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By Scott Burns | 09-18-2014 05:00 PM

Alternative ETFs Gaining Traction

Multi-alternatives and merger arbitrage ETFs are gaining adoption as advisors look to limit downside risk and address a challenging fixed-income environment, says IndexIQ's Adam Patti.

Scott Burns: Taking the pulse of alternatives in the ETF space: Hi, there. I'm Scott Burns, Morningstar's global director of manager research. We're here at Morningstar's ETF Conference 2014. Joining me today is IndexIQ's CEO and founder, Adam Patti.

Adam, thanks for being here.

Adam Patti: Thanks for having me.

Burns: Adam, when we look at this space right now, we look out there in investment products and we see tremendous growth happening in alternatives. It's definitely happening in mutual funds; is it happening in ETFs as well?

Patti: It is, and we're very fortunate to be right in the middle of that with products with five- and six-year track records. So, we've been out there educating advisors for some period of time, but alternatives are definitely the thing that advisors want to talk about. And when combined with ETF structure with the tax efficiency, it's something very attractive to them.

Burns: When you look out there in the advisor adoption, who's really gravitating toward this? Is it rank-and-file [Registered Investment Advisor] or is it more of this institutional ETF managed-portfolio manager we're looking at?

Patti: I think it's really across the board. Our primary channels are the RIAs and the wire-house advisors, and we're seeing it across the board. Either they're running their own ETF models, where they want to fill an alternative sleeve, or particularly at the home offices of some of these firms--they are running their own ETF models that the advisors are migrating to. And they're all looking for downside protection, which is of course the primary driver of alternatives.

Burns: Now, there are a lot of different flavors of alternatives. Morningstar has nine categories in the alternative space. Where are you seeing the most interest right now? Is it multialternative, managed futures?

Patti: We're seeing it in two places; multialternative, for sure, as well as merger arbitrage. Merger arbitrage is something that we've seen quite a big pickup in over the last three months or so. We're pretty bullish on that strategy.

Burns: Advisors who are looking at merger-arbitrage strategies, when you talk to them, what role in the portfolio does it fill? What's it going in for? What are the expectations around that?

Patti: The biggest concern on advisors' minds today is what to do with their fixed-income allocation in a rising-rate environment. And as we know, hedge funds traditionally give 4% to 6% over risk-free; when rates rise, clearly their fixed-income allocations aren’t going to do that well. They're looking for something that's going to appreciate in a rising-rate environment, and that's what hedge fund strategies do. That's why they're really migrating that way.

Burns: That's interesting. And I've been hearing a lot about that, where this alternative is really tackling this concern around the fixed-income space. Just stepping back a second, looking structurally: When it comes to alternatives, the ETF structure, what are the benefits and then what are some of the challenges of doing alternatives inside that ETF wrapper?

Patti: The number one benefit is the tax efficiency. Can you imagine doing a merger-arbitrage strategy with 300% to 500% turnover without pass-through capital gains on a portfolio turnover?

Burns: That would be a very damaging to the overall return stream, I am sure.

Patti: It would be. So, ETFs have a huge tax alpha with higher turnover strategies. It's a big advantage to the ETF structure. The downside, of course, is you've got to look at the individual exemptive relief provided to ETF issuers to make sure that they have the flexibility to implement a portfolio properly. When implemented properly, it's going to have the same parameters as a traditional mutual fund.

Burns: By that, you mean the ability to go short or the ability to use derivatives--is that what you are getting at?

Patti: Multi-asset class, absolutely.

Burns: Awesome. Adam, thanks for joining us and thanks for sharing your insights.

Patti: I appreciate the time. Thank you.

Burns: And thank you for watching. I'm Scott Burns with Morningstar. Take care.

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