How The Trend Can Be Your ETF Friend

[This interview appears in our upcoming issue of ETF Report.]

Pacer Financial, based outside of Philadelphia, launched its first ETFs in the middle of last year. The firm has quickly attracted $500 million in assets to its "Trendpilot" funds, which the company says are designed to provide a selection of strategy-driven ETFs that aim to serve as long-term investments as part of a diversified portfolio. However, Pacer is not new to the ETF industry. The company at one time was the wholesaling operation for RevenueShares when it first launched. And if the "Trendpilot" strategy sounds familiar, it's because Pacer worked with Royal Bank of Scotland and its exchange-traded note platform developing products with the name before RBS decided to exit the ETN market in addition to all its other kind of noncore bank businesses globally.

ETF Report caught up with Pacer Director Sean O'Hara to discuss the unique strategy of the company's ETFs and where he sees them fitting into a diversified portfolio.

ETF Report: Let's talk about your "Trendpilot" ETFs that launched last year and the strategy behind them, which some would say is smart beta. What are the differences between the three: the Pacer Trendpilot 750 (PTLC | D-50), the Pacer Trendpilot 450 (PTMC | F-1) and the Pacer Trendpilot 100 (PTNQ | F-55)?

Sean O'Hara: We would categorize ourselves as strategy-driven, not smart beta; not that we have any problem with that. I read on your website that smart beta is going to attract $100 billion this year. So if we can hang around in that crowd, great, but what we think we do is strategy-driven.

We use a trend-following approach. The "750" is a reference to the Wilshire US Large Cap Index, which holds the 750 largest stocks in their Wilshire 5000. The "450" is a reference to the Wilshire US Mid-Cap Index. And then the "100" is the Nasdaq-100.

The rules are very simple. What we want to do is to be fully exposed to those underlying equity indexes when the trend is positive. And the way we measure the trend being positive is by using the price of the index versus its 200-day moving average.

If the price of the index falls below its 200-day moving average for five-consecutive days, then the dynamic is changed; the trend—at least in the short run—has changed. So at that point, the index calls for us to take half the exposure and go to U.S. Treasury bills, moving away from risk.

We will then either stay in that 50/50 mode and go back to full equity mode, or go all the way out of the market based on whether or not the next risk signal triggers. The next risk signal is whether the moving average itself starts to go down instead of continuing to move up.

The simple idea is to be fully participating in the market when it's rising. When things get dicey or you get some volatility, it moves to a halfway-safe position. And then if the trend really changes by confirming both those signals, then move away from risk entirely.

We use a traffic light analogy—green, yellow, red. Green is fully invested; yellow is 50/50—that means caution; and red means stop altogether. We're trying to provide an alternative way for advisors and clients to include something in their portfolio that helps them manage the risk of being an equity investor without detracting from equity returns when the markets run.

ETF Report: So these funds are purely rules-based?

O'Hara: They are 100% rules-based. Take the midcap as an example: PTMC. It tracks the Wilshire U.S. Mid-Cap Index. On Aug. 24, it was completely out of the market, and it's been completely out of this market since then. Midcap stocks, if you measure them by a benchmark—the Wilshire midcap or the S&P 400 or the Russell 2000, whatever midcap benchmark you like—have fallen about 18% since then. Our midcap ETF is down 6% relative to that decline.

If you look at this over long periods of time, this very simple rules-based methodology will provide a vehicle where somebody can match or exceed equity returns with a whole lot less exposure to the downside, which is inevitable in the market; it's just the way it works.

The 200-day moving average as a way to manage the risk or the exposure to the markets has been a great indicator to move out of the way of that bear market cycle.

ETF Report: Aren't you in jeopardy of missing that eventual market bounce being completely out of the market?

O'Hara: We are, but when we position the story and the idea for financial advisors or clients, we say it works great if you pair it with two other kinds of ETFs: a beta product and another that is alpha-seeking.

