Global Fixed-Income Fund (DFGBX). "We've basically been selling anything with a lot of exposure to Treasuries, since those have been doing well this year," said Courtney. "But we're not dumping them wholesale. We're selling pieces of those positions to preserve income for our clients."

The proceeds gained from trimming those bond positions are going into the DFA Inflation-Protected Securities Fund (DIPSX). "With nominal Treasuries offering roughly 0% Interest, we feel like TIPS offer a better investment opportunity going forward. And with the amount of money being created right now to deal with the economic problems we're going through, once the economic cycle rebounds, we'd rather hold TIPS than nominal Treasuries," said Courtney.

Positioning For A Stock Market Recovery

He's also putting some money into the Vanguard Short-Term Investment Grade Fund (VFSTX). "It has government and corporate bonds," said Courtney. "At some point, when the market begins to recover, people are going to start coming out of Treasury bonds. We like this fund as a means to keep our government bond positions as short-term as possible to negate the impact of any eventual reversal in cycles."

And corporate bonds in a short-term fixed-income portfolio helps to boost overall yields for a portfolio, he added.

With stocks, typically smaller companies and stocks oriented more towards value segments of the market lead the way, notes Courtney. "All stocks look pretty cheap right now," he said. "But since we're positioning our portfolios for a time when market cycles change and stocks rebound, our portfolios are sticking with funds investing in traditional value companies which are more economically sensitive."

He likes right now the DFA U.S. Small Cap Value Fund (DFSVX). It had lost more than 40% so far this year entering Tuesday. "It has taken a bigger hit this year than a lot of small-cap value funds. But that's one of the reasons why we like it," said Courtney.

Over longer periods of time, it has outperformed. "And it has done that by really targeting the smallest and most value-oriented companies in the market - even more so than a fund tracking the Russell 2000 Value Index," said Courtney. "We saw the same thing in 2000-2002. DFSVX fell more during that recession, but it outperformed by nearly 50% once the market cycle reversed and stocks rebounded."

Smaller companies have more difficulties raising money these days as the global credit crunch continues, he says. "When you start to see borrowing costs go down, which is starting to happen right now, these smaller companies will start to benefit," said Courtney. "Those smaller companies are on the front lines of any recovery that's bound to take place."

He also believes international markets will show the same patterns at some point. As such, Burns Advisory Group's client portfolios are investing in the DFA International Vector Equity Fund (DFVQX).

"We're keeping a neutral weighting in large companies, simply because we want to be ready for a recovery and position our portfolios to be slightly overweight in small-cap stocks," said Courtney.

For large-caps, he's using DFA U.S. Large Cap Value Fund (DFLVX) and the DFA U.S. Large Company Fund (DFLCX). Courtney also likes to keep some exposure to mid-caps through the Vanguard Mid-Cap ETF (NYSE: VOE).

As further diversification tools, he also maintains positions in the DFA Global Real Estate Securities Fund (DFGEX). "It has roughly half of its securities in the U.S. and the other half invested in international markets," said Courtney. "We feel that overseas REITs is a burgeoning new market. More companies are starting to accept the REIT structure as we've seen in the U.S. for years."

The truth is that generally Matt and I—mostly—agree, and the arguments we do have are often on the margins. But not today. I honestly believe that Matt Hougan is as crazy as a lark with all his shrieking about commodities being different, the space not working for indexing, etc.

It's a bunch of nonsense. POPPYCOCK.

He spends the first half of his blog talking about index weightings. Like that has ANYTHING to do with commodities in particularly. Matt, I've got a surprise for you: The NASDAQ 100 is overweight Technology, the Dow had a leaning toward blue chips, the S&P 600 performs in a wildly different manner than the Russell 2000. Indexes VARY in their weightings. If you don't know that, you are not a decent index investor. You've got to KNOW and UNDERSTAND what's in your index and make an informed decision on that basis. If you want to be very Energy-heavy, go S&P GSCI. If you want broader exposure, go DJ-AIG.

Next, he tries to make the some ludicrous point about "the persistence of momentum" in commodities. Matt, why don't you tell an investor who bought commodities in April of 2008 about the persistence of momentum to December of 2009? And then he goes on in a convoluted way to try to explain why "commodities are different." Academics say so, so it MUST be so, right?

Your endorsement of long/short based on momentum to me is akin to putting it on black. And whatever effect that WAS ther—if there WAS an effect there—is likely to be priced out of the market next week.

Dipsy Doodle Land

You can have a debate with me about whether commodities are a legitimate asset class. Commodities can't produce wealth, they have no natural expected rate of return, all that. That I can tolerate. But saying that the commodities market operates in some other sphere where everyone is above (or below) average just doesn't make sense. And saying it doesn't have the same ebbs and flows as the equities market would seem disprovable on its face. If I buy a commodities ETF from someone and it goes up 20%, yeah, that was a zero-sum game. I made 20%, and the person who sold it to me DIDN'T make 20% (and if they sold it short they LOST 20%), ahem, much like a stock.

