ETF Expert Corner

Blue Sky’s David Varadi Explains QuantX ETFs

June 5th, 2018 by ETF Store Staff

David Varadi, Director of Research at Blue Sky Asset Management and Co-Founder & Portfolio Manager for QuantX Funds, offers his views on the limitations of buy-and-hold investing and spotlights several QuantX ETFs.



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. They're from Blue Sky Asset Management. They're called QuantX ETFs. There are five ETFs in all. 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, great to have you back on the program.

David Varadi: Thanks a lot, glad to be here.

Nate Geraci: David, before we look at a few of the QuantX ETFs, my understanding of Blue Sky's sort of overriding investment philosophy is that because the economic and investment environment changes constantly, investors should adapt to those changes and not necessarily rely on a buy-and-hold approach. To begin here, can you expand on that? Because I think there's a fairly decent chunk of investors who believe the less you tinker with a portfolio the better, right? That investors' ability to time markets is generally poor. So what's the counter-argument to that?

David Varadi: I think the counter-argument is, is that buy-and-hold is easy on the way up, but on the way down, it becomes an incredibly difficult strategy to stick with. You need to have a strategy that you're going to be able to stick with through a complete market cycle. So momentum is one of those strategies that has been time tested for hundreds or even thousands of years in terms of its ability to help to shift and time that market cycle effectively. So our ETFs primarily leverage using momentum in order to help investors essentially ride the market cycle out with less volatility.

Nate Geraci: And just playing a bit of devil's advocate, why not manage risk through allocations? In other words, someone who can't stomach a large draw down probably should own less stocks and more bonds or other conservative investments. Why not manage risk that way?

David Varadi: I think that's a great question. I think what it comes down to, has to do with capital efficiency. So if you look at bonds, for example, interest rates are quite low and returns on bonds are expected to be quite low for the next 10 years. So to be able to get returns in general, you're going to have to have a higher equity exposure. The problem with that is that you're going to have to have higher volatility. So if you want to have higher returns, but you want to be able to reduce risk, the only way to be able to do that effectively, in our opinion, is to be able to manage risk on holding riskier assets like equities, as opposed to diluting your returns with bonds. If you saw the recent correction, bonds have been a poor diversifier, and started to become a poor diversifier recently. That's because interest rates are rising. So as we go into an inflationary environment, you could see that bonds may not be an effective diversifier and they may, in fact, be a drag on your returns.

Nate Geraci: Alright, so on that note, let's look a few of the QuantX ETFs. Currently, the most popular is the QuantX Risk Managed Growth ETF, ticker symbol QXGG. Walk us through this one. How is it constructed and what's the investment goal here?

David Varadi: Yeah, so the QuantX Growth ETF, it's a very simple concept, which is that it's designed to provide investors with core equity exposure, both domestic and internationally. The majority of the portfolio is devoted to domestic equities, and then still a reasonably large allocation is devoted to international equities. A small component is designed to rotate between whichever component is performing the best. So if domestic equities are performing better, we'll have a higher allocation to domestic and if international equities are performing better, we'll have a higher allocation international. Then, on top of that, is our momentum overlay in order to manage risk. So as the market goes down, we'll use multiple timeframes in order to take a look at the momentum of those various markets. As the market's going down, we'll tend to hold more fixed income or cash. Cash, in the sense that if fixed income is actually declining, then we'll tend to hold cash, which tends to do much better in a rising interest rate environment. So as we get more defensive when momentum and risk assets is going down, we'll be able to protect, or hopefully protect, against recession risk - so longer term secular declines, you know, bear markets essentially.

Nate Geraci: And David, to be clear, this is a fund of funds, correct? This holds other ETFs to get exposure to domestic equities, international equities.

David Varadi: Yes, yes, that's correct, and that's in order to get diversification and it makes it easier to rotate between domestic and international.

Nate Geraci: You mentioned the risk overlay, I'm curious, how did this ETF react back in early February when we saw the big spike in volatility and a brief stock market correction?

David Varadi: I think it's a great question, and so really what we're aiming to provide some protection against is more recession risk, so longer term secular declines. And that's in order to help to maximize the upside capture in bull markets. So for shorter-term corrections, especially the decline in late January, early February lasted just a few days from top to bottom, or at least a handful of days. So because we used backward-looking indicators on multiple timeframes ranging from say one month to one year, we're not going to capture a move like that. So we did actually de-risk a little bit during the decline, but we didn't fully de-risk simply because the decline was so short.

Nate Geraci: Alright, another one of the risk-managed ETFs, and there are four all together, is the QuantX Risk Managed Multi-Asset Total Return ETF, ticker symbol QXTR. Is this a similar methodology to QXGG, just with additional asset classes like bonds and commodities included?

