From the July 2005 issue of Investment Advisor • Subscribe!

Forces of Nature

Fittingly, Frank Holmes is a picture of energy as he fulfills his mission of finding glittering natural resources stocks

Can a global resources fund be right for some of your clients? While the mere mention of digging for oil, copper, coal, or gold makes some investors want to run for the hills, others may want to embrace these cyclical, tangible, infrastructure building blocks, and include them in a diverse portfolio.

Frank Holmes knows this firsthand. Chairman, CEO, and CIO of U.S. Global Investors, Inc., Holmes directs the investment team's activities at the firm's Global Resources Fund. "I look upon myself as a music conductor, and I know the musical score for Beethoven's Fifth. My job is to bring out the best of each of the different players on the team, and make sure the tempo and the passion [going] into playing those instruments is of the utmost. So, I am involved with it every day." That attention from the maestro has helped this no-load fund earn Standard & Poor's five-star overall category ranking, with a four-star style ranking for the one-, three-, and five-year periods.

Morningstar rates this fund five-stars for the three- and five-year performance periods and four-stars overall. Both services agree that the fund's performance is exceptional, with Morningstar saying it has "an outstanding record."

According to S&P, the fund had an annualized five-year total return of 25.51% versus 9.15% for its peers in the S&P 500 Energy Sector Index. S&P ranks the fund 17th of 4346 funds in the domestic equity fund category over five-years.

I've noticed that your U.S. Global funds are team managed. Why? Because we have people on the road all the time. If you have someone on the road and not watching all the holdings during the day they can miss opportunities because different stocks, different sectors in different countries have so many moving parts [that] can have an event that can change the success of the portfolio.

So someone can watch the store? Did you see our report that shows [a map of] where we are around the world? The quarterly shareholder report shows you all the countries. Right now we have someone at a coal conference in Vancouver, two weeks ago I was in China, the week before that, one of our other analysts was in Mongolia, and China, two weeks from now one of the other guys is going to Kazakhstan, someone is in Mexico, Argentina, and Chile. What you want to do is be able to communicate back and forth with someone who knows our models. Someone knows what the buy/sells are for how we value stocks statistically and with fundamental analysis. That way someone is always [watching over] the portfolio.

In terms of Global Resources Fund, you've got three on the team that you list on your Web site (Ralph P. Aldis, Brian K. Hicks, and Evan W. Smith). How hands on are you? Daily. What's important here is that we create these models-it's a matrix of models, and that allows me to be able to question.

Can you tell me a little bit about the investment process for Global Resources? It starts off with Mondays, [which are] always top down, macroeconomic analysis. We look at the G7 and what we call the E7 countries. The G7 everyone knows about; the E7 are for us the seven most populated countries-over 100 million-on which we can get economic data [including] China, and India. We look at their economic development industrial production numbers, and GDP numbers, and we measure how they concert with the G7 countries.

Other than China and India, who else do you have in your E7? Brazil, Indonesia, Mexico, Pakistan, and Russia. They've made Russia part of what they call the G8, but that was over politics-when it is not even as big as China-so if anyone's supposed to be part of the G7 it should be China. They've been invited but they're not part of it. We take the G7 numbers-the industrialized world-and compare them [with our E7]. We do this analysis and on Mondays we look at the three significant factors that drive our alpha. One is time management. Mondays are always top down macroeconomic days; the other four days are stock picking days. Then there are very defined hours in the day when we do analysis on a section of the world, geographically, and a sector from an industry.

I think that there is a time management process, so we don't respond to every broker that's calling. We call brokers on different sectors based on our thoughts. When an analyst comes to visit us from Citigroup, etc., we don't just listen to their recommendations; we do analysis of their recommendations. We're very brutal that way. We hold them accountable. We'll say "Let's take a look at oil holdings you cover, over the past five days, 20 days, and 60 trading days. Are your recommendations above or below the index you cover? We want to know why your stocks are below-what did you miss? What's your process for missing them? What's your process that they'll turn around?" We're really consumed with the investment process-that there is consistency in every analyst we talk to. When you go to these meetings quite often around the table people just take notes on what the analyst is recommending and take it at face value; we turn it back on them.

