ETF Expert Corner

IndexIQ’s Kevin DiSano Talks 50% Currency Hedged ETFs, Hedge Fund ETFs

February 16th, 2016 by ETF Store Staff

Kevin DiSano, Chief Portfolio Strategist at IndexIQ, discusses negative interest rates and highlights several ETFs to consider in this environment.



Transcript

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

Nate Geraci: I'm now pleased to welcome to the show, Kevin DiSano, Chief Portfolio Strategist at IndexIQ. IndexIQ is a leading provider of alternative strategy ETFs. They offer hedge fund replication ETFs, they have some unique natural resource focused ETFs and last year they launched the world's first 50% currency hedged ETFs. Of course currencies have continued to be a very hot topic among investors. We now have Kevin joining us via phone from Chicago. Kevin, as always, great to have you on the program.

Kevin DiSano: Thank you and great to be with you this morning, I appreciate it.

Nate Geraci: I thought we'd start today by talking about negative interest rates. We spent some time on this in our first segment and boy this is a strange world we're living in where some investors are paying to lend a government money. I'm curious, just generally speaking what do you make of this negative rate environment in places like Europe and Japan and how does the average investor even begin to get their head around this?

Kevin DiSano: Yes, this is a very, very interesting time. Certainly it's nothing like any of us have seen in our lifetimes for sure and investors are really challenged in this environment, as obviously those setting monetary policy globally are also challenged. You have on the one hand fears of deflation and governments trying to spur growth in the local economies and you have investors trying to retire and build their portfolios for safety and stability. Those two things kind of almost run counter to each other sometimes, so it is very challenging for investors to navigate their way through these types of market environments when you have central bank policies in the negative arena like we do in Japan and Europe as you pointed out.

Nate Geraci: As we talk about negative rates and their impact, obviously we advocate international diversification for our clients, both in stocks and bonds. It's interesting, we always talk about how five or ten years ago currencies really weren't that big of a talking point. Certainly currencies have always impacted returns but this just wasn't that big of a concern among clients, but now it seems like we're having conversations about currencies all the time and I know we're not alone. Is this just the new normal because of the policies we are seeing from central banks right now?

Kevin DiSano: I think that's part of it, I also think part of it is just the ability to actually act on some of those investment strategies which weren't available before. As you mentioned we launched our suite of 50% currency hedged strategies last year with HFXI, HFXJ and HFXE and you've had now, over the last two to three years, a number of 100% currency hedged strategies that have come online in addition to the ability to invest directly in some things like the Carry Trade or currencies through ETFs in terms of their performance relative to the dollar or Euro or other types of currency. Now you have the ability to actually invest in those types of exposures which really weren't available before and I used to work with international equity investing a number of years back and the whole idea was that the currency fluctuations provided a little bit of diversification for investors, which in fact they do over time but in the short run you can have very explosive moves in local currencies relative to the US dollar which is what we care about here in the United States being dollar based investors. Now I just think the ability to have the exposure in investor portfolio causes folks to think about it as a consideration when they're investing.

Nate Geraci: Well let's talk more about that and I thought maybe we could focus on Japan. Obviously Japan is a big part of the global economy, they're the third largest economy and certainly a well-diversified investor, should probably have at least some exposure to Japan. You mentioned your lineup of currency hedged ETFs, if we look at the IQ 50% hedged FTSE Japan ETF ticker HFXJ, this invests in Japan with a 50% currency hedge. Previously if investors wanted to invest in Japan they have two options, they could either invest in a fund that didn't hedge the Yen, or they could invest in a fund that fully hedged the Yen. Why split the middle here?

Kevin DiSano: Well this is an interesting point that we love to focus on when we talk about the 50% currency hedge strategies. If you're invested in a fully unhedged strategy which means that you have full local currency exposure, essentially what you want in that type of strategy is you want that local currency, in this particular case we're talking about the Yen, to actually appreciate versus the US dollar, thereby giving you additional performance on top of whatever the local equity market provides. If that local currency appreciates and the dollar drops in strength that means that you're actually making money in that scenario. That would be a perfect situation for that type of portfolio.

In the opposite situation where you have local currency weakness then you want a fully hedged portfolio because you're actually betting on local currency weakness and you want to take that risk off of the table. In a fully hedged portfolio the local currency weakness really helps that portfolio because it protects you on the downside. Here's the problem and we've seen this here just in looking at the year to date performance. Year to date the Japanese Yen is actually up about 5% versus the US dollar. The flows into a lot of the 100% currency hedged ETFs peaked last year after a large move in the dollar versus the local currency. Investors were trying to hedge something that had already taken place and in the short run we've seen explosive moves in the currencies which have caught investors on the wrong side of that trade and they're actually hurting themselves. One of the things that we advocate is a 50% hedge which gives you some of the hedge in the local currency when it's declining and you might want to stabilize some of that part of your portfolio, but it also provides the exposure to some of the local currency when it's appreciating like the Yen has been relative to the dollar this year. You have that nice currency neutral type position in your portfolio with one trade as opposed to having two positions in your portfolio to get that same type of neutral exposure which is what we had seen investors doing before. It's just about providing investors with a much more efficient way to execute that position.

