Patti: Volatility Proves Hedge Fund ETFs Work

April 30, 2013

IndexIQ chief says his company’s hedge fund replication has been battle tested during recent market volatility.

Adam Patti is chief executive officer and founder of IndexIQ, an asset manager and index provider that currently has 11 exchange-traded products on the market with a total of $750 million in assets under management. The firm, which self-indexes its ETFs, is known for its hedge-fund replication funds, but also offers ETFs that offer exposure to REITs and commodities. IndexUniverse’s U.S. Editor-in-Chief Drew Voros recently spoke to Patti about the company, the firm’s ETFs and the potential to expand into the actively managed space.

IndexUniverse: Let’s talk about the IQ U.S. Real Estate Small Cap (NYSEArca: ROOF), your only REIT product. Why are REITs the hot ticket right now? Is it part of the search for yields, or is it the real estate recovery?

Adam Patti: It’s some of both, certainly. We found in our research that when investors buy asset classes like REITs, they’re seeking diversification. But if you look at correlations, you notice that these large-cap REITs actually don’t provide much diversification because the correlation to the S&P is so high now.

We found that small-caps not only outperform large-caps over most market cycles, but they provide the diversification you may have gotten long ago with large-cap REITs. And the dividend yields are about two times that of the large-cap REIT ETFs. These small-cap REITs are hidden gems in the marketplace. They are under-followed and are a far-less-crowded trade. Performance has been spectacular. [Editor’s note: ROOF is up 18 percent YTD.]

IU: What kind of properties are we talking about here: commercial, retail or a mix of the two?

Patti: This is a simple market-cap-weighted product. What you find is that the sector allocation is far more diversified than the large-cap REIT ETFs, which typically are pretty concentrated in one or two sectors. We’ve got everything in here from commercial to retail to specialty to mortgage REITs with a well-distributed sector weighting among the seven different sectors in the product.

IU: Talk about your commodity ETFs.

Patti: I’ll talk about GRES, the IQ Global Resources ETF (NYSEArca: GRES). I love talking about this because this is the best broad commodity product that nobody has ever heard of. In our research, we found that advisors were often using derivative-based products. They didn’t know they were getting a K-1 tax form, they didn’t know about contango and backwardation.

Once they learned about all that, they started migrating over to equity-based commodity products. And in those, they didn’t realize they were typically getting a significant overweight to the energy sector.

Worst of all, the correlations to the S&P 500, again, was much higher. You weren’t getting the diversification benefits you thought you might have been getting by buying commodity funds.

So we built GRES, which is the broadest natural-resource ETF in the marketplace. It’s an equity-based product covering all eight major sectors, all the typical ones—livestock, energy, precious metals, industrial metals and agriculture. Then we added timber, water and coal as stand-alone sectors. So it’s very broad.

Then what we did to solve that whole problem with the constant-overweight energy is to simply institute rules on a monthly basis that overweight those sectors that are cheap and that have high momentum. And we underweight those sectors that are expensive and have low momentum.

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