Interview With Eric Ervin, CEO Of Reality Shares

When nine or more of the sectors have a positive Guard Score, the Guard Indicator forecasts a broad market upswing. When eight or fewer of the sectors have a positive Guard Score, the Guard Indicator points toward possible market weakness. Investors can shift to defensive assets or go short during the periods when the Guard Indicator signals a bear market, bringing the potential for improved risk adjusted returns. We wrote a paper describing the precise mechanics and results of the GARD methodology on our website.The GARD indicator is by no means perfect, it works on probabilities.As an example, we tested the methodology back to the 1950s, GARD would have avoided over 65% of the bear markets.

This is the premise behind the dynamic hedge for the GARD ETF. The underlying portfolio securities are based on the DIVCON dividend health model. The GARD ETF is invested 100% long in the DIVCON Leader stocks when the Guard Indicator shows a positive market environment, and it switches to 50% long/50% short position when the Guard Indicator shows a negative market environment. Considering that over time, stocks generally go up, this strategy makes a lot of sense: Long when markets are healthy and hedged when market risks are elevated.

All investment strategies go through periods of outperformance and underperformance. GARD’s historical back test performance is exceptional, but returns this year have lagged the market considerably. What is the reason for this? In what environments do you expect GARD to outperform, and to underperform? 

Historically, the strategy’s outperformance was due to the Guard Indicator capturing the two major bear markets between 2001 and 2015, the tech meltdown (2000 – 2003) and the credit crisis (2008 – 2009). There are two components to GARD’s performance – market timing (using the Guard Indicator) and security selection (based on the DIVCON dividend health rating system).

From a market timing perspective, the GARD strategy may underperform in the following scenarios:

  • Bull markets with participation from only a few sectors. The Guard Indicator is designed to capture a broad based rally rather than one concentrated in a few sectors. For example, the Guard Indicator underperformed during the Internet bubble from 1998 – 2000
  • When the market is range-bound, for example, ±10% for a prolonged period, then the Guard Indicator may switch on and off, giving false signals
  • The Guard Indicator may not capture extremely sharp drops in the market because it is designed to capture prolonged bear markets

From a security selection perspective, it will typically underperform when lower quality stocks outperform higher quality stocks (e.g., what took place from March through June 2009). Earlier this year investors shifted to a significant “risk-on” approach. We saw low quality names in Energy, Utilities and Materials (three of the hardest hit sectors in 2015) rally while high quality names kept pace with the overall market. From February through July of this year, Crude Oil surged 60% and Gold was up 80%. As a result, the low quality short portfolio components exhibited significant positive returns, negatively impacting performance.

What type of weighting scheme (equal weighting, market cap weighting, yield weighting, etc.) do you employ in your ETFs, and why?

We use a factor-based weighting tied to our proprietary DIVCON dividend health rating system. The DIVCON system scores and ranks companies based on a weighted average of seven fundamental factors which measure the relationship between historic dividend trends, cash flow and earnings, buybacks, as well as consensus forecasts and external financial ratings. The DIVCON Leaders and Laggards portfolios are then weighted proportionally based on the resulting DIVCON Scores for each dividend paying company in our selection universe. The healthiest dividend payers with the highest DIVCON Scores are weighted more heavily in the Leaders portfolio (the long component), while the unhealthiest payers with the lowest DIVCON Scores are weighted more heavily in the Laggards portfolio (the short component).

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