David Varadi: Yeah, I would say that it is. It's very similar, it's just that you have a wider range of asset classes that you can get exposure to. So for example, if inflation starts to become more of a secular trend, which we're starting to see, then the Total Return Fund will be able to allocate more to inflationary-type assets. And that's what we're starting to see. So it goes back, I mean, to the philosophy of being able to vary your asset allocation. One of the things that is detrimental to asset allocation is recessions. But the other one that's detrimental to asset allocation is when you go through a secular inflationary regime like in the '70s. So if you have the ability to increase your exposure in inflationary assets, or real assets as we like to call them, then it tends to be very beneficial to your asset allocation, tends to hedge against a rising interest rate environment.

Nate Geraci: Our guest is David Varadi, Director of Research at Blue Sky Asset Management and Co-Founder and Portfolio Manager for the QuantX ETFs. David, you also offer what's called a dynamic beta strategy ETF, the QuantX Dynamic Beta US Equity ETF, ticker symbol XUSA. Can you explain for us what this ETF does?

David Varadi: Sure, I mean, the US Equity ETF is an alpha type ETF. It doesn't go to cash. So it's always invested in equities. But we're attempting to maximize risk-adjusted returns with that ETF by being able to dynamically shift towards smarter volatility stocks. And smarter volatility, we look at stocks that have high upside relative to downside volatility. We also seek to go to lower beta stocks when we anticipate that the market's going to be volatile. So it's essentially a concentrated U. S. equity fund that seeks to provide a better return profile.

Nate Geraci: You mentioned smarter volatility stocks. On the QuantX website, I saw this ETF referred to as "smarter beta," as opposed to just smart beta. And we actually talked smart beta earlier with ETF.com's Dave Nadig. I'm curious, what's the distinction here?

David Varadi: It's a great question. Most of our beta strategies use some sort of individual, or perhaps a composite, of different traditional factors such as value, momentum, size, volatility, and those types of things. They use trailing indicators, so they use backward-looking data. And so, in this case, this is a market-derived indicator, and so we look at option market volatility in order to derive what the forward-looking expectation for return and risk is for these stocks. Any type of a market-based measure, or if you look at option volatility, it tends to capture the market's views including a wide variety of the traditional smart beta factors. It's all sort of combined into one. So market-based measures, we view are smarter because they reflect the smart money.

Nate Geraci: David, obviously your strategies are rules based, they're quantitative. I'm curious, as you look at your quantitative models and sort of the positioning within the various ETFs, just at a higher level, what are those models telling you about stocks and bonds and commodities right now?

David Varadi: Well, right now we're starting to see a shift towards more real assets or inflation-sensitive assets for sure. I think that that reflects the secular trend in inflation that happens to be developing. I think the rising interest rate environment, I think all these things are tying together and sort of painting the same story, which is that this may be an environment with poor returns for fixed income. You know, inflationary assets may rise significantly. I mean, we've seen quantitative easing for a very long period of time and no one knows what that impact is going to be. I mean, so far the inflationary impact has been muted, but I mean, there always comes a point where the impact of that could accelerate dramatically. So I think that that's certainly ... Having the ability to shift your asset allocation to benefit from that circumstance is very important.

Nate Geraci: David, as I mentioned earlier, we have focused on the quote/unquote smart beta ETF space quite a bit on today's program. I'm just curious, what are your views on that space as a whole? Do you expect to continue to see growth there? Where do you expect to see that growth coming from? Is it coming from traditional active management? Just high level, what are your views on the space?

David Varadi: I think high level, I think that the space is certainly interesting. It's growing very rapidly. I mean, just like anything else, it can only grow to a certain maximum size. So, if the entire market was smart beta, then the efficient markets hypothesis would say that you're better off investing in market cap weighted strategies simply because that would capture all of those views. I think we're currently right now, we're not at a saturation point. I think that people are starting to get interested in smart beta. So I think that the trend has room to run for sure, but I mean, I think it's certainly become, you know, gone from outside of the mainstream to becoming a little bit more mainstream.

Nate Geraci: Alright, we have about two minutes left, and on a similar note, why is the ETF structure a good structure for the QuantX strategies?

David Varadi: I think the ETF structure is great, because it's ... from a tax efficiency standpoint and from a transparency standpoint, I think it's excellent. I think if you compare the ... because we're relatively active with our asset allocations, in general, that would have a greater tax impact in a mutual fund than it would in ETF. So I think that that's certainly one of the main advantages. The other advantage is liquidity. I mean, you can essentially, you can purchase and sell relatively easily during the day if you have an ETF. And so, all those things provide strong advantages to the ETF format.

Nate Geraci: Well David, we'll have to leave it there. Enjoyed the conversation today. Great having you back on the program.

David Varadi: Thank you very much. Thanks a lot. Cheers.

Nate Geraci: That was David Varadi, Director of Research at Blue Sky Asset Management, and if you would like to learn more about the QuantX lineup of ETFs, you can do so by visiting quantxfunds.com.