Q: Please, give us some background on how you came up with this series of offerings and this particular strategy? Schweiger: We started about two years ago, myself and my partners along with Chris Guptill and his partners. We were all looking at how we could structure and market a mutual fund product that contained some of the positive features of the guaranteed annuity products put out by some of the major insurance firms. They offered the variable annuities wrapped around mutual funds where they made promises to the investor. We liked the promises, we just didn’t like the way you had to go about collecting those promises from the insurance company. So we put our product design and marketing hats on and Broadmark brought their money management expertise and knowledge about alternative instruments, and together, two years later we presented the Black Diamond Funds. Q: What are the main differences with these similar insurance-driven products we have on the market? Schweiger: The first is I want you to consider our family of mutual funds a high-Alpha producing product, with a secondary feature, 100% principal protection. The other principally protected products mostly use insurance and they also don’t provide much upside potential. Their upside is severely limited by– the amount of money that must go into their bond portfolio to minimize the insurance company’s risk. The insurance company guarantor will protect their AAA rating first before investors receive a return on their money. As an example, what has happened in the past was as the equity portion of the other principally protected products went down. The insurance company was concerned that the combination of funds left in the equities plus whatever the money manager had in fixed-income investments would not grow back to a 100. The insurance company would then , by contract, sweep dollars from equities to bonds. Eventually, it could be irreversibly swept 100% into bonds. The reason why the insurance company requires more funds in the fixed income component is because the insurance company, not the mutual fund company, is responsible to the investor for the guarantee. Therefore, if they don’t have enough money for the guarantee, it’s the insurance company that is liable .The insurance company says “Hey, wait a minute. We’re not going to let you, the mutual fund company, with all that equity money, leave us hanging out here with all this risk.” Q: That obviously doesn’t leave much action to the money manager, does it? Schweiger: That’s right, but remember, they are selling their product purely based on fear to the investor and we think the investor doesn’t understand that there’s not much upside. Currently, some of the insurance-backed products have 95% to 98% of every dollar an investor put now sitting in bonds and government-type securities. So you can see they’re not going to do very well. We are totally different. We have no insurance company whatsoever. Yes, we are AAAR-rated by Standard & Poor’s, and we are the only equity mutual fund in the world that I am aware of that is AAAR-rated. The key reason is that Broadmark and Chris can use certain other instruments that give the funds greater exposure over the long term than your typical mutual fund can that isn’t principally protected. We are 100% principally protected and this includes (nobody else principally protects) – all fees and all expenses. Q: Chris, how was Broadmark doing it so far and how is it going to make it happen from now on? Guptill: We started Broadmark back in 1999 and in the year 2000 we got the backing of California Public Employees’ Retirement System (CALPERS). They purchased about 32% of our firm for cash and provided us with the working capital to build our firm. We’ve had extensive experience running assets approaching a couple of billion dollars in varying strategies that include alternative investment strategies. The Black Diamond Funds would certainly be characterized as an alternative strategy. The other equity mutual funds’ traditional nature is that they own a portfolio of equities and they are to a large extent directionally dependent on a rising market. That’s an important difference. If we determine the market to be of high risk, we can have very low or no equity exposure. As for the other principal protected funds, when we constructed this, we reviewed what was out there and we were less than impressed with the equity exposure that these strategies were getting. Where we differ is we can achieve much higher equity exposure than the other funds by simply using vehicles that are typically deep-in-the-money, long-term options. That’s another major difference. Schweiger: Now, the term “option” probably means the same to you as it does to almost every broker I speak with. It usually has a connotation of high risk, a lot of volatility, a lot of leverage and all that. I want you to understand that first and foremost the type of options that we’re buying and the way that we manage them, substantially reduces their risk profile. I’ll quickly tell you why. You may or may not know, but : S&P did an analysis and they said that indices for the past five years beat the majority of active money managers. And if the index beats almost every other money manager the majority of times, then wouldn’t you be better off and safer buying a deep-in-the-money long-term options on the index than buying a fund with a money manager whose job it is to buy stocks, and try to overweight, underweight, buy early, or sell late, to beat the index. When you think about it, there’s less stock selection risk, there’s less timing risk and less sector allocation risk. You’ve increased your probability of success by buying these deep-in-the-money long-term options on the index itself, without margin, short selling or futures contracts. Q: What is the difference then between this way of option investing and, say, buying an index fund? Guptill: There are many different types of options and option strategies. All we’re trying to do is replicate the performance of the underlying index. What we attempt to do is to mitigate as much as possible one of the larger risks associated with options and that is time decay. If we buy an option that is deep-in-the-money, we