You're questioning the face value and making your own analysis of what they said? Correct. We look at the best-to-worst of all our holdings every day, for the week, for the month, and for the quarter. We try to assess leadership patterns. If I come back to some basic knowledge about people with high IQs-it's not because of a better grasp of history, it's because they have better pattern recognition. We have created systems that try to identify patterns, which are in concert or in great contrast.

Every week in our Investor Alert at www.usfunds.com, we rank all the indexes and all the Global countries best-to-worst for the week; best-to-worst for 20-days; and best-to-worst for 60 trading days, which is a 90-day moving average. We will then take a subset and look at the sectors, the industries, and our stocks. We can take a glance at our holdings at any time and say: that's beaten the index; that's not beaten the index, for the week, for the month, and for the quarter. We ask questions. We want to know where our leadership is coming from, where our laggards are coming from, and ask, should we add more to our laggards or is there a fundamental flaw here, should we be getting out? Should we be selling our leaders, or should we be adding to them? And the stuff in the middle, we see how it migrates-does it float to the top or does it start to sink to the bottom?

Because there are so many events taking place in the marketplace we want to apply Pareto's Law (the 80/20 rule). We apply that concept and another concept called "analytical hierarchy processing," which is really fascinating because four years ago when I was building this multiple process, there was hardly anything using analytical hierarchy processing. [It has] you pair everything--hot and cold--and prioritize, biggest to smallest, fastest to slowest. That process allows you to see pattern changes. It's almost like music; anywhere in the world if you know how to read music, and play the piano or violin, you can all read the same music sheet. You may be Mandarin, and I'm Italian, we can't talk to each other, but we can both play the same musical score. That's what I was trying to evolve. That's how we operate and think.

We use time management, and we use cycles. We're very, very caught up in managing expectations, and there's a wonderful line from Warren Buffett--you know everything is about earnings expectations--if they didn't meet expectations the stocks fall. Right, even if they do [meet expectations].

If they do [meet expectations], they may fall, and if earnings were exceeded [more] dramatically than expectations from First Call, they may rise. Warren Buffett said if you want to have a long-lasting marriage have low expectations. We said-how do you manage expectations best? In cycles. We can do probability analysis with cycles, and we use "mean reversion" which is a classic concept that everything reverts to a mean. We apply seasonal cycles to commodities in particular. You will find that energy prices, gas prices start to rise from March to June, and oil prices fall, because the east coast heats up; more people are driving, and fewer people are heating up their houses because of warm weather. Happens every year. You can have exogenous factors that come in and distort it but that has a high correlation. We also find that gas prices pick up in September because quite often hurricanes hit the Gulf and they shut down the refineries. So you have to understand seasonal weather patterns when looking at various commodities like energy.

You go back how long in your historical cycles? We have up to 30 one-year snapshots overlapped. Right now we're looking at energy prices. One of the charts we're looking at is 15 years of data overlapped every year, and you can see a real pattern. We look at that to try to manage the expectations. The patterns replicate themselves 60%-70% of the time; that helps us manage our expectations.

When we step out of the seasonal expectation cycle, we go to the four-year presidential election cycle. America is one-third of the world's GDP. Very important. Studies show that 70% of the time, the stock market is down or sloppy in the first two years of any president. And, 70%-80% of the time it's up in the third and fourth year of any presidential term. Doesn't matter of it's a Republican or Democrat; that's the pattern and it has close to an 80% probability. We ask ourselves "where are we in the presidential election cycle for the largest economy in the world?" Well, first year, guess what, markets are usually sloppy. Rising interest rates are slowing down the economy. That's part of our managing expectations.

