Volatility Is Rising: Set Your Hedges

10/15/2012 8:45 am EST

Focus: STRATEGIES

Adam Patti

CEO and Founder, IndexIQ

Generally speaking, market volatility increases in October...and with a major election, a looming fiscal cliff, and economic problems stretching from China to Ireland, a smart hedge is a very good idea, observes Adam Patti of IndexIQ.

Gregg Early: I'm here with Adam Patti, founder and CEO of IndexIQ. Given the fact that we're less than a month away from the election-and historically, volatility in the marketplace increases starting in October-where should investors look to take advantage of both the increased volatility and the potential dangers in the marketplace?

Adam Patti: I think we're looking at a very uncertain market environment, not only in the elections, but then we have the fiscal cliff coming right after that. You know, typically in these types of environments-really in any environment, because you never know when the market is going to have a draw down, but particularly when you can see the volatility-you really want to be hedged.

One of the most effective strategies to be hedged in this type of an environment is a market-neutral strategy. Which is why we just brought out a product, the IQ Hedge Market Neutral Tracker ETF (QMN), to mirror that strategy.

Gregg Early: Could you explain a little bit more of what a market-neutral strategy is, for those who aren't familiar with it?

Adam Patti: Absolutely. A market-neutral strategy is very simple. It's a strategy that is designed to provide positive absolute returns in any market environment with very low volatility.

It's kind of an all-weather strategy to give you nice consistent returns with very little downside...to really provide ballast to your portfolio and insure that you lose less. Because that's the thing that investors really need to understand: You make more in the long term by losing less in these drawdown periods. That's what market-neutral is designed to do.

Gregg Early: It's one of those old adages where it's harder to come back after you've lost than it is if you don't lose as much to begin with.

Adam Patti: Absolutely. We've had great success with our hedge-fund strategy ETFs, IQ Hedge Multi-Strategy Tracker (QAI) and IQ Hedge Macro Tracker (MCRO), which are very different; they're multi-strategy and more equity directional.

QMN is linked to an index, so everything we do is index-based and fully transparent. The index has four years of live history, so we've been incubating this for quite some time. The index has provided a return pattern of approximately 4.5% annualized, but with very low, single-digit volatility; about a quarter of the volatility of the S&P 500.

If you look at that compared to the Morningstar average for market-neutral funds, the average over the last four years there is only 0.7% return. Our strategy has done very well as an index, and we're really pleased to bring it out now at a very opportune time.

Gregg Early: Within this context, I think it's important for investors to know that this is a strategy that hedge funds have used for years. I mean, a lot of hedge funds have this strategy implemented within their fund. It's only been relatively recently that individual investors can get access to this kind of strategy.

Adam Patti: That's exactly right. Market-neutral is the second largest hedge-fund strategy out there; long-short is the largest. So there are a lot of hedge funds using this strategy.

It's a very institutional strategy, and there have been some mutual funds that have been launched with this strategy. Many of them have driven assets, but many of them also have had mixed results, because they're actively managed. They're really banking on an active manager to find the right asset classes.

Our strategy is very simple. It's an index-based strategy. It's designed to provide the risk-return characteristics of market-neutral hedge funds, but with full transparency, full liquidity, low cost, and no manager risk. There is no active manager here, which is important.

Gregg Early: Regarding the volatility of the marketplace, do you see any outliers here? Do you see the market going up more or less regardless of who wins the election, or is the fiscal cliff a bigger concern than the election to begin with? Where do you see the volatility kicking in?

Adam Patti: I think we're going to see increasing volatility leading up to the election...and certainly not to get political here, but I think if Romney does win, I think we'll see an improvement in investor confidence and at least see hopefully long term but at least a short-term increase in the market.

Then again, we have to deal with that fiscal cliff, and that's coming up right in January. Whoever wins is going to have a lot of work to do to have us avoid potentially devastating cuts. I think we're looking at least the next six months of a lot of volatility and uncertainty.

Related Reading:

October's Top Seasonal Sectors

The Hidden Dangers of Playing It Safe

How a Pro Deals with Volatility

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