define that as approximately 10% in the money, and we go out long term in the area of 9 to 15 months, we’ve mitigated a lot of the time-decay risk. We then are attempting to match the movement of the underlying index. By definition, if you buy an option on the S&P 500, you automatically have a diversified portfolio of 500 different stocks. It’s the same thing for the Russell 2000, the Mid-Cap Index, which has 400 stocks, and the Nasdaq-100, which has 100 stocks. Larry’s point is that when you invest in a money manager, one of the risks is stock-selection risk. Will the manager buy the right stocks in an upward moving market? Our work and our models also suggest that a buy-and-hold index investor will under perform dramatically for years to come for a number of reasons, predominantly based upon readings of our valuation models. We see a series of cyclical bull and cyclical bear markets with the indexes really going nowhere over time. There is a historical precedent for that. From 1966 to 1982 the Dow Jones Industrial Average traded between 600 and 1000. Never went anywhere for about 16 years. In Japan, for the last 12 or 13 years we had a really ferocious bear market. Along the way, there have been many rallies of 30%, 40%, even 50%. So, we believe that because of the high valuation of the market, because of the bubble and the hangover from the bubble that there is definitely a valuation ceiling in the market. Our strategy is designed to capture the upside in the cyclical bull markets and then to sidestep and greatly reduce exposure in the cyclical bear markets. By doing that, we can significantly outperform on a relative basis and along the way produce a very good absolute return which is again what this strategy is designed to do. Black Diamond is not a relative return strategy. We don’t think we’ve won, if the S&P like last year went down 24%, and we would have only gone down 15%. In our view, we would have lost. If the S&P 500 goes down 25% and we’re flat, we’ve won. And so this is definitely an absolute return strategy, not a relative return strategy. Schweiger: Chris and Broadmark are quite modest. Last year, Nelson’s, which is a division of Thomson Financial, ranked 1,600 equity money managers in their annual U.S. survey, and Broadmark was ranked 23rd. When the S&P was down 20 plus percent, Broadmark was up 8% on one of their funds last year. Some of the major insurance companies did some back-testing analysis from 1996 to 2001, and the indices they back-tested, this investment model and strategy out-produced the indexes anywhere between 2 to 1 and 3.5 to 1, with only 60% of the money in the equity portion of the fund. That is not 60% of the $100, our 60% of the equity portion amounts to about $14. Q: Please, give us some more granularity on your model. How do you assess these trends and apply that to your options trading? Guptill: I’m old enough to have gone through a few bear markets. I started investing personally in the 1970s and then got into the securities business in the late 1970s. So, I’ve seen a number of bear markets in my days. Our approach to the market is we asses the risk opportunity in the market in what we call an environmental model. A substantial amount of it is fundamental in nature. We look at P/E multiples and we relate them back to interest rates. The theory being that in periods of low inflation, with low interest rates, you can support higher P/E multiples and in periods of higher interest rate environments and higher inflation, the market can’t support higher multiples. So, we relate interest rates to P/E multiples, we look at short rates, we look at intermediate rates, we look at long rates, we blend them together. Because interest rates are such an important variable in our valuation models. We look at Fed policy, and we attempt to get a handle on the likely direction of interest rates since it impacts valuation so much. Once we’ve determined whether the market is undervalued or overvalued, or fairly valued, and which direction it is moving in terms of valuation, we then move on to what we call “market psychology.” Some people call it “sentiment.” Most classes of investors are wrong at extremes, hugely wrong. If you look back to the first quarter of 2000, you had record inflow of money into the equity mutual funds. Fast forward to the fall, October 2002, summer of 2002, you had record outflows, again precisely at the wrong time. My peer group, registered investment advisors, as a consensus, we are always wrong at extremes. There are only a few classes of investors that are usually right, and that would be the corporate insider, who tend to be early and the NYSE member and specialist. We track all these classes of investors, and try to determine what the smart money is doing, and what the not-so-smart money is doing at a given point in time. So, ideally, to become bullish on the market, we look for an undervalued market, coupled with extreme pessimism by the wrong-way crowd, accompanied by buying from those two classes of investors, but are typically right. And conversely, to be bearish, we look for a highly-valued market, supported by speculation by the wrong-way crowd, and selling or short-selling by the corporate insider and the NYSE member and specialist. Those are the main components of the environmental model. When we move, our action is determined by our momentum models. If our environmental model warns of an impending change in trend, if our environmental model becomes very bullish after being bearish, we will then begin to act when our momentum models begin to turn up. In two to four weeks we can become fully invested in the early stages of a new trend. Our models were designed to capture the fat part of the trend, if you will, not to get in at the bottom, or to get out at the top We are trying to identify a tradable long term trend and position the portfolio to profit from that sustainable trend. Q: Well, if you try and be there at every inflection point when it happens, as it happens, doesn’t it mean that you will have quite a bit of a turnover? How do you make it look OK for guys who are maybe a tad more tax-sensitive? Guptill: I have a two-part answer to that. One, I think most equity mutual fund investors in the last three years would gladly trade a tax problem for the depreciation in their portfolio. But more importantly, options are taxed at a favorable rate -- 60% of the profits generated from options are taxed at the long-term capital gains rate. Schweiger: That is Section 1256 of the Internal Revenue Code. You can buy it today and sell it tomorrow. 