Third, in cycles, we look at what's important in those E7, emerging countries. Is there a policy to build infrastructure? The most populated countries that are building infrastructure will absorb commodities at a rapid pace. We follow our E7 countries and look for what's called a Kuznet cycle. A Harvard professor [who] died in '85, he was the father of the GNP number. He created that factor. He also noticed that when an economy was emerging, they started building highways, railways, shipping tanks, and skyscrapers. They all used a lot of steel, copper, they used basic commodities, and for those particular infrastructure builders the cycle lasts for 20 years. That's what gives you a secular bull market. When you have the largest economies in the world with policies to build infrastructure, then you have a basic sponge on commodities, a demand cycle. We look at those factors.

When we look at individual stocks, we look at the life cycle of a resource stock. They go through a very defined three stages: exploration, development and production. There are three different stages of risk associated with those three stages-very defined. You look at the life cycle of a product-a piece of software-it's usually good for three years, then it's gone, worth nothing. PCs are good for three years, [then] buy a new one. Cell phones are now almost a year, [then] get rid of it, get a new one. You have to look at the product life cycle, and we look at the resource cycle for an individual company. That's part of our theme: it's time management, it's looking at these cycles, and then it's quantitative analysis.

You mean quantitative analysis of the type you were just describing? Quantitative analysis meaning we use a lot of statistics. We look at metrics. An ounce of gold in the ground in Nevada is worth more than an ounce of gold in the ground in Venezuela because Chavez has got political risk. [It's the] same gold sold in the marketplace, has the same dollar value, but [the cost of] an ounce of the gold, because of political risk, changes. We look at the whole world, all countries, and we have a dynamic model. We apply a [qualitative] SWOT (strengths, weaknesses, opportunities, threats) model and look at management, culture, strategy and talent-intellectual capital. We've used this qualitative, quantitative modeling and then we use price-risk modeling. It's called "volatility timing." It's not market timing, but volatility timing.

Then it's volatility of the actual commodity itself? The commodity, the commodities sector index, and the individual stocks. They all go to overbought/oversold. When we see things mathematically overbought over a 60 day rate-of-change (90 calendar days/60 trading days), above [their trading range] 68% of the time, we raise our cash levels to 10%: when they go two standard deviations, we raise our cash levels to 20%. If we have a stock that goes way above its average price over five years of data, or 10 years of data, that goes up two standard deviations over a 60 day rate-of-change, we will sell some of those holdings. What happens is that actually our overall turnover of the portfolio is less than our peer group.

I noticed that.

That's because we take core positions that are undervalued relative to all the other stocks in the universe and then use mathematical trading to realize times to sell and to buy. What do we find? Money flows always come into a fund when it is up two standard deviations-huge money comes in; it's the worst time to invest, mathematically. It's when we build our cash positions.

When you say that you use mathematical trading to decide when to sell or buy, are you keeping a position of so many thousands of shares and edging it up and down, according to the timing? Yes, to stress levels and to patterns of the market-so it's another way of looking at patterns. Type into Google "volatility timing" and you will see so many pages of PhD dissertations on markets and volatility timing. You'll see very little on market timing compared to studies on volatility timing. The whole premise of The Chicago Board of Trade is volatility timing. That means that if stocks go up one or two standard deviations, you sell the premium-that's the whole basis of it. What it says is that trying to guess when something is going to go up one sigma or one standard deviation or two standard deviations over 60 days or over 12 months is next to impossible. It's very, very difficult to say it will go up--with 100 [%] confidence-it's going up over the next 60 days. But if it's up one standard deviation or it's up two standard deviations over 60 days, there's an 80%-90% probability it's going back to the mean.

