Noted ETF Investor Reveals Current Favorites

TOM LYDON HAS fond memories as a youngster learning the rules of investing from his father. On some days, his dad, a stock broker at the time, would take his son around his office high atop the Prudential building in Boston. Lydon marveled at the atmosphere. Saturday mornings they would drive to pick up a copy of Barron's. His father showed him the mutual fund listings and taught him that diversification, good long-term performance and low fees were the keys to making money.

Now, four decades later, Lydon is still implementing those rules. However, he has mostly forsaken the mutual funds his father embraced and instead uses the rules to evaluate one of the newest — and hottest — investment products on the market: exchange-traded funds.

Lydon, who runs $70 million as president of Global Trends Investments in Newport Beach, Calif., is one of a new breed of financial advisor who is using ETFs as the foundations for most of his portfolios. He hasn't completely done away with traditional mutual funds, but the low fees, transparency, trading attributes and tax efficiency of ETFs have convinced him they are worthy investment vehicles. He's become such a convert that he launched a web site, ETF Trends, that's now one of the most widely read on the subject. He also happens to be the co-author of the new book, "iMoney: Profitable ETF Strategies for Every Investor."

We sat down recently with Lydon to get his thoughts on the first half of 2008, a particularly volatile time for ETFs and the market in general. We also got him to give us his prognosis for what lay ahead and a couple of bets to make in that tricky environment. What this noted ETF investor is buying might surprise you. (To see a video of our interview click on the player at the right.)

The corporate world is in the midst of putting behind it a raucous two quarters. The ETF industry is in the same boat. According to Lipper, 120 new portfolios were launched during that time. The industry now has around 700 offerings, holding roughly $600 billion. Lydon uses traditional valuation metrics to evaluate all those funds. But he has two favorites that dictate a lot of his trading. He keeps a close eye on 200-day moving averages. When a fund shows signs of going above that trend line it can signal a buying opportunity. If a given fund comes 8% off its high Lydon trims or sells the position. He also prefers to invest in funds that have more than $75 million in assets and healthy trading volumes.

During the first half of 2008, Lydon was particularly intrigued with the actively managed ETFs that were launched by Bear Stearns and PowerShares. These funds are billed as marrying the tax efficiency and low costs of ETFs with the insights of a professional manager. The Bear Stearns product, called Current Yield (YYY), invests in a wide array of government securities and fixed-income products. Its goal is to beat the returns of plain-vanilla money-market funds. Three PowerShares products — Active Mega Cap (PMA), Active AlphaQ (PQY) and Active Alpha Multi-Cap (PQZ) — use proprietary trading strategies to pick winning equities. A fourth, Active Low Duration (PLK), is geared toward the fixed-income market.

Like many market watchers, though, Lydon is intrigued but he isn't 100% sold on the concept yet. He's waiting for the funds to post a few quarters of performance numbers and then will decide whether they meet his investing criteria.

"I was a long time coming and finally they have arrived," he says. "Unfortunately they arrived at a tough time for the marketplace." He concedes, though, one day we may see them in 401(k) plans.

One bet he's making now is on biotechnology. Lydon sees the current economic downturn continuing for some time. In that environment he likes the biotech sector for several reasons: It happens to do well in down markets, some industry products could improve crop yields and harvests in developing economies around the world, there are strong research and development programs at a time when many blockbuster drugs are losing patent protection, and for the potential merger or acquisition. Indeed, we first interviewed him a week ago, shortly before Roche offered $44 billion for biotech heavyweight Genentech (DNA).

One way to play the industry, he says, is by scooping up the shares of one of three biotech ETFs. The $1.2 billion iShares Nasdaq Biotechnology fund (IBB) charges a cheap $48 for every $10,000 invested. That's almost half the fees of a comparable actively managed health-care mutual fund. This ETF tracks an index of 152 of the leading biotech companies that trade on that exchange. The group includes companies like Amgen (AMGN), Celgene (CELG) and Gilead Sciences (GILD). The fund is up a decent 5.1% year to date. But Lydon isn't looking to flip this position. Stocks like Gilead, which, according to Zacks, has a five-year growth estimate of 27.7%, keep him interested. Plus, when the dust settled after the last bear market, this fund returned a whopping 45.8% in 2003, tops in Morningstar's specialty healthy category.

Lydon also likes PowerShares Dynamic Biotech & Genome (PBE) and Biotech HOLDRs (BBH), the ETF hybrid product from Merrill Lynch (MER). These two funds, though, are concentrated. The PowerShares product owns 30 companies and the HOLDRs offering has a 38.7% weighting in Genentech. That stock has jumped around 25% the last week on news of Roche's bid to buy it. If certain companies pop this year, these two funds will see bigger increases than the iShares product. But investors are also taking on more risk for that potential reward.

Lydon also keen on sprinkling portfolios with emerging-market and commodity ETFs. However, he's avoiding the areas many investors seem to be gravitating toward — at least the aggressive ones. "You watch TV and you hear about the bottom fishing in financials and housing," he says. "Right now who knows — there could be more bad news out there."

Those are a few sector plays. If you're interested in complete ETF model portfolios pick up Lydon's book. There's a whole chapter on the subject along with specific fund recommendations.

Also See: