ETF Insider is a new Q&A series with the visionaries and innovators transforming the ETF industry. Today we profile Kevin Kelly, Chief Investment Officer of Recon Capital Partners.

What is your role?

I serve as the Chief Investment Officer of Recon Capital Partners where I oversee all research and investment strategies. We have two sides of the business. One side, we manage private capital using individual securities and options on top of a core ETF allocation model. The other side is to provide innovative publicly traded products to be on the forefront of asset allocation — ones that blend the traditional advantages of alternatives but in a simple, easy to implement exchange traded fund.

How long have you been at your company and what drew you there?

I founded the company in the 4Q of 2011 with my partner Garrett Paolella. We built the business on the premise of providing advanced risk-adjusted strategies without the constraints typically associated with hedge funds, private equity and other traditional alternative investment vehicles.

Kevin Kelly

Our business model is pretty straightforward: provide investors with all the potential advantages of alternative investment strategies—diversification, risk mitigation, low-correlation and enhanced risk-adjusted portfolio profile—but without the constraints of traditional limited partnership structures. Instead, we provide investors daily liquidity and transparency so they will have the ability to rebalance easily, enable the opportunity to make strategic allocation decisions without any constraints, have the flexibility to make frequent tactical changes, and give the comfort of knowing that their assets can be converted to cash each day. We view the 1940 act space (ETF space) as one of the best ways for us to deploy our absolute return strategies.

How long have you been working in the industry?

I have been working in the industry since 2004. I obtained my series 7 and 63 licenses at age 19 and fell in love with investing. I’ve worked at several bulge bracket firms in capital markets and asset management capacities.

What does your firm do with ETFs?

Our firm utilizes ETFs in two facets -

1. We are an ETF issuer. We issue ETFs that fill a need in our own private portfolios and that will fit well in any global asset allocation. In December of 2013, we launched the Recon Capital NASDAQ-100 Covered Call ETF (QYLD ) as a fixed income alternative. We currently have two funds in registration: The Recon Capital FTSE 100 ETF (Nada: UK) and the Recon Capital DAX Germany ETF (DAX) which provide exposure to the 4th and 6th largest economies in the world. The FTSE 100 and DAX indices are not currently exchange traded in the US. We have several more ETFs in the pipeline and are looking to launch more in 2015.

2. We also use ETFs as the cornerstone of our global tactical asset allocation. The foundation of our strategy is to offer risk reduction, uncorrelated returns, and liquidity across multiple asset classes ETFs. The appeal of the global tactical asset allocation lies in its potential to weather an array of economic and market environments delivering uncorrelated returns. Our process is risk-focused, concentrating on volatility, which helps us to determine sensitivities to various market conditions and how correlations, among other variables, will impact the portfolio.

What are the major benefits that ETFs bring to your client base?

We believe the major benefit of ETFs to our clients is the access to nontraditional index strategies that are redefining the ETF space. As investors are facing a “rebalancing conundrum,” we believe these strategies are needed now more than ever given growing concerns about lofty equity markets, the resumption of interest rate hikes, and the increasingly cozy relationship between the prices of many traditional assets during times of uncertainty.

Our first ETF, the Recon Capital NASDAQ-100 Covered Call ETF (QYLD) fits that mold as a fixed income alternative. Unlike bonds, it does not have duration or interest rate risk and provides a high level of differentiated income because it sells NASDAQ-100 index call options against the portfolio every month. The portfolio consists of all the NASDAQ-100 constituents including Apple (AAPL ), Microsoft (MSFT ), Google (GOOG ), Starbucks (SBUX ), Facebook (FB ), Gilead Sciences (GILD ), and QUALCOMM (QCOM ).

We believe it fills a demand in low interest rate environment as QYLD, since inception, has distributed between roughly 0.80% — 1.0% a month and does not rely on the credit of one company or even interest rates for that matter. It also provides professional options management at a 0.60% expense ratio, a relatively low cost when compared to a self-directed account. Covered call strategies can have higher transaction costs over traditional buy and hold strategies. It also removes the necessity of having an options and margin agreement in place.

