Kotok: Be Nimble At Markets' Turning Point

February 07, 2017

Cumberland Advisors’ Chairman and Chief Investment Officer David Kotok spoke with ETF.com at Inside ETFs about the long-awaited launch of the first ETF to be managed by him as well as how investors should approach their portfolios in the current investment environment, among other topics.

ETF.com: I think a large part of the ETF industry has been waiting for a while for an ETF managed by you. What precipitated the launch of the Virtus Cumberland Municipal Bond ETF (CUMB)?

David Kotok: We've been in this discussion for several years on an actively managed muni ETF, and CUMB now exists. We’re applying what we've done for years to the management of it, within a set of rules, because it's a lot different from a separate account.

But we got there. It's been a long road. I don't know what to say other than we're kind of excited about it. We think we can use the tools we use to manage munis actively.

Whether we can apply them within the constraints of the rules that we have to operate within [for the ETF]—which is entirely different than a separate account for a resident of a single state with certain criteria—remains to be seen. But we think we can. And we think we can add value, and we're going to know soon enough.

ETF.com: What’s so great about the ETF structure for your purposes?

Kotok: I think there's a case that can be made to distinguish an ETF from a traditional mutual fund for munis. Now, the third alternative is to have a separate account. In other words, be your own mutual fund. And we do a lot of that now.

But if you look at the construct of a traditional mutual fund, when it has a redemption, for whatever reason (people want out, they get afraid, they need the cash), but more importantly if it's driven by an event (whether it's an election or a crisis or some financial catastrophe or something else that scares them), in the traditional mutual fund system, the shareholder gives notice and says, “Give me my cash.” The fund manager must raise that cash and pay that shareholder tomorrow.

If it's a bond portfolio, a muni portfolio, that manager has to sell into market conditions that are not liquid. Not only that, but say the fund is Fidelity, and there are redemptions that are systemic. There's no Vanguard to do the other side of the trade.

So the ETF is a different animal. The ETF has a creation unit in it that can take effect. But as a practical matter, the pricing of the ETF when there’s a drift from a net asset value protects the long-term owner. Because, if you think about the redemption, the [mutual fund] manager sells, raises the cash and pays the exiting shareholders. What about all the rest of the shareholders? And if everybody redeems, you have a full catastrophe.

I think the ETF has a built-in cushioning mechanism that a traditional mutual fund doesn't have. And we're going to test it ourselves, because actively managed, total return muni ETFs are rare; there aren't many of them. We've been doing that in separate accounts for a long time. But to do it in an ETF, we'll see how it goes.

 

ETF.com: Interest rates are expected to go up. Is that changing your approach to the fixed-income space at all?

Kotok: There are two component parts of interest rates—the short-term interest rate and the long-term interest rate. And then there's the relative change; with a tax-free bond, the relative change is very, very important.

Look at what's happened in the last few months. We had a situation in which the long-term muni reached a yield lower than the long-term taxable Treasury. That’s what you would expect because we have an income tax code, so a high-grade muni should yield less than a high-grade or the very-highest-grade taxable.

Now, we've had an election—the muni market got clobbered, bonds went down in price, up in yield, and the 30-year Treasury may have backed up 40, 50 basis points. At the same time, munis backed up over 100. It went from being richly priced to a cheap bargain.

You can seize those opportunities in the ETF. We're going to be able to move those things around a little bit. Our anticipation is, if we have volatile changes, we'll be able to do so even more easily, because of the nature of a total return ETF. You're not just buying an old-fashioned pool of bonds and holding them forever.

ETF.com: Do you see any major risks that investors should be watching for right now?

Kotok: Generally speaking, we have a huge inflection point here. Doing an inventory, the U.S.—the largest economy in the world—is slowly raising interest rates, with a new regime in power talking about trade and protectionism and altering the tax structure.

The second-largest economy in the world is China—it's more of a closed, controlled market, not a free-market pricing system, trying to establish itself in a world order.

With the third-largest economy, Japan, the policies are anchoring two points on the yield curve at near-zero. It’s in a confrontation with the second-largest economy over a piece of real estate that’s been turned into a military base and is disputed.

