ETF Expert Corner

Blue Sky’s David Varadi Spotlights QuantX Suite of ETFs

April 11th, 2017 by ETF Store Staff

David Varadi, Director of Research at Blue Sky Asset Management, spotlights the QuantX suite of ETFs and explains the concept of “smarter beta”.



Transcript

You can listen to our interview with David Varadi by using the above media player or enjoy a full transcription of the interview below.

Nate Geraci: We're actually spotlighting a suite of ETFs this week, the QuantX ETFs. These just launched back in January. These are all advised by Blue Sky Asset Management and joining us via phone from Toronto to discuss these ETFs is David Varadi, Director of Research for Blue Sky and Co-Founder and Portfolio Manager for the QuantX ETFs. David, a pleasure to have you on the program today.

David Varadi: Thanks a lot. Good to be here.

Nate Geraci: David, since QuantX is new to the ETF space and we haven't had you on the program before, first just tell us a little bit about Blue Sky Asset Management and how the QuantX ETFs came to be.

David Varadi: Blue Sky Asset Management started as a separate account manager for advisors. We were commissioned by our advisors to essentially create managed portfolios that could help them achieve their clients' needs. We essentially created a series of quantitative models. Eventually, we decided that things were working well and that we wanted to be able to productize to be able to capture some of the efficiencies of being an ETF product and to be able to create greater customization abilities for the advisors for their clients.

Nate Geraci: I'm curious, was there a particular catalyst that maybe pushed Blue Sky to offer these separately managed account strategies in an ETF wrapper?

David Varadi: I think it was really capturing a lot of the efficiencies. I think in a separately managed account framework, you have to deal with a lot of different moving parts and different types of issues including ticket costs, managing the overall taxation accounts of different sizes. By switching to ETFs, we would be able to resolve a lot of operational hurdles and be able to improve our execution and be able to improve our ability to deliver our strategies.

Nate Geraci: Just for our listeners out there, what were some of the efficiencies that you saw that ETFs brought to the table?

David Varadi: Taxation is certainly a huge one. We're basically active managers in the sense that we seek to manage risk. Our philosophy is predicated on managing downside risk. A lot of our clients are ages between 50 and 70, the vast majority of them. They see risk as downside risk. They can't afford to have another 2008 happen to their portfolios, because that would derail their financial goals. We effectively created strategies that could manage that downside risk. In doing so, you tend to have more turnover than a typical strategic portfolio. Turnover can lead to trading costs and to taxation. To be able to minimize that taxation and minimize those trading costs, we felt that going with ETFs was the best option.

Nate Geraci: Our guest today is David Varadi, Director of Research at Blue Sky Asset Management. They're the advisor on the QuantX lineup of ETFs. David, let's talk about a couple of the QuantX ETFs. Overall, the five ETFs you offer fall into two distinct categories. One ETF offers what's called a dynamic beta strategy. The other four ETFs fall into a risk managed category. Let's start with the Dynamic Beta US Equity ETF, ticker symbol XUSA. I've seen this referred to as a smarter beta ETF. Walk us through what this ETF does.

David Varadi: There's a lot smart beta ETFs. Really, smart beta is a really broad name or category. Originally, smart beta was designed to create different schemes for managing risk. Eventually, smart beta came to be characterized as any type of factor that might improve your returns over the benchmark, such as value, or momentum, or perhaps buying higher dividend yielding securities. We sought to essentially create what we call a smarter beta ETF. A smarter ETF does three things. First, it seeks to enhance returns just like other smart beta ETFs. Second, it seeks to lower risk. Third, it seeks to use forward looking information, rather than historical looking information. A typical smart beta ETF will look at trailing momentum over the period of, say, 12 months. It may look at trailing volatility over the past three to five years. We believe that that doesn't keep you in sync with what's going on with the market. We believe that looking forward at what the market is actually telling us, by looking at the option market, we're able to derive a unique view of basically what the market is saying that incorporates a wide range of factors including the smart beta factors in terms of whether a stock is favorable, or unfavorable. By looking at this unique option market data, we're able to select stocks that the option market believes have higher upside relative to downside. What we found with our research was that it allowed us to create a better index that gives us more upside capture with less downside capture. That's what our research showed. We were very excited to launch this as essentially an equity play that we would be able to put into our portfolios as a substitute for an S&P 500, or for a Russell 1000. We believe that this is a core equity holding.

