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February 2005 Issue
According to the government’s preliminary estimate, Gross Domestic Product
rose at an annual rate of 3.1% in the 4Q of last year, well below
expectations of 3.5% or better. Even taking into account a weaker than
expected 4Q, the economy grew at the rate of 4.4% in 2004, the best rate
since 1999. And the next two GDP reports for the 4Q could be revised
upward. So, the economy is still on a solid growth track for 2005, although
not likely to match last year’s pace.
While I have been guardedly optimistic about the stock markets for the last
year, equity prices have gone essentially nowhere. January’s price action
in the broad equity markets has been a disappointment, and there is the real
chance that another top is in the making. A move to a more defensive
position would seem advisable at this point. Of course, if you are invested
with one or more of our professional mutual fund Advisors, then you don’t
need to take any action.
The bond markets did surprisingly well in 2004, despite my concerns, and
they might hold their own this year with inflation expected to remain fairly
low. However, I don’t expect bonds to stage a repeat of 2004 this year.
The US dollar reversed higher since the first of the year, and this resulted
in losses by most Commodity Trading Advisors who trade currencies. While
this upward correction in the dollar could continue for a while longer, the
longer-term trend in the greenback remains lower.
This month, I feature the newest Advisor to be added to our recommended
list. For years, we have searched for a successful Advisor who uses
both long and short positions in mutual funds, with the potential to make
money in both bull and bear markets. We have recently found a real gem in
this regard. In this issue, I will introduce you to Third Day
Advisors, LLC which has one of the most impressive performance records
we have ever seen. Third Day has an average annual return of 23.4%
over the last three years with a worst drawdown of -12.2%, net of all fees
and expenses. This is a program you should take a serious look at
if you are a sophisticated investor. See pages 2-6 and the important
disclosures on Third Day that are included with this newsletter.
Introduction
As you probably know, “hedge funds” have been the rage in investment circles
for the last several years. However, most of these funds require minimum
investments of $1 million or more, if you can get in at all.
This week I am delighted to introduce you to a professional money manager
that applies some hedge fund-like strategies to mutual funds. The
money manager discussed below is the latest to make it into the select team
of successful Investment Advisors that I recommend through our
AdvisorLink program. See performance information on page 4.
For over five years, we have been looking for a mutual fund money manager
that has a successful performance record using hedge fund-like strategies
both on the “long” side and the “short” side,
and who has made money both in a bull market and a bear market in stocks.
I am happy to report that we have now found a money manager who: 1) made money
in the bear market of 2002; 2) made money in the bull market of 2003; and 3)
who even made money in the choppy, sideways market of 2004.
I strongly suggest that you read on and find out about a money manager that
uses widely-known mutual funds in an effort to make money when the equity
markets are trending higher AND even when the markets are trending lower.
Let me now introduce you to THIRD DAY ADVISORS, LLC and Ken Whitley
, the founder and mastermind behind the system. Third Day has
an impressive performance record which is shown in the table on page 4.
Keep in mind, however that Third Day’s money management system is an
aggressive program which uses both long and short positions. It is
therefore not suitable for all investors. Past performance is not
necessarily indicative of future returns.
Third Day Advisors, LLC
Like many active money managers, Ken Whitley began his career in an industry
unrelated to financial services and asset management. Ken graduated from
college in 1981 with a B.S. in Computer Science and has spent his career in
the fast-paced high-tech industry. The story of how Ken utilized his
extensive knowledge of computer hardware and software to develop an
effective money management system is very interesting, so read on.
After working for various employers in the high-tech industry, Ken joined a
small software firm in 1989. When this company’s software product was
acquired by Intel Corporation in 1997, an offer of employment came with the
deal. Ken accepted the offer and is still employed full-time by Intel where
he is engaged in project and engineering management.
Having enjoyed the fruits of the 1990s high-tech boom, Ken built up a nest
egg that he wanted to invest. He began studying the market in his spare
time, and after much trial and error, he developed a sophisticated model for
trading the Nasdaq 100 Index. In November of 2001, Ken completed
back-testing this model back to 1995 and concluded that his system indeed
had potential. He then started trading his own money using the signals
generated by his system. The results, as you will see on page 4, have been
outstanding, and they have been delivered in three very different market
environments.