The fourth bloc in the world, with 500 million people, is Europe, where the interest rate is negative. They're trying to get to some inflation, and they hope to have growth of 1-1.5%. And their banking system is riddled with difficulties, particularly in Italy.

That's the world. This is a very, very different world, where you don’t have correlated economies. You don’t have interest rates aligning all at zero anymore. And you have differing degrees of economics: slowdown and recovery. And now there’s regime change in a political sphere that is now adding trade and protectionism.

So what do we have? A huge inflection point, a massive inflection point. There are a lot of characteristics that support that notion.

What don't we know? What is the direction of change and how rapidly will it exist?

 

If we have a major inflection point, and we don’t know the direction of change and the velocity of the change, what do we do? That is the context in 2017 that everybody else as market agents has to deal with managing portfolios, stocks and bonds, asset classes.

ETF.com: So are you buying a lot of Maalox now?

Kotok: I ran out!

I think you have to be nimble. I think tactical decisions as opposed to buy/hold are more important than ever. And if one wants to buy/hold and not make tactical decisions, you can do that at very low cost.

ETF.com: With so many question marks in the current scenario, are you taking on additional risk by not being tactical?

Kotok: Well, I think so, but there are people who would disagree. That's what makes markets. In my view, cash is an asset class now. It has a legitimate place even though the interest rate is near zero. And one has to view the world in this context of a dramatic inflection point without a direction known.

The turning of the inflection point will happen before you can confirm the trend. And that means you have to do some guesswork, do some estimation, and be prepared to be wrong and change your mind quickly.

ETF.com: How do you recover if you guess wrong?

Kotok: Take small losses, take them fast. Admit you don't know everything.

ETF.com: And regroup?

Kotok: Well, if you want to stay in the game. Otherwise, go fishing and stop being in the business.

 

ETF.com: What do you see as the opportunities now? Because we just talked about the risks, which seem multitude, but what are the opportunities?

Kotok: There are a couple of themes that I think are at work that aren’t going to be derailed by the Trump administration or the activities that we see. The first one is an easy one. We know the administration leans in favor of domestic energy. That's pretty apparent. Now, what the nuances and details are, I'm not sure.

So we have two ETF positions—the First Trust Natural Gas ETF (FCG), with natural gas domestic; and the SPDR S&P Oil & Gas Exploration & Production ETF (XOP), because we think it's more heavily concentrated on U.S. domestic exploration. And it's a pro-energy portfolio position.

Rationale? Oil prices, energy prices seem to have bottomed or near-bottomed, and the U.S. government is going to be friendly to the industry, not adversarial, which the Obama administration was for eight years. So that's a pretty clear theme.

Another good theme is the changes in banks and banking. The administration under Trump is likely to be less hostile or more friendly. Interest rates and the construction of interest rates in the world have been altered so that the large bank deposit gatherers have an advantage in a world now, where the rest of the financial community doesn't have that access. So the PowerShares KBW Bank Portfolio ETF (KBWB) is a position in our portfolio, and it captures the big banks, because they've got 75% of the deposits. They're the asset gatherers. And they have footing.

Now, the flip side of this is, what do you do with income-oriented things like utilities where we don't know what the tax treatment will be? Imagine what happens to the utility sector if the corporate tax rate goes down and the deduction for interest is eliminated. In the utility sector, you've just imposed a tax increase. You've just raised everybody's electric bill to pay for it in rate recovery.

The dynamics of the details become very important in themes like utilities and interest rates and taxation. They become less important in the themes where you have a general trend that's favorable, like with the energy sector.

ETF.com: Why do you favor passive management for your equity exposure?

Kotok: We actively select the ETF that’s the construct of the portfolio, so the ETFs enable us to create portfolios any way we want anymore. I would say our approach to the stock market is active, and the vehicle is not individual stocks but ETFs.

It’s entirely different in bonds. We don’t use very much in the way of ETFs for bonds. We do separately managed accounts very specifically to try to address client needs. And we're now the manager of a bond ETF, but because we're the manager, we can’t use it and we can’t buy it ourselves.

 

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