Q:  What is your investment philosophy and how does it differentiate you from other fund managers?

A: Our investment philosophy is based on the belief that market leadership changes over time, while most fund managers don’t recognize that fact. They usually follow a particular style or a strategy that works well in certain market environments although it may not work as well in others.

Contrary to that approach, we have an investment strategy that adapts to changing market environments without trying to predict future leadership. We don’t believe that we are able to forecast the future, or that we would add any value by doing that. But we believe that by monitoring the performance of the funds and the components of the market, we can take advantage of changing market leadership.

We manage a total of seven funds with a common strategy that is applied in a variety of ways. The funds differ mainly in terms of allocation, portfolio construction, and risk profiles. Currently we manage over $2 billion and the FundX Upgrader Fund has about $830 million in asset.

Q:  What's the process that allows you to benefit from the changes in market leadership?

A: Our strategy is based on relative performance and the approach is fairly straightforward. We classify the mutual funds by risk, which we measure by the level of concentration and by the historical downside record. To determine the different risk categories, we look at a combination of performance, volatility, portfolio construction, style, and management.

Once we classify the funds, we rank them based on the average performance over the last one, three, six, and twelve months, or the various results within a year. The system is not overly optimized, and I believe that this is one of the reasons for its success. Effectively, we take a snapshot of the current winners on a bi-weekly basis but we rely on the monthly rankings for major portfolio decisions.

Then we review the rankings to select the funds that are in the top 10% of their risk category for the portfolio. We have specific sell thresholds, and when they reach the threshold, we replace them with the current leaders. By consistently applying this approach, we incrementally move from style to style and from one area of the market to another in response to changing market leadership. Our goal is to capture the broad trends that last for years as opposed to every little shift that might take place in the marketplace.

Q:  Would you explain your risk categories in more detail?

A: We want enough variety in each risk catgory to potentially provide exposure to new areas as market leadership changes. In other words, in each risk category, we need value and growth orientations, different market capitalizations and both foreign and domestic funds represented. At the same time, we are cognizant of the fact that for each component of the portfolio, we have to understand and be comfortable with the level of risk. We only allocate money to funds with risk levels that are consistent with our objective.

Class I represents the most speculative fund category. It includes very concentrated funds, usually country-specific, or diversified funds that are very aggressive. Class II consists of speculative funds, which usually have regional focus such as developed countries or emerging markets. This category may also include broadly diversified funds that are more aggressive than the broad U.S. market.

Class III represents the core component of our portfolios. It consists of funds that are more diversified and with market-level risk. These can be international, domestic, large, mid, and small cap, value and growth funds. The idea is to have a diverse group that we can select from. Class IV represents total return funds, of funds that generate a significant portion of their gains through income. These could be REITs, balanced funds, or convertibles funds.

Q:  How do you approach the portfolio construction process?

A: In the FundX Upgrader Fund, we typically hold anywhere between 50 and 70 different funds. About 70% of that portfolio is in the Class III category, or the more diversified funds. The other 30% is in the more speculative risk categories. Typically, our smallest positions are in Class I, while the Class III holdings are two to three times the size of the holdings in the speculative funds.

We don’t have any static allocations and our holdings change in response to changing market leadership. For example, in the late 1990s we had no international exposure; we held domestic growth-oriented funds. In 2000, we started a transition into value funds, still mostly domestic. When the FundX Upgrader was launched in November 2001, it was mostly in small and mid-cap value funds because that's where our rankings were leading us. By late 2002 and into 2003, we began to own a lot of international funds, which currently represent about 70% of the portfolio. Before we invested in mutual funds only; now we also use exchange traded funds.

Overall, we sidestep from the conventional wisdom that because you can’t predict leadership changes, you have to ride through difficult periods with a diversified portfolio, including components that underperform over a sustained period of time with the hope that they will add value later. Instead, we hold the areas that do well and we get rid of all the others. But the portfolio is still diversified. Among the 60 different funds that we hold, we have hundreds of securities. For example, the 70% exposure to international funds is diversified broadly geographically and by market capitalization.

Q:  What are the major drivers of your sell decisions?

A: Typically, if we own 60 funds in the portfolio, we would sell three or four of them each month. Although our turnover rate is about 100% to 150% per year, a lot of the turnover takes place on the fringes. We always have a series of funds that we hold for several years, and we have funds that we hold for three to six months.

It is a fully invested strategy, so we don’t sell something unless we have something else that we find more attractive. Everything we own is a buy or hold; we don’t sell just because it’s going down. We are patient enough to allow our system to guide us to future leadership as opposed to following the temptation of reacting to market events. Ultimately, if leadership changes, we'll change as well.

A side effect of our strategy is its tax effectiveness. First, we get distributions from the funds that we invest in and many of them end up being long-term capital gain distributions. And since we invest in funds based on performance, the funds that perform well tend to last awhile. The ones that we end up selling in less time usually have smaller gains or even losses.