The major benefits to our client base is that they are getting an alternative strategy but are not constrained by a number of factors like investor qualifications, investment minimums, costs, and tax reporting. Furthermore, there is transparency into portfolio holdings, and the investment decisions behind them.

Why should an individual investor consider ETFs as part of their investment strategy?

I think users are already familiar with the liquidity, transparency, cost efficiencies, tax efficiency and intra-day pricing.

I think one of the biggest considerations would that ETFs are similar to mutual funds, but they are significantly less expensive to own since they are designed for passive investing and not active management. The average equity mutual fund charges between 1.3% and 1.5% in expense ratio. Meanwhile, the average equity ETF charges just 0.60%.

Investors should also consider ETFS because they could replace higher cost mutual funds, which may be closet indexers, with an index fund and still reap diversification but at a lower cost.

How have ETFs responded to recent events in the world economy?

ETFs can, and do serve, as hedging mechanism in asset allocation tilts. I think it is most pronounced when there are geopolitical conflicts as investors move towards treasuries and gold ETFs as a flight to safety. ETFs has given investors the ability to express market views through both long and short positions and provides increased flexibility to take advantage of any economic environment within the same asset classes.

I also believe that ETFs serve as a great proxy to hedge exposure to a certain sector or asset class. Take for example the traditional ways of hedging risk which used to be security vs. security – going long Coke and shorting Pepsi. Now with ETFs, managers can remove the unsystematic risk of going security vs. security and have the ability to go security vs. sector.

A perfect example would be if an investor owned McKesson (MCK ) and sold short the health care ETF. As of July 25, McKesson was up over 60% and the health care ETF was up only 20% over the past year. The ETF removes unsystematic risk of the other company since there are a basket and hedges the health care sector exposure solely focusing on McKesson as a business. This approach allows an investor to add the benefits of the strategy, while mitigating the idiosyncratic, company-specific risk.

How have strategies changed over the years?

Strategies have changed from plain vanilla market cap weighted — think NASDAQ 100, Russell 2000 – to utilizing alternative indexing methods. It started with equal weighting and has now evolved to focus on other factors including value, momentum, size, and volatility. The strategies call themselves “fundamental,” “enhanced,” or “strategic.” The strategies have also been built around factors like retained operating cash flow, buybacks, and even dividends.

The role in portfolios would be to get similar exposure to an active manager but at a fraction of the cost – say sub 0.75%. The other role, that I am not sure everyone is considering, is that these strategies are set to exploit anomalies and those anomalies will be eliminated over time. Most are merely an effective strategy for the moment and investors need to be ready to shift their investment capital around at a moment’s notice from one segment to another such as shifting from momentum based to low volatility.

Investors need to be aware of money flooding in and out of these strategies as some could be capacity constrained leading to their presence to drive up the correlation of stocks and/or drive up stock prices as they are rules based.

I think it is important to note that 9 out of the 10 largest ETFS today are market-capped weighted equities and the only one that is not is gold at the eighth largest. I do not believe that dynamic will change as those ETFs are not capacity constrained and give market exposure at a very cheap cost.

When discussing ETFs today, what are we not discussing that we should be?

I think we are not discussing how ETFs are impacting corporate governance now in passive structures and possibly in the future with active and nontransparent ETFs.

Current rules had all but required many investment fund managers to hand off voting decisions in corporate elections to outside proxy advisers and those proxy advisory firm recommendations have a substantive impact on companies. The problem of outsourcing of voting to proxy advisory firms could have unintended economic consequence that boards of directors are induced to make choices that decrease shareholder value.

One of the major issues is that the two main firms, Institutional Shareholder Services and Glass Lewis, are riddled with conflicts of interest. ISS sells consulting services to corporations and is owned by a private equity firm and Glass, Lewis is majority-owned by a pension fund for a teachers union. Their market dominance in proxy voting can empower a few individuals to fundamentally transform corporate governance without owning a single share of stock.