Nate Geraci: Kevin I think that's well said, I believe IndexIQ calls the 50% hedge the hedge of least regret which I think describes that perfectly. If we look at Japan, we were talking earlier about central banks and negative interest rate policy. We know Japan has been trying to stimulate their economy for years now and they've done that through many different ways, but can you maybe talk about what Japan's goal is here and how this impacts both their stock market and the currency, just so the average investor can understand.

Kevin DiSano: Yes exactly, the goal here is obviously to spur inflation. It's actually not that much different then what we hear about all the time when we talk about The Fed here in the United States. Actually, recently the Bank of Japan was talking about an inflationary goal of around 2%. Here's the problem is that as we all know energy prices have been falling and so as that energy price declines, that keeps a lid on inflationary pressures. When you back out that type of exposure in inflationary scenario you're not dealing with a lot of inflation and that's the whole goal of this reduction in interest rates to zero or negative in the case of Japan, is to try to spur economic growth, which in theory long-term would be very good news for stock market investors because stocks tend to do a good job of hedging against inflationary pressures as earnings rise over time stock prices tend to appreciate. The problem is in those scenarios interest rates rising that spells tough challenges for bond investors. That's obviously what these central banks want is that they want investors to move assets from less risky investments to a little bit more risky investments to try to spur growth and inflation in their local economies. That's the goal here, the problem is that the energy prices have been working in counter to that which is making it a little bit more difficult.

Nate Geraci: Again, we're visiting with Kevin DiSano, Chief Portfolio Strategist at IndexIQ. Kevin I want to switch gears and spend some time talking about alternative investments. We know investors are searching for solutions right now, I think you just described some of the reasons why that's the case, they're looking for ways to manage volatility and protect their portfolios and perhaps find some income. IndexIQ offers several alternative strategy ETFs including hedge fund ETFs. Can you talk a little bit about these, why might investors consider these strategies right now?

Kevin DiSano: I think a couple of things. I just mentioned the idea of rising interest rates, so you have these inflationary pressures and typically in a rising inflationary environment you have rising interest rates that come along with it and in the United States we've been talking about The Fed actually in a tightening posture in terms of raising interest rates until recently as we've seen energy prices sell off. You have the whole idea and spectra of rising interest rates on the horizon, so investors that have bonds in their portfolio, especially in pooled investment strategies like ETFs or mutual funds will end up with what I would call a perpetual duration risk pool. In other words they don't have the ability to hold a particular bond to maturity, realize the par value plus the coupon payments along with way. As interest rates rise, those performance numbers become less and less attractive to bond investors overall in a rising interest rate environment. The alternative strategies like QAI for example, which is our multi-strategy ETF, it's the largest alternative ETF in the market with over a billion dollars in assets, have a very similar volatility profile to a diversified bond portfolio, yet they don't rely exclusively on interest rate risks to generate their returns. What we've seen is in periods of rising interest rates these strategies become very effective as a way to hedge some of that interest rate risk in investor portfolios, while at the same time helping mitigate some of the downside like we've seen in the stock market this year.

Nate Geraci: Kevin what about an environment like we're in right now where perhaps rates are coming down?

Kevin DiSano: Yes, in a declining interest rate environment obviously investors want to maintain a nice exposure into their fixed income part of their portfolio, so we're not certainly advocating investors take all of their bonds, sell out of their bond part of their portfolio because of the threat of rising interest rates and have alternatives and equities as their only allocations. Investors should have a mix of three components: stocks, bonds and alternative strategies. If you implement that type of a portfolio you can actually take advantage of these types of environments when you have the bond part of your portfolio in a declining rate environment performing quite well, especially during periods of market stress. The alternative strategy part of your portfolio is going to act almost like a keel on a boat, you don't really care much about it in calm weather, but when things get nasty you're really glad that you have it because it's going to keep you a little bit more stable in the water. That's what we're really talking about here in this type of environment is you have a lot of different forces working in the market and so having an alternative strategy in your portfolio can really be a nice diversification tool and mitigate some of that volatility.

Nate Geraci: I think a good example of that, you mentioned your flagship ETF, the IQ Hedge Multi-strategy Tracker ETF, ticker QAI. It's only down about 2% so far this year while you have the S&P 500 down over 8%. I guess for our listeners can you explain in a little more detail exactly what this ETF does?

