ETF MarketPro (ETFMP) recently spoke with Michael Paciotti, Chief Investment Officer at Integrated Capital Management (iCM), to discuss his firm’s approach to investing with exchange traded funds.

ETFMP: Tell us a little about your firm and investment philosophy.

Paciotti: iCM originated as a “lift out” of the investment department from one of the nation’s largest mutual insurance companies where we managed a $775mm proprietary investment program since 2004. Today, iCM provides outsourced investment management services to both institutions and individual high net worth investors using a contrarian approach that combines a focus on relative valuation with a patient, long-term philosophy.

ETFMP: How do you identify opportunities?

Paciotti: We are quantitative investors who seek out inexpensive common factor beta exposures. Typically, we find that by operating around the edges of asset classes, regions, styles or credit qualities where we can find inefficiencies where others may not be willing to tread. By buying inexpensive assets and selling expensive assets our goal is to capitalize on the mean reverting quality that exists among broad asset classes and factor exposures.

For example, we were early adopters of high financial quality equities in 2006. Given the tremendous rally in value stocks and in lower quality segments of the market such as REITs, your franchise type big blue chip names had become very cheap on a relative basis. We held this position until early 2009 when it was neutralized but have since gone back to it.

ETFMP: What opportunities are you seeing today?

Paciotti: Generally, we are seeing a multi-year inflationary theme as we think the Fed will use the wealth effect to encourage consumers to start spending again. We see inflation manifesting itself in one of two ways, either cost push or demand pull inflation with the latter being the least likely but still a possibility. We are positioned for both by including broad based commodities in our portfolios as well as implementing a treasury yield curve flattener strategy as a portion of our fixed income strategy.

As I mentioned before we are also high on high financial quality equities. We see these companies benefiting as organizations who can maintain pricing power in an inflationary environment and who have an international footprint that can benefit from a weak dollar environment. These franchise names are organizations with low debt and high and stable ROE.

On the sell side, we have a great deal of concern for the REIT market which is likely reaching bubble status. These organizations have appreciated by more than 134% from market lows and are typically highly leveraged organizations. Given the legal requirement for REITs to distribute the majority of their earnings n the form of a dividend, a 3.5% yield is not nearly enough to composite for the risk in this market.

ETFMP: How do you incorporate exchange traded funds into your practice?

Paciotti: We start with the strategy and then look for the best products to provide the appropriate exposure. We use a lot of multi-factor regression analysis as a starting point to find the right products. In determining if an ETF is a workable real world solution we look at index construction rules, the liquidity of the underlying assets, tracking error and total cost including the bid-ask spread relative to NAV.

ETFMP: What innovation would you like to see in ETFs?

Paciotti: One thing we’d like to see are inverse ETFs that are better equipped to track the short side of the market. The usefulness of the current funds is limited because they have a one day beta. In an environment where most assets are becoming expensive, we see more opportunities on the short side of the market but little ability to implement these ideas where we have long only mandates.