Q: In terms of portfolio construction, how many ETFs do you typically hold?

A: As we start to get in, we start with only two or three ETFs. By the time we’re 100% invested, we could hold anywhere from 12 to 15 ETFs. Typically, we wouldn’t invest more than 15% or 20% in any single ETF and we have rules that prevent us from owning more than a certain percentage of an ETF’s assets.

Our rules are designed to keep human emotion out of the decision making process. We can’t change the model if it doesn’t work today. Human beings are subject to fear, hope, and greed, and every investor knows how these emotions have failed them, so we stick to our rules. Another benefit of that strategy is that everyone in the investment department can handle it. It is not just my selection process; the entire department is on board on how to do this.

Q: How often do you change or redesign your set of rules? What would lead to such a change?

A: If we believe that there is a need for a change, we implement it outside of the arena of being invested. As a hypothetical example, if I have a feeling that we should be fully invested, but our model says differently, I can’t just change the model. The change should happen when we’re fully invested or fully defensive, because then it can be determined with adequate testing and very conservatively.

Obviously, we know that markets will change over time and that the process needs to be reviewed periodically. We do that and we have an investment committee that has to approve it. It has to be run through some very critical thinkers before anything could be changed. PMFM has used this approach since 1991, and the only change is that the model has evolved over this period. Some of the components and the parameters have changed, but the process is still the same.

Q: What’s the importance of breadth as an indicator? How do you leverage it to your advantage?

A: We have quite a few breadth components in our weight of the evidence, because breadth arrives at the party on time, but always leaves the party earlier. As the market bottoms and then starts up, breadth starts improving just like the price-based indicators. Breadth is not capitalization weighted and if the large caps continue to hold on as the market tops, breadth will start to deteriorate because it also includes mid and small-caps, This is a very good early indication and an early warning shot. Breadth is probably the best existing picture of liquidity.

Q: Does that mean that you follow the breadth but you don’t try to anticipate it?

A: Yes, definitely. I’ve been doing this a very long time and I think that forecasting is just folly. We are trend followers and we are not picking tops and bottoms. rather, we are identifying up moves and jumping on board. When those up moves end and start down, we get out. But breadth only can’t take us to cash; it takes the whole weight of the evidence, which is price, breadth and relative strength. These are the three major components. We also have a small interest rate component that looks at the non-Fed controlled rates.

Q: What’s your view on risks and how do you control them?

A: We believe that risk is critically important. For example, if you examine the Dow Jones Industrial Average index annual performance for the last 110 years, you will see an almost normal distribution, skewed to the right. The was up 67% of the time in the last 110 years. At first site, that chart supports the notion that the market is up more often than it is down, but the probability isn’t high enough. In other words, you can bet $10 on the probability to win, but you wouldn’t bet your life on it.

Once you shift your focus from probabilities to risks, that percentage doesn’t look high enough to play the game of buy and hold, or to use a strategy that will lead you to sitting and holding on during a bear market.

We deal with risks by having stops. We never own a position that does not have a stop. It’s not a simple price stop, but a dynamic stop based on price movement. It follows it along and as our weight of the evidence gets better, our stops get looser. We can’t have really tight stops because good markets still have daily volatility and we have to live with it. Overall, we address risks by rules that I cannot break.

Q: Do you consider yourself a relative-return investor or an absolute return investor? What’s the targeted performance?

A: It would be fruitless to set targets when our process is controlled by the market. If we can participate in most of the uptrends, we will do well. We strive for equity-type returns with lower beta, lower volatility. We don’t set targets.