In 2003, Ken brought in Doug Fisher and his wife Angela as additional
partners in Third Day. Doug, also an employee of Intel, provides marketing
assistance while Angela is responsible for day-to-day trading. Ken and
Doug’s money management activities at Third Day have been fully disclosed to
Intel management, and they have no objections since their positions at Intel
have nothing to do with providing investment advice.
The Third Day Aggressive Strategy
Investors familiar with alternative investment strategies, such as hedge
funds, often seek out programs that can go both long and short in the
market. In such programs, the potential for profit exists no matter what
the market’s direction. Unfortunately, many such programs are available
only to wealthy investors through hedge funds. The Third Day
Aggressive Strategy allows many aggressive investors the ability to have
long and short exposure to the Nasdaq 100 Index.
Ken’s Aggressive Strategy is a proprietary blend of momentum,
trend-following and overbought/oversold indicators. There are six basic
indicators that Ken uses to analyze the market, with a number of
sub-indicators that also factor into each trading decision. Each indicator
“votes” on whether to be long, short, or neutral in the market. The model
is 100% mechanical, though Ken does reserve the right to override his
system’s signals in the case of a national emergency.
The relative strength of each indicator then determines to what extent the
Third Day program will be invested in the market. The investment vehicles
used are the Rydex Venture and Rydex Velocity mutual funds. These funds are
part of the Rydex Dynamic class of funds that seek to provide investment
returns that correlate to 200% of the daily performance of the Nasdaq 100
Index, with Velocity providing a positive correlation and Venture providing
a negative correlation.
Unlike most mutual funds, the Rydex Dynamic funds also allow Third Day to
trade in or out of a fund two times per day, once at 10:45 AM Eastern time
and again at the close of business at 4:00 PM Eastern time.
To limit risk, Ken will only allocate up to 75% of an account to any fund
position, resulting in a 150% maximum exposure to the Nasdaq 100 market.
However, maximum allocations of 75% are rare. Historically, Third Day’s
allocations are in the maximum range only 12% of the time on the long side,
and only 2% on the short side. The program is projected to be in cash
(money market fund) an average of 38% of the time in any given year based on
historical performance and back-testing.
When first developed, Ken’s model would issue a trade signal that would last
a maximum of three days, which is where the “Third Day” name came from.
This automatic exit from the market also acted as a method of risk control,
since the duration of each trade was limited. However, in the strong stock
market in 2003, Ken found that automatically exiting the market after three
days left additional gains on the table in many cases. Thus, he adjusted
the model to allow it to stay invested as long as the buy signal is
confirmed by his indicators.
The Third Day Aggressive Strategy does not currently employ any traditional
stop-loss techniques to automatically exit losing trades. This is another
reason why the program should only be considered by aggressive investors who
are comfortable with high volatility and significant periodic drawdowns.
While the Third Day program has been successful in limiting losses, it
should not be considered as a low-risk program. While Third Day’s
Aggressive Strategy has had only a –12.18% maximum month-end drawdown
to-date, Ken says that his target is to limit drawdowns to no more than
-20%. You should keep this in mind when evaluating this investment for
your portfolio.
The short-term trading nature of the Third Day Aggressive Strategy will mean
that there will be a significant amount of activity in your account. In
addition, all gains will be short-term in nature, so this program may not be
the most suitable option if tax efficiency is a priority.
Performance Evaluation
As noted above, Ken did not start actual trading of his program until the
end of 2001, so it has a relatively short actual performance history. While
the track record is just over three years, 2002, 2003 and 2004 provided
three very different types of markets to test his strategy. In 2002, we saw
a major bear market in stocks. In 2003, the market reversed itself and
experienced a powerful rally. then in 2004, we saw a sideway market where
long-term trends were hard to come by.
Many times, strategies that claim to be effective in all types of markets
can do well in a bull or bear market, but usually not both. Even the ones
that can negotiate both up and down markets often get whipsawed during
sideways markets due to volatility and the lack of tradable trends.
