3 ETFs to Achieve Specific Goals

06/28/2012 7:30 am EST

Focus: ETFs

Adam Patti

CEO and Founder, IndexIQ

IndexIQ CEO Adam Patti tells MoneyShow how three of his firm’s ETFs can round out investor portfolios, and what type of investor they are best suited for. He also explains why it’s not a good idea to buy any ETF at the market’s open or close.

Kate Stalter: Today, I am speaking with a repeat guest that I’m honored to welcome back: IndexIQ CEO Adam Patti.

Adam, as volatility has returned to the market, it has made it tougher for both investors and traders. People are looking at some different ways to capture gains, whether it is using non-correlated assets or hedging. Your ETFs are designed to address some of these needs. I wanted to start out today by talking about your ETF, the IQ Hedge Macro Tracker (MCRO). Explain to me what this is, and how you envision people using this one.

Adam Patti: MCRO is a perfect product for today’s markets, because if any of your listeners are familiar with global macro strategies—these are typically some of the more popular hedge-fund strategies. What they are designed to do is protect investors as best they can from global macro events, by really having a strategy that is go-anywhere and do-anything across different asset classes, whether that is real estate, and currencies, and commodities, and equities, and fixed income.

They are really trying to find those opportunities that may hopefully do well in an environment where there is a lot of macro overhang. In terms of today’s environment, we are talking about Europe, obviously. We are talking about the Middle East, and we’re talking about our own economy here. So a global macro strategy is a great strategy to have, and is part of the alternative sleeve of your portfolio, because it is really designed to help you get through this type of volatile period.

Kate Stalter: How do you envision people using an ETF such as this one in addition to their existing equity and fixed-income investments?

Adam Patti: Typically MCRO—which is actually just past its three-year anniversary of live history—usually investors use that as a carve-out of their equity portfolio. So we have different types of hedged vehicles that typically would be used as different carve-outs from your portfolio, but typically MCRO is used for part of your equity portfolio.

If you have 60% of your portfolio in equities, typically an investor would carve out a portion of that and put that into a product like MCRO, because it gives you more equity directional-type performance characteristics. So it is going to protect your downside by providing less volatility on the downside, but it is also going to provide that upside potential if and when the market is going up again.

Kate Stalter: In which type of market conditions will this particular ETF work the best?

Adam Patti: Well, that is the beautiful thing about global macro—and why I was so pleased to highlight that today. It is because it is really an all-weather strategy. It is the type of strategy one has as a core holding as part of your alternative sleeve of your portfolio.

Because again, it does provide about one third of the volatility of the S&P 500, so it is going to protect your downside. You make more money by losing less in the long-term.

It is so hard to make up those big drawdowns in tough markets. But then the market does turn, and MCRO has proven that it is able to keep pace with the equity market, which is critical, of course. Because you don’t want all the downside protection and then, of course, the market turns and you don’t go up. That is not what you want. MCRO is really designed to do both things for you.

Kate Stalter: Let me turn to another one of the IndexIQ instruments, and that is your Merger Arbitrage ETF (MNA). I actually spoke with a mutual-fund manager recently with a merger arbitrage strategy, but it seems a mutual-fund manager can have a little more discretion. How does it work with an ETF that is pegged to an index?

Adam Patti: Well, interestingly, what we found in our research is that merger arbitrage strategies are very mechanical. And in fact, over ten years we looked at around 10,000 merger and acquisition transactions, and we found that there are specific characteristics that make a merger arbitrage transaction successful, and certain characteristics of the deal that make it unsuccessful.

We simply built that into a process. So we are really on a very similar strategy to an actively managed mutual fund, but it is all rules-based and it is fully transparent. And the beautiful thing about an ETF structure is that it reduces your tax drag on your portfolio turnover, since a merger arbitrage-type product can typically have 300% to 500% turnover, because you are following different deals that are either coming to completion or they are not.

What that does in a mutual-fund structure or a hedge-fund structure is, it takes a very big bite out of your return. In an ETF, we are able to reduce that pretty significantly, which helps the overall return profile.

Continued…

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Kate Stalter: I’m looking at the chart for MNA, and one of the things I did want to ask you: On a couple of days, January 27 and June 6, there appears to have been some unusual trading action in here, well out of the established norm. Can you say what happened there, or what would cause that?

Adam Patti: Absolutely, and I don’t know on those specific dates what happened, but I can tell you what happens generally, because we have seen it across many, many, many ETFs…because it is really an ETF phenomenon.

What usually happens is: An ETF is not a single stock, and investors need to be very careful how they trade ETFs. One thing is, you never want to trade an ETF at the open or right at the close. And the reason for that is, the market makers at the open are not all set and ready for business right at the open. Similarly, at the close, many of the market makers get out of the market. So what happens is, you have much more of an erratic trading for ETFs generally.

The other thing is, you have to set limit orders when you invest in an ETF. Because an investor comes in and says, “I’m going to buy 1,000 shares at the open with a market order.” So what happens is, the market makers that are in the market at that point are going to take advantage of that, and they are going to give you a very poor execution.

That is not just a phenomena for our ETF; that is just an ETF structural issue that investors really need to be careful about. So always set limit orders and try to avoid trading at the open or the close whenever possible.

Kate Stalter: Those are some great tips right there for individuals who are looking at the ETF space. Let me ask you about one more today, Adam, and that is IQ Real Return (CPI). Tell us about that one. The name certainly does give a clue as to what this one might be related to.

Adam Patti: This is a very interesting product, particularly in today’s environment when a lot of investors are going to cash. Really, CPI is an inflation-protected cash alternative.

Now, it is not cash; I want to make that very clear. What investors are using it for is a cash alternative for pulling your money out of the market and putting it into a typical money market instrument where you are getting pretty much zero return on your cash. That is not good for those looking at retirement.

So what CPI is, is a very low volatility strategy; it is typically around 2% volatility, so it doesn’t move much. But what it does is, it is designed to give you a rate of return of around 2% to 3% over the inflation rate, with around 2% of volatility.

So it is a very nice strategy to help you with your cash balances, as well as to protect you against inflation when and if that day comes, because the current instruments out there like TIPS bonds are typically not the most efficient way to protect your portfolio from inflation for a variety of reasons. CPI has given our investors a return of around 3% over the last 12 months with 2% volatility, which is very strong, and it is a pretty consistent return pattern.

Kate Stalter: Let me just finish up today by asking you: Are most of the investors in your ETFs individuals buying them directly, or are they advisors putting them in client accounts?

Adam Patti: I would probably say that most of our investors are probably working with a financial advisor. And the reason for that is, our own sales effort is really focused on the financial advisor community.

However, we do have a pretty significant number of direct retail investors, and we can tell that by where do you get assets being held, whether sometimes they are at E*TRADE or with TD Ameritrade or some of the online brokers.

So I would say probably about a fourth of our asset base is probably with direct retail investors, and most of the remaining is really with the retail investors working through a financial advisor.

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