The Frank Holmes interview is continued on the next page

Again, that regression or reversion to the mean? Correct. But you have to wait until it's expanded itself or fallen below, way below, its mean. When do most of the redemptions happen? When the commodities are down one or two standard deviations from the mean. What happens is that our cash levels start to shrink because people are redeeming; that's fine-we give them back their money; we charge them for it but our long-term investors are not hurt. That helps buffer some down days. We may be up to 20% cash, but then as the market corrects, that cash buffers our holdings.

That's why you keep that much cash? Yes, but we'll go down to two percent

And that would be in an opportunistic way? Yes, that would be because it's down two standard deviations.

You'd have been buying? We're investing. Because mathematically we have an 80%-90% confidence factor that things would revert back to the mean, which could be 12%-20% over the next 60 days. That's the opportunistic mechanism of how we use volatility timing models, and we use many of them. We use weekly, monthly, quarterly models and we created a dynamic process for our algorithm that allows us to look at sector stocks and manage cash flow for the investor. That, roughly speaking, is how we take a look at the big picture.

The other thing we do, [and] why we believe we're in a secular bull market for commodities, is that almost all commodities are priced in U.S. dollars. In the latter part of the '90s, the strongest currency in the world was U.S. dollars. That means that commodities prices were at an all-time low so no one was exploring or developing for commodities-for oil, for gas, for coal, for any of them-because prices were so cheap you couldn't get a return on capital. During that period of almost a boycott on exploration and development, environmental rulemaking which is very important and which we're big believers in was growing at double-digit rates. Clean air, clean water, [the] Kyoto Agreement. All these things came in during a strong-dollar, weak-commodity-price environment. All of a sudden now, the dollar falls, commodity prices go up.

The inverse effect? People say yes, well the cost now for exploring has gone up 300%; environmental insurance is up 300 to 400%. Who is our best case study to confirm this thought process? The greatest investor of all time is Warren Buffett. Warren Buffett used to say that he'd never invest in natural resource stocks because it was too easy to get into the game and it was too volatile. Well, when Enron went bankrupt and all the pipelines were having great financial difficulty he came in and bought them-the Williams Companies-he became the third largest pipeline owner in America. But he said 10 years ago that he would never invest in resources. Why is that? One of his critical drivers is that barriers to entry have to be high. That's why he bought Coca-Cola. He didn't try to compete with Coca-Cola's brand; [with] their marketing dollars, basically it's very difficult to compete with them. The barriers to entry are high for Gillette, the barriers to entry are high for McDonald's, and the barriers to entry are high for Coca-Cola because their brand is so strong.

The other way is what took place in all the environmental rulemaking. Try to build a pipeline through seven states today: you've got salamanders, you've got certain types of crickets, bugs etc., you go from Oklahoma to Nebraska-the costs and the time delays to build to build new pipelines have gone up dramatically. And when you look at refineries-not a new refinery has been built in America for over 25 years. You have an economy that's been growing at 3% a year, but there's been no additional supply factor to meet the demand for people growing the economy-more cars on the road, etc. You get this shrinkage of supply. Warren Buffett becomes the third-largest pipeline owner in the world, and he comes out and he says there are going to be gas shortages, and Greenspan comes out immediately after that and says there are going to be gas shortages. Why is that? We did our research and found that Berkshire Hathaway's largest source of cash flow is insurance. Its second source of steady cash flow is pipelines-interesting enough-but what does he do in the reinsurance business? He reinsures environmental problems. Guess what happened to the premiums? They went up 300%-400%. Guess what that means if you're drilling for a well that used to cost you a $1 million and just cost-because] your insurance went up-$1.5 million? You were only paying $150,000, now you're paying $500,000 for that insurance. Guess what you're going to say? I can't drill for two bucks an Mcf of gas; I need six dollars to justify this risk. Gas shortages. That cycle is being seen around the world [with] no new refineries built for 25 years.