Third Day is one of the very few managers we’ve ever seen who has been
successful in all three different market environments - up, down and
sideways. Since its inception in November of 2001, the Third Day
Aggressive Strategy has proven its ability to navigate different market
environments by posting an average annualized return of 23.43%, net of all
fees and expenses. The worst-ever losing period (or “drawdown”) was –12.18%
in the bear market of 2002. See the actual performance history in the
tables below for more comparisons and monthly returns. SEE IMPORTANT
DISCLOSURES INCLUDED WITH THIS NEWSLETTER.
(click charts for larger image) PAST RESULTS ARE NOT NECESSARILY
INDICATIVE OF FUTURE RESULTS.
While Third Day’s performance is impressive by itself, it’s even more so
when compared to the S&P 500 Index’s average return of 6.14% and the Nasdaq
100 Index’s average return of 4.61% over the same period. While past
performance is not necessarily indicative of future results, it’s clear that
Ken’s sophisticated model has been effective in dealing with very different
market conditions over the past three years.
Low Correlation To Our Other Programs
While performing our due diligence evaluation on Third Day’s Aggressive
Strategy, we found that this program has virtually no correlation to any
of the other programs offered by ProFutures. By correlation, I mean the
tendency of an investment to go up or down in relation to other investments.
If two investments go up and down together, they are said to be positively
correlated. If one goes up when the other goes down, and vice versa, they
are said to be negatively correlated. However, if an investment's gains or
losses are independent of others, then it is said to be non-correlated.
Non-correlated investments are preferred because they have the potential for
gain without respect to how any other investment in the portfolio may
perform.
So what does this mean to you? Including non-correlated investments in your
portfolio helps to reduce the potential risk of your overall portfolio and
may also improve overall performance. Specifically, this means that
if you add Third Day to your other existing investments with us, you add not
only Third Day’s outstanding performance, but also additional
diversification to your portfolio.
The Trading Platform
As noted above, Third Day is a small firm and Ken still has his full-time
job with Intel. However, Ken’s location on the West Coast (Pacific time
zone) and his outsourcing of “back-office” operations have overcome the
usual constraints associated with a small business. Ken has the benefit of
living in the Portland, Oregon area, a three-hour time difference from the
East Coast. As discussed above, the first trading opportunity for the Rydex
Dynamic Funds is at 10:45 AM Eastern, which is 7:45 AM Pacific time, before
Ken’s workday starts at Intel. The second trading deadline is 4:00 PM
Eastern, which is 1:00 PM in Oregon, during the lunch hour.
The luxury of the time zone differential, however, does not cover the lack
of a back-office capability for processing accounts. Third Day has also
covered that base by outsourcing its “back-office” activities and account
administration to Purcell Advisory Services, LLC, a company that
provides back-office services for small Advisors nationwide. Purcell
Advisory Services handles the account set-up paperwork, reporting, fee
billing, etc. while Third Day need only make a call to Purcell each day to
communicate the trading instructions.
Since the system is 100% mechanical, all Angela has to do is enter market
data and the software produces the actual trading instructions. If the
system gives a signal, either to enter a trade or exit a trade, Angela then
confirms the signal with either Ken or Doug, and then communicates the
trading orders to Purcell.
Because of this outsourcing, the ProFutures due diligence team also made an
on-site visit to Purcell Advisory Services to review their administrative
capabilities and internal controls. We are happy to report that they passed
our due diligence review with flying colors.
The minimum investment for the Third Day Aggressive Strategy is $50,000,
and the annual fees are 2.5% billed quarterly in advance. Client funds are
held in Rydex mutual fund accounts, and investors have access to their
accounts through the Rydex website. Both Rydex and Purcell Advisory
Services issue quarterly statements, and Rydex produces year-end tax reports.
When Tragedy Strikes
One of the most important questions we ask when performing due diligence on
an Advisor is to what extent they have someone to back them up should they
not be able to fulfill their duties. In most cases, we have to evaluate a
hypothetical back-up plan, but in Third Day’s case, we were able to see the
back-up plan in action.
In November of 2004, Ken was called home from a hunting trip due to his
wife’s sudden illness. A few days later, his wife, Jane, died at only 41
years of age. Jane had, up until that point, shared trading
responsibilities with Angela. During the period of time that Ken was
attending to his wife in the hospital, and then making funeral arrangements
and spending much more time with their four children, the Third Day back-up
system performed flawlessly. Ken’s partner, Doug Fisher, ran the model and
his wife Angela called in the trades.