Put all three of those in a portfolio and then you go through the scenarios: What if the market goes up? Then your beta ETF goes up. And if the market goes up, your alpha ETF should go up. And if the market goes up, our funds should go up with the market; or we might lag a little because of the timing, but generally speaking, when the market's up, we'll be up.

Now, when the market goes down substantially, what will your beta do? It goes down like the market went down. When the market goes down substantially, your alpha sometimes underperforms your beta, so it goes down more. Trendpilot funds provide protection by giving a position where I don't really worry about whether the market's going up or the market's going down, because I know I have an ETF in my portfolio that's going to track the market. I have an ETF in my portfolio that I believe over time will produce excess return because it's an alpha-driven story. And I have an ETF in my portfolio, because of the way the Trendpilot strategy works, that will provide protection.

You put those three things together and you can produce a much smoother ride and better long-term results than just simply being a pure, low-cost beta investor.

ETF Report: In terms of pairing, do you suggest beta or alpha products?

O'Hara: It doesn't really matter to us whether it is the SPDR S&P 500 (SPY | A-98), the iShares Core S&P 500 (IVV | A-98) or the Vanguard Total Stock Market (VTI | A-100). Same with the alpha piece. What we want people to understand is that you can build a better long-term portfolio for your end investor by pairing those three things together if you understand how they work. And the piece we deliver that's unique in the market today is the protection piece by using this trend-following methodology.

ETF Report: You've launched some European funds. The Pacer Trendpilot European (PTEU) I presume is similar to what we've discussed. Tell me about the Pacer Autopilot Hedged European (PAEU). What's the Trendpilot versus Autopilot difference?

O'Hara: Trendpilot is really supposed to be in the market or flat, whereas Autopilot just changes exposures. So what we thought was that the hedged products works great as long as the dollar is strengthening and the euro is weakening.

But if that trend changes, which it inevitably will, then I'm going to be forced to sell my hedged ETF to buy an unhedged ETF. We came up with a methodology that simply determines whether or not I should be hedged. So I never have to liquidate my ETF, thereby not needing to pay tax.

ETF Report: What is the toggle trigger there?

O'Hara: We try to be simple, simple, simple. The more complicated you get, the more chances you have to get things wrong.

So at the end of every month, we look at the 20-day moving average of the euro versus the dollar versus the 130-day moving average; simply one month versus six months.

If the one-month moving average or 20-day moving average of the euro versus the dollar is above the 120-day, that means the euro is gaining versus the dollar in the short run. We will not be hedged during those periods.

If the relationship is normal, where the trend is that the 20-day is below the 120-day, that means the dollar is dominating the euro in that ratio, and we want to be hedged during those periods.

When you look at a long-term currency chart, euro versus dollar, what you'll see is over the last 20 years, it started exactly where it ended today. But there have been big swings in the middle. What we want to do is capture as much of that swing as we can by having the currency exposure come on or come off.

We want to create excess return by having a reliable signal or methodology that will determine when the ETF is hedged and unhedged.

We thought we would have a lot more time to get out and tell the story and get a lot of first-mover credit here. And fortunately or unfortunately, WisdomTree and iShares launched dynamic hedged products. They work a little bit different than ours; that might be the next big trend in the business, this dynamic approach to currency.

And it's bigger than just the portion of the assets that people are thinking about in ETFs, because there's trillions of dollars of retail mutual fund money in non-U.S. investments that haven't even thought about currency. And they've been getting clobbered here lately: The stocks go up, the currency goes down. They wind up losing money and they don't understand.

Having an effective strategy to deal with currency that is dynamic—or on Autopilot, like we say—where you're hedged at certain periods and unhedged at other periods, where you don't have to then change ETFs to change your view, to us made a lot of sense.

We'll continue to build things out in that area. Another Autopilot idea would be to just take growth and value in an index and split it, and have an Autopilot methodology that overweighted growth when growth was in favor, and overweighted value when value was in favor. Well, you can build methodologies that do that. And we'll do that as we go forward.