Then you have the cheapest resource of fuel in the world, uranium, but no one wants nuclear energy. Nuclear energy is the cheapest in the world; the second cheapest is liquid natural gas, (LNG). Nobody wants to build [LNG terminals] on the coastlines because of the threat of terrorists blowing these up because they're like a bomb. We're going to be living with this whole issue. We also saw environmental rulemaking, which we're totally believers in-we've got this simple [phrase] "You can no longer buy commodities at Wal-Mart prices, you have to pay Gucci."

That's because of the regulation? Yes. One of the things about that the Exxon Valdez [oil spill] was if that ship had had twin bladders or twin hulls then the oil would not have been able to leak as rapidly into the ocean. Then they came out with a mandate that within 10 years all ships shipping oil had to have twin hulls. Guess what? Not enough ships.

Because they're more expensive to build? Well they never realized that demand from Asia would grow. We did some back-of-the-envelope math and basically if you take a look at energy as a component, in Asia there are 3 billion people consuming about 20 million barrels of oil a day. There are about 300 million Americans consuming 23 million barrels of oil a day. Think of the math, 10:1. Our economies-if they grow at six percent we put the brakes on. In Asia, if the economies fall to six percent growth rates they accelerate them. During this whole period Asia has been struggling on, growing, and growing, and growing, and you get this [situation of] no-inventory now. By the way, where's this ship to ship the oil? You get this huge backlog. In February ExxonMobil gave a $10 billion shipping contract to the Koreans. And then Qatar gave a $15 billion contract to build LNG ships, because China and everyone else is going to start using LNG.

Instead of gas? Yes. Because it's cheaper for them to export/import [LNG] than oil. Rather than increasing their oil [consumption] at the rate it's growing-their oil is going to continue to grow rapidly-they said we have to replace it with something else. LNG is only three percent of their energy use. What does that mean? Well, guess what, for steel, you need coal. You need coke and metallurgical coal. There is not enough explored [coal] around; coal prices go up 200%! Oh, ships to move the coal; where are they coming from? They're coming from North America and Australia. If you want to make steel you need iron ore. That has to be shipped around the world, too. That's what you need to make the steel. If you want stainless steel, you need nickel. You see with the cycle, what's going on? You're in this secular bull market for commodities, and it lasts many, many years, but it's extremely volatile because of currencies. Currency swings have an impact; government policies have an impact. But you're still seeing [that] the most populated countries in the world have GDP growth rates on average twice ours, and they have policies to build infrastructure. That's what is leading to the long-term secular bull market in commodities. In the short term, we see softening in several of the commodities because we're getting a global slowdown when we look at our year-over-year rates-of-change. And we feel that the bottom will take place when interest rates peak here in the U.S. Here's a last bit of math to help you for energy, a given for copper, everything. There are no inventories around basically for copper, for nickel; no new mining discoveries but the demand has been growing. [With] no new mine discoveries, no new supply coming outside it's only a matter of time before these prices gap on the upside.

You're saying it will be a short bottom? Yes, a very short bottom and it's not all going to be at the same time; different commodities will have bottomed [at different times]. The other thing that's really important is that when America became the most powerful industrialized nation in the world we went from one barrel of oil per person per year to 38.

Over what period of time? About 50 years. Japan went to 28 [barrels]. Korea and some others went to 18. Mexico is seven. Do you know [how many barrels] China is [consuming] today?

It's got to be low. [China is] 1.7[barrels]; India is 0.7 [barrels]. You have two countries where 2.3 billion people are embracing the American dream. They're watching CNN every day. They're watching MTV every day. I just came back from China; they love America. You wouldn't think so the way a lot of the general media and television carry it but they love America. They send all their best students to American schools; they've been doing it now for 25 years and they've been going back with American capitalism. They have this infrastructure need so I just think we're in that secular bull market and you're going to continue to see this demand cycle.

