Q&A: IndexIQ’s Adam Patti On The Tremendous Growth Of ETFs

Feb 11 2015 | 11:55am ET

Exchange-traded funds are booming. According to a report by PwC, assets invested in ETFs are expected to double in the next five years to reach $5 trillion. Adam Patti, founder and CEO of IndexIQ, is a pioneer in the industry. FINalternatives recently spoke with Patti about the growing demand for ETFs, as well as how hedge fund managers are using these liquid vehicles in their portfolios.

How much demand are you seeing for alternative ETFs?

Adam Patti: We have seen a significant uptick in demand for our liquid alternative products over the last two years, something we attribute to more people understanding the role that liquid alternatives can play in their portfolio, both as a means of adding exposure to new strategies and asset classes, as well as for volatility alleviation and downside mitigation.  In addition, investors are increasingly concerned about positioning their portfolio for the future given the significant appreciation in equity and fixed income investments over the past few years.  Our exchange-traded fund (ETF) assets increased over 46% in 2014 and our flagship ETF, QAI, grew 57% and just crossed the $1 billion asset mark in late January. QAI was the first liquid alternative ETF when we brought it to market in 2009 and passing a milestone like that says a lot about investor acceptance of the product and the space. QAI is now considered the “S&P 500 of the hedge fund market” and we’re finding that message resonating with all types of investors, from retail to advisors to institutions to, in some cases, hedge funds themselves.  Moreover, industry reports project that ETF assets are likely to at least double, reaching $5 trillion or more by 2020, with a significant portion of that growth coming from alternatives (according to a report, ETF 2020, by PwP).

We also announced in early December that New York Life Investment Management (NYLIM) is planning to acquire our firm. For an organization with the size, scale and track record of New York Life to say not only that it wants to get involved in ETFs but that it sees liquid alternative ETFs as one of the true growth stories on the ETF landscape is both tremendously validating and exciting. We already see the passion they have for alternative funds and we’re eager to see how things grow going forward. We could not have found a better partner.

What are some of the benefits of investing in alternative ETFs as opposed to hedge funds?
 
I’ve always believed that it’s not an “either or” question when looking at alternative ETFs and hedge funds. If you think you can identify and access hedge fund managers who are likely to deliver alpha, then by all means you should look to that approach.  But if you don’t have the time or the resources to conduct rigorous due diligence on various managers or if you’re not able to invest directly in hedge funds, then the exposure offered by alternative ETFs merits consideration. I also feel a fund like QAI can check off a lot more boxes than just providing “hedge fund exposure.” That term itself is one that gives me some pause, since there are thousands of different hedge funds taking hundreds of different approaches. What QAI can provide is the type of performance that hedge funds were originally tasked with delivering, i.e. returns that are uncorrelated with the broad markets over time, lower volatility, and downside mitigation. If you’re interested in those things, then ETFs are worth a look, especially when you consider the transparency, tax efficiency, liquidity and the potential for lower overall costs of the ETF product wrapper.  The tax efficiency point is of great importance particularly in the alternative space with strategies that typically have higher turnover.  This higher turnover can result in quite a reduction in after tax returns in a traditional limited partnership or mutual fund structure.  ETFs on the other hand are generally more tax efficient based on their creation/redemption process and that they can be bought and sold on an exchange.

Are you seeing hedge fund managers use alternative ETFs in their portfolios? How?
 
We are. While I can’t get into specifics about managers and funds, what we tend to see is hedge funds slotting in a QAI or one of our other liquid alternative offerings as a way to gain specific exposure during transitions or to reduce the impact of cash drag on their portfolio.  There is no need for them to keep significant cash balances available if they can invest in an ETF that seeks to provide a similar return profile to the rest of their portfolio, yet one they can sell at any point they choose. Other types of exposures that have been packaged in alternative ETFs are certainly finding favor with hedge funds as well, including leveraged and inverse funds, which is not an area where we have focused but which are certainly most appropriate for that kind of sophisticated investor. 

Can most hedge fund strategies be shoehorned into a liquid alternative fund? Or are there some strategies that work better in these vehicles than others?
 
I like that you used the word “shoehorn” because it does sometimes seem like strategies are being shoehorned into 40 Act vehicles for the sake of getting to market quickly. We’ve always been a believer in incubating our strategies for long periods of time prior to bringing them to market, and in the value of investor education. People need to know how these funds work and what they’re designed to do in order to make the best use of them in their respective portfolios. Sometimes that can get lost as a marketplace gets more crowded.

To your question, not everything is going to work as a liquid alternative fund. There are regulatory realities that are going to keep the exposures offered by alternative ETFs within a certain range, meaning strategies that focus on certain exotic, illiquid securities will best remain the province of hedge fund managers. But I think we are still in the early stages of the growth of the liquid alternative fund category and that there is still a lot of innovation to come.

Active ETFs run with input from hedge fund managers themselves, for example, may hold a lot of promise both for the ETF industry and for the hedge fund space. Some of the so-called “hedge fund” ETFs, though none of IndexIQ’s strategies, on the market now are backward-looking vehicles, so investors run the risk of getting “last quarter’s best ideas.” But that aside, liquid alts remain an area of tremendous opportunity.  I’m excited to see what the future holds.


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