Under The Hood Of QuantShares: Q&A With Bill DeRoche (QLT, CHEP, SIZ, SPY, DIA)

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January 10, 2012 2:19pm NYSE:CHEP NYSE:QLT

Industry newcomer QuantShares broke ground in late 2011 with its release of a full suite of intriguing market neutral ETFs. Each of the firm’s products are linked to an equal-weighted index that is both dollar neutral and sector neutral, offering long/short exposure to sub-sets of broader indexes.

Bill DeRoche, chairman and CEO, recently took time out of his schedule to discuss what makes QuantShares ETFs unique, the basics behind market neutral investing, as well discussing how the strategy might fit into investors’ portfolios.

ETF Database (ETFdb): Explain the basic idea behind market neutral investing.

Bill DeRoche (BD): The basic idea behind market neutral investing is to create a strategy that has limited correlation with the return of the equity market. We accomplish this by creating a portfolio that has an equal amount of capital in long positions and short positions. The goal of the strategy is to have the long portfolio positions outperforming the short portfolio positions thus earning a positive return for shareholders. Take for example our value strategy, this fund is long the least expensive stocks in each sector and short the most expensive ones in each sector, in equal proportions. Thus if cheap stocks outperform expensive ones, as they commonly do, then the strategy will earn a positive return, even if the market is falling. Market and sector neutrality minimizes the effect of the market and sectors and in turn emphasizes the effects of a fund’s stated strategy. The result is a diversified source of returns that investors can use to improve the risk and reward characteristics of their overall portfolio [see QuantShares Debuts Market Neutral ETFs].

ETFdb: The QuantShares ETFs are unique in that they are specifically constructed to avoid simply being long in one sector and short in another. What was the thought behind that part of the product design?

BD: Just as market neutral prevents a fund from being just another beta product, sector neutral ensures that we are not just replicating a long-short sector strategy, which can be implemented with sector ETFs. The objective of our funds is to provide investors easy access to a source of returns that have a low correlation to market and sectors.  Our strategies focus on a particular investing theme, such a value or small size, and attempt to derive as much of the fund’s return as possible from exposure to that particular theme.  For example, a returns analysis of our value fund would show the largest determinant of performance would be valuation.  The attribution to sectors would be insignificant.

ETFdb: How might that strategy fit into a portfolio? What are the potential applications of this investing technique?

BD: More than ever, investors understand the importance of asset allocation, diversification, and risk management. It is not enough that a product only offers the potential for high returns.  Investors desire products that also complement their existing investments. Our value (NYSEARCA:CHEP), size (NYSEARCA:SIZ) and quality (NYSEARCA:QLT) funds provide investors access to attractive returns, but just as importantly returns that have low correlation to the overall equity market. Combining these funds to a core equity portfolio can produce portfolios that have higher returns and lower risk. For example, a 50% allocation to the broad U.S. equity market and a 50% allocation to our value strategy over the last 10 years would have had 1/3 less risk than the broad market with higher returns [see our Low Volatility ETFdb Portfolio ]. Combinations with our other funds provide investors more opportunities to diversify, preserve wealth and minimize drawdowns while maintaining the potential for upside. Just as critical, our strategies are delivered to investors in a passive manner through a subset of the 1,000 most liquid equity securities in the U.S. market through a process that is fully transparent to all investors.

ETFdb: Market neutral strategies are nothing new, but the marriage of these strategies with the ETF wrapper is. Why does it make sense to use an ETF to pursue market neutral assets?

BD: The strategies we are offering are based on academic research and have solid historical track records. These strategies have been used successfully for many years by institutional investors. Historically, these strategies have been offered either as active strategies or through derivatives. Our motivation to use an ETF to deliver these strategies was to reduce costs, improve liquidity, increase transparency and increase access for all investors [see Six Noteworthy ETF Innovations]. The investment process for selecting securities for these strategies is a series rules and is commonly referred to as “rules-based investing”. Our idea was to use the rules that we had used as active quantitative managers to create indices that our strategies could track. The result are products that allow investors through the purchase of a single security on an exchange access to attractive diversified returns without the need to manage large baskets of long and short security positions.

ETFdb: There are some out there who believe ETFs have gone too far from their initial intention of offering broad-based exposure to buy-and-hold investors. What’s your take on the innovation in the ETF industry over the last several years?

BD: Innovation can only be successful, if in the end investors see value in the products offered. Without question, not all of the products currently available will be successful as evidenced by some recent fund closings. For us at QuantShares, when we look to innovate the starting point is always an investment strategy that has stood the test of time, one that has had relevance in different market cycles and is not just a passing fad. Next, we research the best way to deliver that strategy. We look for methods that are cost effective, transparent, liquid and differentiated.  In the end, we believe this approach leads to products that are not only innovative but ones that add value over the long term.

ETFdb: What do you expect in terms of ETF adoption going forward? What types of investors have been slow to adopt or are potentially major beneficiaries of embracing ETFs?

BD: Over the last few years ETFs have become more mainstream, both with institutional and retail investors. Retirement assets have been slower to adopt ETFs, but that is changing. Some of the most impressive innovation in the ETF market has come from RIAs who are using ETFs to build creative customized investment solutions for their clients [see 25 Things Every Financial Advisor Should Know About ETFs]. The key attributes of ETFs, namely transparency, liquidity, tax-efficiency and low cost, make them advantageous to all investors. Over the last few years, ETFs have demonstrated their ability to provide easy, cost effective access to a wide range of international markets. As more advanced strategies such as ours come to market, RIAs and retail investors will be able to access the same strategies that have traditionally been limited to only the wealthiest of investors.

Written By Stoyan Bojinov From ETF Database Disclosure: No Positions

ETF Database is committed to giving our audience, consisting of both active traders and buy-and-hold investors, information that, to our knowledge, is truthful and non-biased. [For more ETF insights, sign up for our free ETF newsletter or try a free seven day trial of ETFdb Pro ETFdb Pro Members Only.]

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