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Where ETFs and Mutual Funds Collide

As the number of ETFs and ETF issuers grows at a breakneck pace and the focus of many products continues to narrow, it's a challenge to address methodology and liquidity when composing a portfolio. Simply comparing short-term performance among various ETF in any given sector often misses pitfalls such as liquidity and depth. Investors may find themselves paying up for a fast-moving ETF that looks good on paper but trades poorly in the open market.

One response to these difficulties has been the emergence of several ETF mutual funds. While the transparency and low fees offered by ETFs have drawn some investors away from mutual funds, Paul Frank, who manages the ETF Market Opportunity Fund (ETFOX), believes that the transparency of ETFs and the guidance of mutual funds can be combined effectively in a complex marketplace.

According to Frank in a recent Fidelity Independent Adviser interview, such a hybrid assists investors in tackling both security-specific and systematic risks, both of which ETFOX addresses. "I am a student of Markowitz and the modern portfolio theory, which has helped me combat market risk by using ETFs," Frank said. "I am also taking security-specific risk out of the equation."

In the second half of 2008, Frank used iShares Barclays 20+ Year Treasury Bond Fund (TLT) and iShares Barclays 1-3 Year Treasury Bond (SHY) to achieve both short- and long-term exposure to the Treasury market.

At the beginning of 2009, ETFOX owned the inverse Treasury fund UltraShort 20+ Year Treasury ProShares (TBT), a position that was increased in late January. Frank decreased his TBT position on February 10 but scooped up shares again in early March. Frank decreased his position again in mid-March but has been increasing his position in TBT since April 4.

Frank said he did not sell the entire TBT position in mid-March because it was a macro bet, had high momentum and had consistently stayed near the top of his longer term rankings.

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