You said before that for part of the needs of Asia, LNG would help. Can you address the issue of peak oil production and reserves relative to the rising demands of China? Yes, that's part of the lack of exploration. What I was sharing with you is that now that oil prices are higher, going out to explore for oil is a cost. We used to see this for looking for a barrel of oil [and with] replacement cost and exploration for gold and for copper too. All those exploration costs, development costs have doubled so you in fact need a higher commodity price to justify a return on capital. ExxonMobil and these other companies are all looking for 15%-20% return on capital. To get that for the cost of exploration and development they need a higher commodity price. Many of the copper mines said we're not going to explore, we're not going to develop until we get higher copper prices.

Would you explain why you invest in resource companies rather that the commodities themselves for the fund? For leverage. You get more leverage on an equity play than on a commodity. Sometimes you can do a calculation that a commodity rising 20% can represent a 60% increase in cash flow or earnings for certain companies. We try to focus on pure zinc stock for a zinc play; coal for coal. We don't buy the BHPs [BHP Billiton] which is a conglomerate; it has iron ore, it has coal, and a lot of gas; we'd rather buy very specific stocks.

Right now, which sectors of the oil and gas businesses do you favor? We like royalty trusts. Certain royalty trusts that are very popular, more so in Canada, and they pay a monthly dividend. One that was recommended was Penn West. The yields on these are twice what 10-year governments are. And they pay monthly dividends. I was buying these things with one percent a month dividends, while money market funds were paying one percent a year.

Other than royalty trusts, any of the others? We have metrics for growth stocks; the same thing I look at for companies that are rapidly growing their reserve base. We would like some of these mid-cap oil stocks that we feel could be bought out by royalty trusts.

How would you classify the fund? Do you feel it's more value or more growth oriented? I think it's GARP-growth at a reasonable price.

In terms of capitalization, do you feel that mid-cap is about right or is that just because it's averaged out to mid? I think it's mid-cap because a lot of resource-based stocks [are] outside the U.S. Because it's a global [fund] most of the resource stocks that are big-cap in other countries are mid-cap in the U.S. so it falls into a mid-cap arena.

Can you tell me about your largest holdings? [One is] Fording Coal [Fording Canadian Coal Trust]. Coal prices have doubled in the past year, and Fording Coal has started [as of] June 2005 getting a much higher cash flow on a contractual basis so we expect the dividend to double in the next 12 months. From that we see that there's a continuing need for coal in Asia. There is a $10 billion [contract] given to Korea to build ships for ExxonMobil, $15 billion to Qatar to build LNG ships. Well, you need metallurgical coal to make that steel; you need iron ore and metallurgical coal, and Fording is metallurgical coal.

Other largest holdings? Penn West [Penn West Petroleum Ltd] just went royalty trust [June 2005], listed on the Toronto Stock Exchange [PWT]. It pays almost one percent a month dividend. The other one is Gold Corp., which is the lowest cost gold producer, produces gold at less than $80 an ounce when the average gold mined-cost is pushing $300. It has a dividend, a small, modest, dividend. It is growing from 1.2 million ounces to 1.5 million ounces over the next three years. So, it's the lowest-cost gold producer, it has almost $1 million in cash, and it has all the growth metrics we like.

What about your biggest winners and losers-can you talk a little bit about those for the fund? It depends on what time period.

Recently-in the last year or so? My biggest win was Algoma Steel. It's near the Sault Ste. Marie, [Ontario] where Michigan touches Canada at Ontario if you looked on the map, [near] the Great Lakes. We bought it at $3 and it went to $30 in less than 18 months.

That's a good one. Yes, in one year we made seven times our money in one stock. [And] disappointing-in the gold end, probably Placer Dome; very, very disappointed. We are disappointed in management's inability to manage costs for producing an ounce of gold. In addition, shareholders are not seeing the benefits from higher copper and gold prices.

Where do you think this fund would fit into an investor's portfolio? I think I'd have to go with Roger Gibson, and Roger Gibson recommends that you basically have four asset classes, and commodities resources are 25% of it. If you were to put something into the PIMCO or Oppenheimer Commodity fund, let's say you had five percent in each of those, then I think that you could comfortably have 10%-15%, maximum 15%, in this fund-in a diversified portfolio. The magic though, is the rebalance. We are big advocates and understand if people want to rebalance once a year-that's fine.