Nate Geraci: David, what is the universe of stocks that this ETF starts with? Is it large cap US equities?

David Varadi: Yes, we use the Russell 1000 base universe as our starting pool. The Russell 1000 is the largest 1,000 stocks by market capitalization. From there, we select the top 50 securities as a function of the stocks that have the highest upside relative to downside as measured by the option market. For example, a call option will take a look at essentially the upside volatility. The put option will look at downside volatility. By looking at upside relative to downside volatility, we can gauge the favorability of any particular stock. That is what we use to select our stocks. The second layer that we use is we look at forward looking data. Then, during periods where market volatility is low, we'll tend to hold a higher beta portfolio. When market volatility is high, we'll tend to hold a lower beta portfolio. That allows us to manage risk better, because during a period like a 2008, we'll have a tendency to hold lower beta securities and have less exposure to the downside. During periods where the market is rising, we seek to hold higher beta securities and therefore, have greater upside potential.

Nate Geraci: David, for the layman out there, why do you think the options market is an ideal place to determine which stocks to be invested in, versus other factors that are out there?

David Varadi: The options market is capturing a lot of unique information. It will capture, for example, insider smart money information in terms of corporate events, such as they could be people that are aware that there is going to be earning surprises for a particular company. They could be people that are aware that there are going to be a revenue surprise for a particular company. It could be a very sophisticated buy side manager who has a unique piece of information about the company. The option market tends to reflect, tends to lead the equity market. People who have a unique source of information tend to buy options in the option market. This changes the volatility. You can essentially see where these informed traders are essentially placing their bets in the option market. You can see it also in terms of looking at the volume as well. We have found, and other academic studies have found, that the option market captures this unique source of information. It's almost like getting the inside track on what is likely to happen to a stock.

Nate Geraci: David, in terms of where XUSA may fit in an investment portfolio, do you see this as a substitute for core domestic large cap stock exposure?

David Varadi: Yes, we do. We also believe that the unique aspect of both those portfolios - we also capture a fair amount of mid cap exposure as well. We also think that that's an under-invested area in the market. It's an area that has historically produced very strong returns relative to risk as well.

Nate Geraci: Our guest today is David Varadi, Director of Research at Blue Sky Asset Management. Again, they're the advisor on the QuantX lineup of ETFs. David, the other four QuantX ETFs all fall into the risk managed category. These use dynamic asset allocation to provide exposure to different asset classes. Let's take the QuantX Risk Managed Multi Asset Income ETF, ticker symbol QXMI as an example. Explain for us how this ETF works.