We have spoken extensively to Ken in the aftermath of his wife’s death to
make sure he still wants to commit to continue his money management
business. Ken has told us that he is just as committed as ever to
continue Third Day, partly because his wife was an integral part of founding
the business, and she would have wanted it that way.
Experienced investors will recognize that life-changing events, such as a
spouse’s death, can have an effect on an Advisor’s continued success. We
recognize this factor and will stay in close contact with Ken in the weeks
and months ahead. However, with the nearly 100% mechanical nature of the
system and the proven back-up in the form of Ken’s partners, we feel that
the Third Day program continues to be a viable option for our aggressive
clients.
Conclusions
The Third Day Aggressive Strategy can be an attractive option for investors
who understand risk and want to diversify their portfolios by adding an
investment that has both a long and short exposure in the market.
As noted above, the program has an average annualized return of 23.43% since
inception, net of all fees and expenses, with a worst-ever drawdown of only
–12.18%.
Yet the most impressive thing about this program is that it has shown
outstanding results during the last three years of very different market
conditions. And you can access Third Day for a minimum investment of only
$50,000.
Our analysis has also shown that Third Day’s historical returns show little
or no correlation to the other Advisors I have written about over the past
two years. Thus, the Aggressive Strategy is an ideal complement to the
other actively managed investments offered under the ProFutures AdvisorLink
Program.
In conclusion, the Third Day Aggressive Strategy is one of the most
impressive programs we have seen in several years. Normally, we like to
see a performance record that is longer than just over three years, but the
last three years have seen a bear market (2002), a bull market (2003) and a
sideways market (2004). And Third Day has had outstanding
performance in each of those very different years, averaging over 23% .
(Past results are not necessarily indicative of future results.) Also,
because the system is nearly 100% mechanical (no discretion on Ken’s part),
we have more confidence in the program going forward.
If you believe, like I do, that there is a recession in our future, and that
the equity markets will face some tough times in the next several years,
then I suggest that you take a serious look at Third Day’s very successful
program. Having the potential to make money in a sideways or bear
market may prove extremely important over the next few years.
If you want to learn more about the Third Day Aggressive Strategy, or have
questions regarding any of the information provided in this Profile, you can
call ProFutures at 1-800-348-3601, or e-mail us at
mail@profutures.com.
The Economy Cools A Bit
The government’s advance estimate on 4Q Gross Domestic Product was well
below expectations. The Commerce Department reported on January 28 that
GDP rose only 3.1% (annual rate) in the 4Q following the gain of 4% in the
3Q of last year. For all of 2004, based on this latest report, the economy
grew at the rate of 4.4% last year, the best pace since 1999.
Personal consumption spending rose by 4.6% in the 4Q, so consumers continue
to spend. For all of 2004, consumer spending was up 3.8% as compared to
3.3% in 2003. Government statistics continue to show that consumers have
record debt levels, but these figures do not consider home equity or gains
in securities and other investments. The bottom line is that consumers are
likely to continue spending and keep the economy reasonably firm again this
year.
Business investment spending continued to be robust in the 4Q. The
government reported that capital investment rose 10.3% in the 4Q versus 13%
in the 3Q. Business investment spending is expected to remain strong all
this year.
A Bloomberg survey of economists and market analysts conducted in early
January found a consensus estimate of 3.6% growth in GDP for 2005. This is
consistent with The Bank Credit Analyst which forecasts GDP growth of
3.5% for this year. BCA continues to believe there will not be a
recession in late 2005 barring some unexpected negative surprise such as
another terrorist attack in the US.
In summary, the US economy will remain in positive territory again this
year. Growth is not likely to match last year’s 4.4% pace, but a recession
does not appear to be in the cards as the gloom-and-doom crowd promises
(over and over again). Consumers have high debt levels, but the overall net
worth picture is much more positive.
Will The Fed Tighten Too Much?
The Fed has made it no secret that they plan to continue hiking short-term
interest rates this year. Since last June, the Fed has raised the
short-term borrowing rate from 1% to 2.25% as this is written. The Fed is
expected to raise the key rate another 25 basis points to 2.5% at the next
FOMC meeting scheduled for this week.
