Talking ETFs With Industry Expert Gus Fleites

by: IndexUniverse

Gus Fleites has a long track record in the ETF industry. After leading the ETF effort at State Street Global Advisors for years, Fleites moved on to ProShares, where he oversaw the launch of the now wildly successful leveraged and inverse-leveraged ETFs. When he left ProShares in 2006, many wondered where he - one of the biggest names in the industry - would wind up.

The suspense ended in September when Fleites joined IndexIQ, a developer of alternatively weighted indexes and innovative investment strategies including hedge fund replication tools. The firm recently announced the launch of an asset management business, to be led by Fleites.

Fleites spoke recently with editor Matt Hougan about his new position at IndexIQ : How did you get involved with IndexIQ?

Gus Fleites (Fleites): I've known [IndexIQ CEO] Adam Patti for a while now, dating back to my days at State Street, when we managed the Fortune 500 ETF. Adam was at Fortune at the time.

We starting talking about IndexIQ early this summer, and I was intrigued in terms of everything that they had developed. What I saw was a lot of parallels with what I had done at State Street and ProFunds, which was really the theme of bringing institutional-caliber investment approaches to a much broader audience. So that's what drew you to the company?

Fleites: Yes. The idea of democratizing a lot of the tools and instruments that institutions have used for many years and finding ways to repackage those so they can be used with a broader audience. If you look at what IndexIQ has developed ... there are:

  • Alternatively weighted index products that seek to capture the type of risk-adjusted returns characteristics long enjoyed by sophisticated institutional investors
  • Portfolio strategies like rotation products that try to capitalize on inefficiencies in the market, try to add value against the broader benchmarks, and make it easier for investors to access more esoteric asset classes.
  • HedgeIQ hedge fund replication products, which I think are very well suited for the market right now. There's been a lot of talk about hedge fund replication strategies. Why do you think there's so much excitement?

Fleites: Hedge funds for many reasons will continue to play a larger role in investor portfolios. But right now, the way that people have to access them is really not suitable, I would argue that that is true even for institutions, but it's definitely not suitable for smaller investors.

It's all very exciting. And it's exciting to be able to work with an organization that has such a robust stable of indexes and is looking at very broad distribution channels to start to commercialize different products. Can you talk a little about IndexIQ's products and your marketing strategy in terms making them available to investors?

Fleites: I just joined, so pretty early days. The biggest challenge is that we do have a lot on the table, so we really have to figure out where we want to prioritize. But in my mind, we have opportunities in probably two and maybe three segments right from the get-go.

On the financial advisor side - and that includes everything from your typical wire house advisor all the way through some of the family offices and then more sophisticated independent RIA's - I think there is tremendous potential with the hedge fund replication product. So that's an area that I think we want to focus on a lot of attention pretty quickly to try to get something out. We are ready to start managing separate accounts right from the beginning. Are there any other product lines you are working on?

Fleites: The alternatively weighted index products, I think, will have appeal definitely with the financial advisors, as a better way to get exposure to core asset classes. Anyone who's looking to build an asset allocation plan should be looking at our IQ 500 product. And some of the strategies we've developed on the international side - like our international rotation products - would be solid core products, having a similar risk profile to the traditional benchmarks but with the potential to add some significant value added. People are always hungry for an alternative to a plain index product.

The other segment that I think has tremendous opportunity is the DC market. Having a rules-based product that sits squarely in the asset allocation boxes, with specified parameters in terms of how it's going to trade, with all the risk profiles and the fiduciary responsibilities of index-based products, but with the ability to generate some increment of value added, I think could be very attractive. Do you think there is going to be a shift in the retirement market away from traditional indexes?

Fleites: Traditional indexes will continue to play a very big role in the retirement market, but I think something healthy has happened over the last several months with the whole debate about fundamental indexing. Maybe we do need to rethink how indexes have been built in the past?

When you look at the IndexIQ's Rules-Based AlphaTM products, they really address the core of the market, and I think we should have the opportunity to bring some of those products out on the retirement side. Do you think hedge fund replication strategies have a place in the institutional market?

Fleites: I think so. When you look at the hedge fund issues, unless you're a very large institutional investor, you never really have the tools at your disposal to conduct proper due diligence on funds. A lot of the money that's going into alternative space right now ends up going to into a fund of funds where you're one step removed from the underlying investments; there's very little information in terms of what you're getting exposure to; that exposure is probably very concentrated in terms of having managers and strategies with the same discipline; etc. So it's a tough sell. By which you mean...

Fleites: If you look at the difficulty that an institution has in terms of hiring an active manager in, let's say, the large cap space, it's almost like looking for a needle in the haystack. It's really hard to find a good one. If you take that problem and apply it to the hedge fund space, it's that much more difficult. So I think the notion of hedge fund replication is going to start gaining traction on the institutional side as well: it distills the beta of the segment, and if you're an institutional manager, it opens up new markets without limiting capacity constraints and at low costs. What do you think is necessary to make that hedge fund replication really catch on?

Fleites: If you could come up with a liquid investable alternative that gives you the same risk profile of the asset class, which I think we can develop with these replication strategies, liquidity becomes less of an issue, the issue of manager selection goes away, you have a liquid investment that you can come in and out as you please, and you can understand it a lot better. It's going to be priced more along the lines of beta exposure rather than the traditional two and twenty [most hedge funds charge a 2% annual fee plus 20% of all returns], and I think most institutions are coming to the conclusion that hedge funds are not worth two and twenty. So finding a more reasonable way to access that beta in that asset segment is going to get a lot of attention from the institutions. Hedge funds have not been getting a lot of positive press lately. Do you think that could present a problem for these products?

Fleites: To the contrary, the reasons for the current hedge fund crises are the very reasons why hedge fund replication products represent very strong investment solutions. I think a lot of the issues that the hedge fund industry is going through now as a result of the subprime crisis are just heightening a lot of the concerns that people have for how they've been investing in the asset class. So where everything that's happening right now may be reason for pause for concern about hedge funds, I don't think that's true for hedge fund alternatives. I think the idea of hedge-fund-like returns is here to stay because everybody's realizing that a lot of the constraints that traditional equity mandates have really minimizes their ability to generate returns. We need the returns to defuse a lot of liabilities that are out there, especially on the institutional side, so I think you will continue to see money move into that space. But these alternatives offer a better way for people to put a lot of money to work in that space. When you were a free agent, you were the big name that a lot of people were looking to hire. When you were looking around, what kind of opportunities or open spaces did you see in the ETF industry?

Fleites: I spent a lot of time thinking about what I wanted to do next over the last several months. There weren't a lot of places that I was too excited about. One of the things that concerns me is that a lot of the developments that you're seeing in the ETF space is really starting to look more like what the mutual fund industry does ... you're looking at what sells, and not looking at developing products that can really sit squarely and have a real place in somebody's diversified portfolio.

IndexIQ fits squarely in terms of trying to bring out those kinds of products that will make a real difference for the typical investor. It fits a mold of everything that I've done for the last several years, whether it was at State Street, or Pro Funds, and now here.