INTERVIEW: How Brooks Cutright Thinks About Index ADDS and Market Opportunities

Pretty much every investor owns an index fund. Far fewer understand what happens when those indexes rebalance or the opportunities those forced moves can create.
That’s the idea behind the Hedgeye Index Adds ETF (NYSE: ADDS), a systematic strategy run by Brooks Cutright designed to identify stocks positioned for potential inclusion in major indexes.

We sat down with the Hedgeye Asset Management Portfolio Manager to discuss how the strategy works, what he watches for signs of market stress, the lessons that shaped his investment process and the rules he refuses to break.

1. For people who've never heard of an "index add" strategy — explain the mechanical trade you're capturing and why it exists.

Pretty much everyone owns an index fund somewhere. It's either in their 401k, their IRA, their pension, etc. What they don't necessarily understand is that when those funds rebalance there can be significant price moves. They also don't necessarily understand that at any given time, their index fund may hold stocks that don't meet the criteria to be admitted if they were to start over. My strategy offers people a way to complement their index fund with the stocks that meet the criteria to be included and are positioned to benefit from a market move when they are admitted.

2. What's your process for screening candidates likely to be added to the S&P 500 or other major indexes?

My process is essentially the same process as the major indices I track. I look for minimum market cap and liquidity, then, if I'm looking at a straight add, I look to see if a company is profitable, or at the very least if it's forecasted to be profitable in the medium term. S&P announces its next rebalance in early September so the book is positioned for the cycle now. Roughly 11 trillion tracks these indices and is required to buy every addition, regardless of price.

3. Looking back over your career, what market shift fundamentally changed the way you invest?

2008. Prior to the events of the GFC we didn't really have an activist federal reserve. The fed's (and others) balance sheet is absolutely something you need to keep an eye on.

4. When you look at markets, what indicators or signals do you pay attention to before anything else?

Factor volatility and credit spreads. Both are early warning signals that can indicate that although the water looks still on the surface there can be strong undercurrents. For factor volatility you can look at the daily volatility of the spread of say the iShares MSCI USA Momentum Factor ETF (MTUM) over the State Street SPDR S&P 500 ETF (SPY). For credit spreads just watch the Invesco Senior Loan ETF (BKLN), when that is really selling off you know that people are truly panicking.

5. What is one market misconception you believe investors repeatedly fall for?

A big misconception is that stocks and bonds always diversify each other. Not true. Bonds can diversify you from a stock implosion (see 2008) but stocks will not diversify you from a sovereign credit issue (see Europe PIIGS in 2011).

6. How often does the portfolio actually change, and what's the difference between a shift that's driven by genuine regime change in the macro data versus something you'd dismiss as short-term noise?

ADDS is a systematic strategy so the turnover and composition is a function of what the market is giving us.

7. What's one mentality trait you believe every PM absolutely needs to have — something you'd consider non-negotiable regardless of asset class or strategy?

A few things come to mind. You need to be able to emotionally detach and stay objective. Fear and greed can equally cloud your judgement. You also need to be able to not get emotionally attached to a particular trade, stock, trend, etc. Lastly it is critical that you don't dwell on the past - good or bad.

8. Do you have any rules you never break, regardless of how good an opportunity looks?

For ADDS specifically I aim to always sell on inclusion date. If a stock is chosen to be added or promoted I don't want to overthink things; I'm happy to just take the win and move on to the next. There will always be a next. For general rules - always have a max position size that you can never breach.

9. Walk us through the best trade ADDS has captured so far and what made it textbook.

The best trade so far was Marvell Technology (MRVL). It was positioned at the maximum permissible size before announcement and S&P added it to the 500 in June. It rallied into announcement and stayed there as we sold out on inclusion date.

10. Is there an investor or intellect from history you wish you could sit down with for a day — not just to pick their brain on markets, but to understand how they approached problems and made decisions in general? Who would it be, and what do you think you'd take away from it?

There are three. Charlie Munger, Bruce Greenwald, and Stan Druckenmiller.

• Charlie Munger for the axioms, historical perspective, and brutal honesty.

• Bruce Greenwald for technical valuation expertise.

• Stan for how to best monetize.