So far, the interest rate increases have not caused any serious damage to
the economy. As noted on page one, the bond markets actually held up quite
well last year despite the short-term rate hikes by the Fed. However,
analysts all over the world are trying to gauge just how far the Fed intends
to take short rates. The consensus seems to be that the Fed will raise
rates to 3%. If so, this round of monetary tightening could be over by
mid-year.
The Bank Credit Analyst, on the other hand, believes the Fed is targeting
a 4% level in the Fed Funds rate. If correct, that would mean the Fed will
continue to ratchet up short-term rates pretty much all year, and that will
not be good news for the equity markets and possibly bonds as well.
Obviously, the Fed will continue to monitor the economy and what’s happening
in the stock and bond markets. Policy will be set accordingly. Given that
this is Alan Greenspan’s last year as Fed chairman, he does not want to go
out with the economy in a recession or the equity markets in the tank. So,
as he puts it, the rate hikes will be “measured.” Even so, BCA predicts
that the Fed funds rate is likely headed for 4%, and this is above what Wall
Street is currently expecting.
Are Stocks Set To Trend Lower?
As you know, I have been generally positive on the outlook for equities over
the last year. In fact, I have been bullish since just before the war in
Iraq began in March of 2003. If you followed my advice back then and moved
to a fully invested position in stocks and/or equity mutual funds, you have
done very well. But if you have watched the market at all, you know that
January was NOT a good month for the stock markets. My optimism is
fading fast.
While the economy is expected to remain solid again this year, the equity
markets are facing some stiff headwinds. The interest rate environment is
not friendly as discussed above, and the Fed Funds rate is likely to rise
more than Wall Street expects. The US dollar is likely to be lower later
this year, and this is also not positive for US equities. Oil prices remain
high and there is still the risk of another spike up again this year.
Corporate profit growth will not match 2004’s heady pace.
Equity prices churned mostly sideways in 2004, ending the year with only
modest gains in what was clearly a more positive environment than we see for
this year. Also, this is the third year after the bear market which ended
in 2002. Historically, the S&P 500 only gains about 3% on average in the
third year after a bear market low.
So the question is, will stocks churn sideways again in 2005, and maybe edge
slightly higher, or could we be seeing another major top in equities?
Obviously, I don’t know for sure, but price action so far this year is NOT
encouraging.
At the very least, the downside risk in equities is higher now than it
was in 2004, and last year was not a banner year. Given this outlook,
readers who are overweighted in equities are advised to reduce holdings just
ahead, especially if prices recover somewhat after the beating in January.
BCA’s forecast is that the equity markets will continue to be choppy for
most of this year and ease moderately lower. They do not expect a major
bear market. They believe some sectors will do reasonably well, even in a
choppy to lower environment. Their favorite sectors are energy,
health care, consumer staples and telecom services. Sectors they
recommend you avoid are technology, financials and consumer discretionaries.
The Argument For Active Management
Given where we are in the economic cycle and the interest rate cycle, there
are no really attractive asset classes to buy. Stocks are vulnerable, bonds
are vulnerable, real estate is frothy, metals have topped out and currencies
are very volatile. It is precisely these kinds of uncertain times
when active, professional management is in order.
“Active” management, in this case, refers to professional Advisors with
time-tested systems that can move them partly or fully to cash if market
conditions so dictate. Some of the managers we recommend will “hedge” their
positions using short funds, rather than sell out positions. If
the equity markets turn lower this year, you need that kind of active
management.
In the case of Third Day Advisors, you have a program that has a
record of “shorting” the market during downturns in the equity markets.
Third Day uses certain Rydex funds which go up when the market goes down.
While this is an aggressive strategy, and therefore not suitable for all
investors, Third Day has delivered outstanding results over the last few
years in an up market, a down market and even the sideways market of 2004.
(Past results are not necessarily indicative of future results.)
If you are a sophisticated investor, I highly recommend you check into Third
Day for a portion of your equity portfolio. Call us at 800-348-3601
for more details and account paperwork. You can also see information on
Third Day and all of the Advisors we recommend at
www.profutures.com .
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