The issue is particularly charged right now, as activist hedge funds have become more aggressive in challenging management and nominating dissident directors to boards. The SEC has recently given new guidance that allows ETF providers to abstain from voting but we will have to see how that plays out. I think the SEC needs to really consider how the advent and growth of actively managed and potentially non-transparent ETFs will play a role in this corporate governance as well.

What are some of the biggest challenges in trading ETFs in today’s markets?

I think one of the biggest challenges is in trading ETFs are distinguishing the correlations and differentiations between ETFs. Take for example an investor who is seeking to diversify their real estate ETF exposure and wants to solely focus on residential real estate. The problem is that three of the top five holdings, over 26%, in the residential real estate ETF are not residential REITs and have different lease length and dynamics than traditional residential real estate. One position is a storage company and the other two are healthcare REITs, a far cry from residential.

Another component of the correlation challenge is that equity, sector, and asset correlations have been running extremely high since the financial crisis of 2008. This can be attributed to many factors including fiscal and monetary policies (quantitative easing, tapering, zero interest rates). As of June 2014, the average correlation for the 10 sectors of the S&P 500 to the index itself fell to 68.7% last month, which is still above the 50% reading from the 1980s-1990s but significantly lower from the 95% levels of mid-to-late 2011.

It actually represents a post financial crisis low. Currency correlations to US stocks are near zero in regards to the Aussie dollar and Euro and high yield bonds now trade at a 25% correlation down from 2009 to 2013 when their price correlation was 50-90%. ETF asset allocators need to comprehend how correlations will disperse as assets start to trade on fundamentals rather than central bank policy.

Other challenges include the usual suspects of operational issues, such as tracking error and trade failures, and regulatory burdens.

How do you see the future of ETFs changing over time?

I see the future of ETFs giving investors access to innovative yet easy-to-use liquid alternative funds that enable investors to utilize advanced risk-adjusted strategies without the constraints typically associated with hedge funds, private equity and other traditional alternative investment vehicles. The best reference can be how low volatility funds and ‘high dividend’ funds have helped carve an equity exposure niche. I think that success will morph into the aforementioned alternative funds.

Just take a look at the senior and levered loans ETFs which have taken off in the past few years in this low interest rate environment. There are filings to release Bitcoin ETFs and most recently the SEC gave regulatory approval to credit default swap (CDS) ETFs. CDSs typically are harder to trade and are operated in privately negotiated markets where an International Swaps and Derivatives Association agreement is required. ETFs are gaining traction in asset classes outside equities and I believe these ETFs will evolve and have more traction than non-transparent ETFs – should they get SEC approval.

What questions are you hearing most often from your clients?

Our clients ask us often about liquidity when it comes to ETFs. Most often it is hard to know the difference between an ETF’s volume and its true, underlying liquidity. The first two things clients see are price and volume.

An ETF does not require a certain amount of trading volume in order to be liquid. The underlying securities of the ETF determine its liquidity. When evaluating an ETF investors should ask one question, “What is in this index?” For example, our ETF owns a highly liquid and well-benchmarked index, the NASDAQ-100, and sells the front month index options against those positions. The top positions in the portfolio include Apple, Microsoft, Starbucks, Gilead which are deep and liquid names. The volume and liquidity depends on those names.

Another question that is often asked is that if they try entering or exiting of significant size, will it impact the share price of the ETF? Buyers, sellers and trading volume do not dictate price fluctuations for equity index ETFs, but rather the up and down ticks of the securities within the index that the ETF tracks.

What do you do for fun outside the office?

I try to get in as much traveling, snowboarding, yoga, and family time as possible. One caveat is that I am a true student of the market, so outside of the office you can catch me reading books on the market and Barron’s. The current book I am reading is The Predators’ Ball: The Inside Story of Drexel Burnham and the Rise of the Junk Bond Raiders, which depicts the leveraged buyout boom in the 1980s and the men behind it including Michael Milken, Carl Icahn, Ron Perelman, Steve Wynn, and Nelson Peltz. The name of the book references the conference that was thrown every year and the Beverly Hilton.