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.

Patti (cont’d.): The weights of each of the eight sectors can run between 2.5 and 22.5 percent. Every month, we’re buying low and selling high for each sector. That solves the constant-overweight in energy. Then the key is, How do we reduce the high volatility typical of equity-based commodity ETFs and improve upon the diversification benefits of equity-based commodity products?

What we did is a constant 20 percent short position in the product, half against the S&P 500 [domestic equities], half against MSCI EAFE [international equities]. The short is rebalanced to 20 percent every month. That reduces volatility and it also reduces your correlation to broad equity markets. If you go back and look at the performance, GRES has been the best-performing broad commodity ETF on the market.

IU: Broad-commodity ETFs haven’t been performing too well. Has GRES been performing positively, unlike the others?

Patti: No, year-to-date performance has been rocky just like the rest of the commodity sector. GRES will generally follow the overall trajectory of the other commodity ETFs. But if you look at performance over most periods of time versus any of the other products in the marketplace or versus the benchmark Dow Jones-UBS Commodity Index, you’ll see quite a big performance gap to our benefit—but also, importantly, with lower volatility.

IU: Let’s talk about gold, because that’s a hot topic right now. How do you explain what happened a few weeks ago?

Patti: Well, I think it’s something many people were looking for, for quite a bit of time, since the gold trade has been crowded for some time. Gold, at first, was going up because of the volatility in the market. People look at it as a safe haven. Then they were looking at it as a hedge against inflation. The gold market had really just become a bubble, in my opinion.

It just seems, as with anything else, it ran up very quickly in a very short amount of time well beyond historical norms. If you look at returns in a band over time, it broke through that band a long time ago. I think a pullback is healthy. And gold as an asset class is a good thing. People should be invested in gold. Regarding whether they should be invested directly in gold as a stand-alone asset class or part of a broader commodity strategy, I would argue the latter. I’m an index guy, so I think broad and cheap is typically a better approach.

Patti: Have you contemplated actively managed ETFs?

Patti: We’ve been very fortunate to have received exemptive relief for active ETFs. We have broad capabilities there. We will certainly be using those capabilities.

IU: You have 11 ETFs in the market. Are you looking to expand the product line?

Patti: We’ll be thoughtfully expanding the product line for sure. But what you won’t see from us is launching a whole bunch of products and hoping something is going to stick. We’re really trying to make a difference in the industry. So we think less is more.

IU: In general, how’s business?

Patti: Very good. We had a terrific fourth quarter and we had a better first quarter. The products are performing very well, and the asset flows are coming in.

IU: What are total assets under management in your ETFs right now?

Patti: Just under $750 million.

IU: Is that where you expected to be at this time?

Patti: Yes; we are on plan and where we expect to be. Let’s put it this way: If you look at the mutual fund marketplace, around 30 percent of that is indexed at this point. The hedge fund marketplace looks very similar to the mutual fund marketplace in terms of number of funds, not in terms of total AUM. There are around 10,000 hedge funds and there are 10,000 mutual funds out there.

We believe some significant portion of the hedge fund market will be indexed just like it has been in the mutual fund market, because the same premise, the same strength of indexing comes through regardless of the wrapper.

We want to offer products that become the S&P 500 and other benchmarks for the hedge fund market. We think the asset opportunity is very significant. We have the track record. Now we’re building out our distribution capabilities to drive awareness in the investment community.

IU: What hurdles do you face in conveying what these products do?

Patti: Well, in terms of hedge fund replication, early on, people said you couldn’t replicate hedge funds. The challenge has been first to educate investors on the benefits of the replication approach, then of course prove to them that it does work, and in fact it has done exactly what we said it would do.

The last few years the market have been very volatile, and it’s been really a perfect testing ground for these types of strategies. If you look at them, they’ve performed beautifully in a very tough environment.

IU: You originally began as an indexing firm?

Patti: Yes; we spent the first few years of our life specifically building out our indexes. We’re a little bit of an odd bird in the ETF market, because at the heart of what we do is research. We pride ourselves on the quality of our strategies.

IU: And when it comes to your indexing business, I assume you license your indexes?

Patti: We do in a select way.

IU: So it’s not a key portion of your revenue?

Patti: No, it’s not a key part of our revenue, nor is it part of our strategy.

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