PLEASE tell me all the ways in which I "just don't get it." And next, get out all your pointy-headed spinmeister friends who have hypnotized you with visions of free money dancing in your head.

Let me tell you something. There IS no free money. And if you can accurately track the investable opportunity (and commodities indexes do track an array of them in the commodities space), then net-net, you'll beat everyone who tries to tap dance their way into milking alpha out of the market.

And THAT, my friend, is the way it is.

Bogle: Play Through The Recession

Vanguard founder John Bogle is the subject of a Q&A with the Associated Press. Nothing really new here except that the story's headline plays up the fact that the indexing pioneer seems to think that the recession could last 18 months to two years before things get better.

But the gist of the icon's comments is basically to play through the downturn, no matter how long it lasts. Bogle actually makes a pretty good argument for using such downdrafts to buy shares of the indexes you like at lower costs. Smart investors can wind up benefitting in the long run from such periods if they remain disciplined and focused, according to Bogle.

Have you ever read anything you didn't like from this guy? Check out the article here.

PIMCO A Key Player In Bailout Plan For Automakers?

General Motors may ask unsecured debt holders Franklin Resources Inc. and PIMCO Advisors LP to accept as much as two-thirds less than the face value of their bonds as the automaker cuts debt in a bid to win U.S. government aid, according to Bloomberg News.

Although not directly related, such a hit could push back PIMCO's plans to enter the exchange-traded funds marketplace. It has already altered its first bond ETF from a portfolio tied to an intermediate index to short-term Treasuries.

Speaking on CNBC television, PIMCO's Co-Chief Executive Mohamed El-Erian said Monday that the Fed move "to stabilize the mortgage market last week ... was an important step in that direction," according to a separate Reuters report.

As Congressional hearings resume today on the big three automakers' request for a bailout, PIMCO could end up playing a bigger role than many would've first thought. The Bloomberg report explains that other fund companies with stakes in GM also might have to sign off on its final proposal to lawmakers. You can see the story here.

Top Traded ETFs In November

Richard Widows of TheStreet.com has compiled a list of the 20 ETFs with the highest average daily dollar volume of trading activity in the past month. No surprises here with SPY and QQQ on top. But the ProShares Ultra Short S&P 500 (SDS) moved up a spot to No. 3 from the previous month, knocking the iShares Russell 2000 (IWM) down to No. 4 in November.

Another big mover was the iShares MSCI Emerging Markets Index (EEM), which gained four spots from No. 11 the prior month. The Financial Select Sector SPDR (XLF) and the Energy Select Sector SPDR (XLE) also slipped downward in November. You can see the full results here.

The picture was relatively bright for the performance of the ten-largest exchange-traded funds in November. After the two-month market rout of September and October, even among volatile conditions, seven of the 10 largest ETFs had positive performance in November, according to Morningstar data through Nov. 26. At end of day Friday, the S&P had posted its best week since 1974, so the numbers should improve even a little more once the last day of the month is added, at least for the majority of equit yportfolios among the Top Ten.

Leading the way among equity ETFs was the iShares MSCI Emerging Markets Index (NYSE Arca: EEM), up 12.70% for the month.The Thanksgiving week was also kind to EEM, when the ETF surged 10.24%, through Wednesday the 26th. 

The best performer overall was the SPDR Gold Shares (NYSE Arca: GLD) up 14% for the month as market volatility continued to favor the long-time safe haven asset class.

EEM and GLD were the only ones among theTop Ten ETFs with double-digit performance for the month—at least, double-digit positive performance.

Amid the continued financial stock meltdown, the Financial Select Sector SPDR (NYSE Arca: XLF) was down 11.11% for the month. The situation did improve in the last week of November, however, as Citigroup's agreeing to a bailout plan by the government allowed XLF to gain 18.17% through the first three days of the week.

The only other funds among the Top Ten innegative performance territory for the month were the PowerShares QQQ (NASDAQ: QQQQ) and the iShares Russell 2000 Growth Index, down 0.66% and 1.02%, respectively. IWO, along with XLF, had large one-week gains in the Thanksgiving week. IWO surged 13.08%, only surpassed by XLF's gain of 18.17%.

Even with a healthy helping of positive performance in November, the Top Ten were still showing woeful year-to-date performance.

Here are the year-to-date numbers, through Nov. 26, as well as the rest of the performance picture for the Top Ten ETFs, which controlled more than $200 billion of the industry's $488 billion at the end of October, according to the National Stock Exchange:

Source: National Stock Exchange

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