60% of the gain is long-term capital gain. But what is interesting is that Broadmark’s models are not timing, that’s No. 1. And No. 2, it only produces three to five signals a year. Since 1995 through to 2002 it has produced a 75% accuracy rate on market movements. Now I am not here to tell you that the models will continue to be that accurate, although they keep fine-tuning the models and all of the components that go into making up the models. And remember, you’re speaking to one of the top-25 money managers in the Nelson survey. Q: Now, why was it important to have these different series based on different indexes in Black Diamond – the S&P 500, the Mid-Cap 400, the Russell 2000, and the Nasdaq-100? Schweiger: When you really look at the Game of Life that’s been played in the brokerage community, the whole idea was asset allocation, diversification, large-cap, mid-cap, sectors, contrarian, sub-sectors, you name it. And if you had 64 different colors showing 64 different asset allocations, whoever had more colors ended up getting the client’s business. The reality is the indexes beat the majority of money managers every time. If you take the indexes that we picked, you really have provided the investor with about 60% to 70% of all the diversification they could need from an equity perspective. Aside from increasing the probability of success, because we’re using instruments that, most of the time, out perform the money managers, we’ve made it easier today for a client to make a decision without trying to tell them that we’re having thousands of different choices for them. It’s ridiculous and serves no purpose other than to justify high fees. We decided we were not going to do that anymore, because the American public is sick and tired of hearing all that and quite frankly the studies show they are completely numb to it. Enough is enough. Q: What is the ultimate danger, then, for your type of portfolio? What would you definitely hate to see, that can definitely hurt you? Guptill: We spent a lot of effort in designing the strategy, a lot of thought went into it. I might even add that one thing that we do and the other strategies don’t is we believe there’s potentially a large degree of interest rate risk in the system at these very low interest rates. A backup in rates could definitely hurt fixed-income securities, and because most of these principal protected strategies have large components of fixed income, there is a hidden danger there. There is a large degree of potential risk to the fixed-income side of the equation, so we spend a lot of time and effort to actually hedge the fixed-income side of the equation. Having said that, the most challenging environment for us would be an environment that we haven’t really seen, nor historically I can find, and that is a flat-line market, a market that just goes sideways for an extended period of time. In that environment, our models are designed to avoid the whipsaw. If it’s a downward trending market we should do well by having low exposure and being out. Now, if the market stays flat for a persistently long period of time, I’m talking about a multi-year flat market, we wouldn’t make any money. Schweiger: There’s never been a time in history when you’ve had a prolonged flat sideways move. As long as there’s volatility, and if the models are correct, you can make money in any environment. Every other mutual fund that is long-only, stock pickers can only buy it at $40 and sell it at $50. Therefore, they need the market to go up. We do not. Q: So, in Black Diamond, you have basically money managers that have perfected themselves in using a very limited number of instruments. Am I correct? Schweiger: That’s one of the keys that you have just picked up. Most every mutual fund out there has long-only, stock-picking money managers. Why is it long-only? Because they started 20 or 30 years ago and the SPDRs, the Diamonds, the QQQs have only been around four to 8 years. Other mutual fund companies were busy buying and selling stocks, while our money managers, Chris and his team, were busy studying and learning and perfecting the use of these alternative instruments and trend models. Go to some of the principal protected mutual funds – those companies are not touting their money managers’ fine performance. I think the sale is: “For those of you who are in equities and are afraIdent, put it over here, and you don’t have to worry.” NASD came up with a specific three-page alert to the investor regarding principally-protected mutual funds. It’s buyer beware, you might not be getting the upside that you thought you might be getting. And that’s what makes us totally different. So, generally what the NASD is trying to accomplish is for the consumer to just be more aware, and that makes a lot of sense. It’s a new world now. Markets for the last four years have mostly gone down. It’s even more important to have some safety and security attached to your money. And it is just as important that you can capture the upside when it becomes available. That’s an area of specialization known to many, because mutual fund managers could make a one-way bet as the bull run of the 1990’s unfolded. But those aren’t the markets anymore. The markets aren’t favoring long-only. They are favoring what we’re doing. The markets may trade sideways for the next five or more years until the valuation bubble is worked off. Remember, from 1966 to 1982, for 16 years, the markets bounced up and down, but went nowhere. If you buy it at $40 and sell it at $40 16 years later, you’re in trouble. But with Broadmark’s models, coupled with the investment instruments we are using, we can make money. As long as there is volatility, we don’t care where it is trending. We only need a 10% or more volatility, and I don’t think there has ever been a time when there has been less than that for any period of time.