David Varadi: I think the QXMI, we believe solves a major challenge in today's market, which is that interest rates are obviously very low. A lot of investors are reaching for yield. If interest rates continue to rise, then that can create a lot of risk. What we want to produce is we want to produce sustainable income. We wanted to create a vehicle that could give investors access to a diversified source of income across a wide variety of different asset classes, but essentially manage the risk of a large decline in any of those individual asset classes. For example, in our multi asset income ETF, we have a wide variety of different sources of income. We have interest sensitive income. That can include treasury bonds, or international treasury bonds. We have credit risk income. That can include corporate and high yield bonds, and emerging market bonds, as well as bank loans. We have equity risk income. We have high dividend yield stocks. We have preferred stocks, convertible bonds. We have real asset income, which we include real estate investment trusts, master limited partnerships, and royalty trusts. We also have option income, which we believe is a unique source of income, because it's less tied to credit risk. These are basically put-write, or covered call writing strategies. We combine these five different sources of income in a diversified manner within the portfolio. We seek to tilt towards the better performers, while simultaneously managing risk. What do we mean by managing risk? We take a look at the momentum, the trend and the volatility of these underlying instruments. If their trends and momentum are declining, then we will reduce our exposure to those underlying holdings and hold more cash and short-term fixed income. That prevents us from having exposure during, for example, a 2013 scenario when bonds fell across the board, or, for example, when interest rates rose significantly in the 70s. It prevents us from having exposure to a lot of highly interest rate sensitive, or credit risk sensitive instruments. For example, in 2008, a lot of the high yield bonds and a lot of credit sensitive instruments fell 30 to 50%. Ordinarily, they had very, very low volatility during normal conditions and high yields. During 2008, they fell substantially. We don't believe that that is acceptable. To produce sustainable income, we believe that you need to diversify. You need to shift to the better performers and you need to manage risk.

Nate Geraci: David, just high level, the way this ETF determines which asset class to be invested in, is by using momentum - is that correct?

David Varadi: That's correct.

Nate Geraci: In terms of the asset classes themselves, how does the ETF get exposure? Is it using other ETFs?

David Varadi: That's correct. It's a fund of funds and so, it uses other ETFs. We have a very large pool of different ETFs that we can hold, and so it's very widely diversified. We seek to have as broad of a spectrum of different types of asset classes and sub asset classes as we can.

Nate Geraci: As I understand it, this ETF's holdings are reconstituted daily. This is truly a dynamic strategy. Of course, the goal here, as you mentioned, is to manage risk. Just playing devil's advocate, is whipsaw a potential issue with this ETF? How do you balance the turnover?

David Varadi: First, to address your first statement is that we have the option, but not the obligation, to change our holdings daily. Since we've launched, the turnover's been very low in this fund. We take a look at the underlying risk and momentum on multiple time frames, not just daily. We have unique algorithms that try to adapt to the speed of market conditions. They also try to balance responsiveness versus volatility. If conditions are stable, then they will transact less and tend to hold onto positions longer. If risk emerges very quickly, but it emerges in a clear fashion, then we will rapidly de-risk. I believe whipsaw can affect a variety of different momentum and trend strategies. The way we've designed multi asset income is that it tends to use longer time frames, tends to stay diversified. It doesn't tend to overweight any particular category too heavily. It tends to make gradual adjustments, so it's nimble, but at the same time, we believe it's reasonably stable.

Nate Geraci: David - we have about two minutes left - obviously, we focused here on QXMI. Overall, how should investors think about the risk managed suite of QuantX ETFs? Where do these fit in a portfolio?

David Varadi: We launched this as a suite to be able to manage our own advisors' money for their clients, so they could basically customize using these different ETFs. Risk managed ETFs are almost like a color palette to basically be able to blend these ETFs to meet different client objectives, whether it's growth, or if they need more income, or they need more total return. You can effectively use these ETFs in combination in order to achieve different investment goals. By having the risk management in place, you don't have to worry during a situation, an extended recession like a 2008 or a 2002. We will be able to reduce risk and be able to manage that situation for investors, rather than putting the pressure on people to be able to have to figure out how they're going to reallocate their portfolio. Essentially, you can create the strategic allocations using these ETFs and just set it and forget it in our opinion.

Nate Geraci: David, with that, we'll have to leave it there. Congratulations on the launch of these ETFs. We certainly wish you all the success moving forward and we hope to talk to you again down the road. Thank you.

David Varadi: Thanks a lot. Thanks for having me. Appreciate that.

Nate Geraci: That was David Varadi, Director of Research at Blue Sky Asset Management. If you would like to learn more about the QuantX lineup of ETFs, you can visit quantXfunds.com. That's quantxfunds.com.