Do you own this fund yourself in your own portfolio? I don't. In my portfolio, what I own is GROW [the publicly traded stock of U.S. Global Investors].

The stock of your company? The stock of my company. When I became CIO, I put [in] all my money and started buying more; I own 22% of GROW and I buy that every month. That means all my funds have to do well, or I don't do well.

Right.

It was also intuitively that in being the CEO and seeing how regulators operate-they would just try to find fault if I did anything, if I sold at anytime. And now, with this whole fiasco that took place with Strong, you know. I've never day-traded. I've never done it with my funds, etc., but just that whole factor of, would you be in conflict, why did you pick one fund over the other? And so I backed away from that, and I put everything into buying the stock itself.

The team that's on the Resource Fund gets a bonus every month that it's in the top half of their peer group. It's a modest bonus, but half of it goes into the fund for them, and half is cash. They get other bonuses for being a five-star, a four-star, for being in the top 20% of their Lipper Rankings, etc. There's a more complex formula, which is based on three-year numbers. Every month that the fund is in the top half of its peer group it can be a couple thousand dollars to someone. That is to keep them focused. The other thing that's important in relation to that, I believe [is] I never want people to try to be number one, because you take on too much risk. All I'm concerned about is that you're watching the portfolio; that you're striving to be in the top half by one basis point every month. What happens is if you're there eight or 10 out of the 12 months, other groups will make mistakes, and you'll go up to number one, or into the top 10.

So, you're not tempted to make the grand slam? Exactly-I'm all about singles, and it's really helped people stay long-term focused, but understanding where they are ranked every day, every week, [to] look at their holdings this way. By the way, they love it, but no one thinks of taking big gambles with that portfolio.

Very interesting. What else should our readers be aware of about the fund, and investing in natural resources? I think that resources have volatility but what we've noticed on the volatility, in say, the mid-cap Holmes Fund, is if a company announces that they are going to have disappointing top-line growth for this quarter or The Street's overestimated their earnings these stocks fall up to 25%. Seldom do we see resource stocks fall 25%. Maybe it's because there are more hard assets for these companies. What we find is currency movements can create the volatility in the overall stock sentiment in that sector. Someone has to be sensitive that the volatility is quite often a currency-driven event or a perception that China is slowing down so everyone gets out of resource stocks. That's the emotional factor we see that drives the price action of that fund and the currency moves. We don't hedge the currency; we try to make sure we're picking stocks where the currency is going to be weak-but we do see that volatility factor.

I thought there was a great line from Mark Faber, who is a regular in Barron's. When I was in China, we had lunch together and he said if you look at the great equity bull-market from '82-2000 it was the most spectacular bull market and it was also this 20-year run where we saw the 1987 Crash; the 1989 Mini-Crash; the 1998 Nasdaq drop [of] 10% in a day; we saw Desert Storm; but you know, the market went higher and higher. That's a long-term 20-year secular equity bull-market. You're going to experience that in the resource cycle; you will have these volatile [times] which could be a currency event, or it could be a sentiment event, but this is a longer-term, secular bull-market.

One of the things we do is use volatility timing models. So that if the commodities are really overheating, and money is flowing into the funds, we raise cash, and that helps us capture opportunities when it corrects. If people end up redeeming, because people are quite often emotional in investment decisions-not all are RIAs-we're not in a position where we are forced to sell, and exasperate our volatility. What we've found with a lot of sector funds, that is the money flows, people overbuy at the top and then they oversell at the bottom to meet redemptions.

So you try to anticipate redemptions? We anticipate with using complex, quantitative, volatility timing models. Very different from market timing. The opposite.

Staff Editor Kate McBride can be reached at kmcbride@investmentadvisor.com.

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