Kevin DiSano: Absolutely, it provides exposure to six of the more popular hedge strategies in one wrapper. Just very similar to what you would experience if you invested in a traditional fund of hedge fund portfolios, except in an ETF wrapper, it's a much more cost efficient and tax efficient strategy and it's available to all investors. There's no lockup requirements, it’s fully liquid on a daily basis or intra-day basis with the ETF. You have the ability to have that alternative exposure in your portfolio by in one wrapper with QAI that provides exposure to six of the more popular hedge strategies. One of the things that we like to talk about it is it's almost like the S&P 500 of the alternatives world. It provides you with a nice benchmark exposure in the alternative space for those investors that don't want to have to decide, do I want to put money in a long short strategy or a global macro strategy or a market neutral type strategy. You can buy QAI and have all of those different types of strategies in one wrapper for your portfolio.

Nate Geraci: Again we're visiting with Kevin DiSano, Chief Portfolio Strategist at IndexIQ. Kevin, you know often times I think the average investor hears the words hedge fund or alternative strategies and automatically thinks complexity or that maybe this is something only available to the wealthiest investors. I know the idea with QAI and your other hedge fund ETFs is to make these strategies accessible to everyone. What's the best way for investors to become comfortable with these strategies?

Kevin DiSano: I think it's really to understand what you actually own in these types of strategies. Again, to your point about the complexity, that was one of the big challenges when you're dealing with hedge funds. Traditionally hedge funds were only available in a partnership type structure to accredited investors, in other words those with a million dollar net worth or higher and they were very opaque, you didn't know exactly what was in those portfolios. Now with these strategies being in an ETF form you can see exactly what's in those portfolios, if you go to our website you can look at the holdings on a daily basis and what you actually own in these portfolios is exposure to the same asset classes that hedge fund managers themselves are exposed to, which essentially are stocks, bonds, commodities, currencies, real estate and cash.

At the end of the day those are the same six things that we're all picking from whether you're a hedge fund manager or an individual investor managing your own portfolio. The thing about hedge fund managers is they deploy that capital in those asset classes a little bit differently then what most traditional individual investors would have in their portfolios. As a result, you get a very different volatility profile and as you pointed out, this year is a good example of that. QAI is down about 2%, you have the stock market down 8% in the United States, a little bit more then that even globally and so now you have a portfolio that's performing very differently than traditional long only stocks and long only bonds. That's the whole point here is that transparency, the cost efficiency is much more attractive and certainly when you look at the tax efficiency of an ETF wrapper versus some of these other types of structures, for hedge fund strategies it really makes a lot of sense for individual investors to consider.

Nate Geraci: All right, we have a few minutes left here. Before we let you go we've talked today about negative interest rates and currency devaluations and then you add to that a slowing global economy. We still have geopolitical uncertainty in places like the Middle East, we have a presidential election coming up in November, there's a lot to digest for investors right now. Any words of wisdom you can offer to investors?

Kevin DiSano: Well yes and unfortunately my crystal ball broke a few years ago so it's very, very difficult to ... You laid out a whole host of issues that are very, very uncertain and I think this is actually what you're seeing in the market is a lot of uncertainty because I've yet to meet anybody in my almost 25 years in this business that's able to predict exactly what's going to happen in one of those areas much less all five or six of them that you mentioned. For investors I think the real key in this environment is to have a very well diversified portfolio and a lot of people hear that and they think about okay great, but how do I know if my portfolio is diversified? Well here's the best litmus test, whether you look at your portfolio monthly or quarterly, the thing about your portfolio to consider is, am I unhappy with one part of my portfolio all the time? That's really important because if it's not the same part of your portfolio all the time that's a pretty good gauge that you have a properly diversified portfolio. If there's something that you're unhappy with all the time that's probably a good idea and that takes the typical investor mentality and flips it on its head because everybody always wants to look at the thing that's performing best in their portfolio. Nobody complains about those parts of their portfolio, so if you have a diversified portfolio and you're looking at in on a quarterly basis and there's always something that you're unhappy with but it's never the same thing in your portfolio that's probably a good litmus test for most individual investors.

Right now it's probably going to be the stock portion of their portfolio. The last few years it might have been some other part of their portfolio, but that's really the key in this type of environment is to have a diversified portfolio that you can rebalance on a periodic basis to take advantage of some of these buying opportunities. The whole idea here is to buy low and sell high and a lot of investors forget that and rebalancing helps you do that because you're taking your allocation where it started and you're actually rebalancing to that from the assets that have performed well, adding that money then, taking it off the table to the assets that have not performed as well. That's really the key in this type of market environment to navigate your way through it.

Nate Geraci: Well Kevin I thought that was perfectly said, we'll have to leave it there. As always we greatly appreciate your time today.

Kevin DiSano: Thanks guys, appreciate you having us on and have a great rest of the day.

Nate Geraci: Thank you, that was Kevin DiSano, Chief Portfolio Strategist at IndexIQ and you can learn more about the entire IndexIQ ETF lineup by visiting indexiq.com and I should mention they do a wonderful job at their website of explaining the rationale for both 50% currency hedged ETFs and also alternative investments. Certainly worth a look if you're interested in these areas. Again the website is indexiq.com.