The Horizon Kinetics Inflation Beneficiaries ETF (INFL), which launched in January, quickly has become one of the breakout hits of 2021. Already the fund has amassed $620 million in assets under management, one of the quickest-growing launches of the year.
It’s easy to see why. As inflation fears continue to mount, INFL has proven for many investors to be the right product at the right time. The fund’s portfolio of royalty companies provides exposure to inflation-protective commodities, without all the headaches and margin requirements of venturing into the futures market.
Recently I sat down with James Davolos and Alan Swimmer to discuss INFL’s trajectory, Horizon Kinetics’ path to ETF land, and how royalty companies can provide returns that actually benefit from inflation.
Lara Crigger, Managing Editor, ETF Trends: Give our readers a little bit of your origin story. Who is Horizon Kinetics?
James Davolos, Portfolio Manager and Research Analyst, Horizon Kinetics: Horizon was created in 1994 by employees of the private Bankers Trust Company. They were original-thinking, Graham and Dodd-value type investors. The world was moving toward modern portfolio theory and the efficient market hypothesis, and within the private banking construct, they weren’t able to do their type of unique thinking.
So they created Horizon Kinetics. The real impetus of the firm was about taking that long-term investment horizon. Their main competitive advantage over larger firms with better resources was to not play the game of trying to outperform in each discrete calendar year, but to really extend that over rolling 3-, 5-, 7-, 10-year periods.
Since day one, we’ve published and written all of our own research. We truly are independent-thinking. We rely on little to no Street research. So we come to many unique conclusions and investment theses.
Alan Swimmer, Managing Director, Horizon Kinetics: We don’t like going places where the rest of the Street is participating. For example, we were involved in crypto five years ago, before it was really a thing. That’s really unusual for a value firm!
We also do research on companies with different types of revenue streams. We also look at something called “dormant assets,” where there’s valuable businesses on balance sheets that aren’t being recognized in the valuation of the publicly traded stock.
Crigger: Sure, but why take that to the ETF world?
Swimmer: We were looking more into how we could develop a product for all investors so they could participate. We wanted a product that could be accessible to RIAs, family offices, etc. So we looked into ETFs, which gave people easier access and wouldn’t be too expensive. The firm had never done an ETF before.
Davolos: We actually have a family of mutual funds, which we launched in the late 1990s. Our first was the Horizon Kinetics Internet Fund (WWWFX), launched right as the Internet investment wave was starting to take hold. So we have a lot of familiarity with ’40 Act mutual funds.
But the world doesn’t seem to have much place for a small- or medium-sized issuer of mutual funds anymore. The cost structure is far higher, and the tax inefficiency is a big thing for long-term, compounding investors like us. So between the ability to be cost-competitive, and then to defer those long-term capital gains, it was kind of a no-brainer to go with an ETF.
Crigger: You launched the Horizon Kinetics Inflation Beneficiaries ETF (INFL) in January 2021. You could not have picked a better time to have launched an inflation-linked ETF. Inflation is so top of mind for, well, pretty much everybody.
Swimmer: We looked around at the different strategies, and what was available for investors to use to participate in inflation, and the choices were TIPS and commodities. We don’t think, based on what we believe will happen, that TIPS will really work; and commodities, you have to go into the futures market. My background is in futures, but even still, some of the things that can occur there—you can be right and still lose money unless your timing is perfect.
That’s where royalty companies make sense. These are asset-light businesses, you can participate in them and not worry about perfect timing in terms of direction. These ideas will compound through a full business cycle.
Crigger: What is a royalty company, in this context, and how does it serve as a play on inflation?
Davolos: If there’s inflation, you want exposure to a hard asset – some finite, high-quality, low end of the cost curve asset. In inflation, that asset will participate very aggressively. The problem is, most companies involved in these industries—from agriculture to timber, from energy to copper—are extremely capital intensive. They spend a lot of money to make their money, and they use a lot of debt to do it. But if you don’t time the cycle perfectly, or if there’s some fits and starts in the cycle, you can lose a lot of money on a long-term basis, because that working capital and debt works against you.
Royalties, and other capital-light businesses, are powerful because they spend almost zero money to make money. In Texas, they call energy royalty money “mailbox money,” because you walk out, open up the mailbox, and the check is there. They have 70-90% gross margins. When you have that high of a return on assets, you don’t need to use debt financing. These companies can scale with inflation, but they don’t have a lot of the negative components that you typically have to accept to get exposure to these types of markets.
Swimmer: I think a great example is gold. Look at gold since 2010 or 2011 to now; the price remains pretty close to flat. If you look at gold miners, you’re seeing about a 50% decline. But if you look at the largest gold royalty company – it has returned over 220%.
Crigger: That’s huge. But what business would a gold royalty company be involved in, exactly?
Davolos: Imagine you wanted to dig in Nevada to mine for gold. And the mine was going to cost you $300 million. It’ll be really tough to get a loan to do that, because you have no cash flow coming in through the door, and your cash interest cost will be very high. It’s a prohibitive form of financing, and quite frankly, the markets aren’t even willing to accommodate that today, given how the gold cycle has played out for the last decade.
But a royalty company, or a streaming company, could come in and say: “We’ll give you the upfront financing. But now we own part of your production free and clear for the life of your mine.”
That’s how many royalty streams originated. Nowadays, they’re large, diverse portfolios, where you have basically a call option on the gold price, as well as on the production level/life of the mines.
People ask, how can you really invest in the future of gold? It’s going to get harder: there’s fewer mines, fewer streams available. But what I want is access to the biggest and best portfolios today, where you’re basically investing in the existing portfolio, not the ability to go out and expand the portfolio as a capital allocator.
Crigger: So in the example of gold miners, royalty companies are looking at proven mining operations. They’re not necessarily financing brand-new exploration so much as expansions of existing mines or mining businesses, and as part of the trade, they’ll own part of the mine.
Davolos: For gold miners, they’re looking at the largest and best streams in the world. You want top-quality jurisdiction. So think North America, South America, Mexico. And you want the best operators, so Newmont (NEM), Barrick Gold Corp (GOLD), and Goldcorp (GG), and so on. There’s a place for the more speculative jurisdictions and the juniors, but it’s de minimis in the overall portfolios.
Crigger: So this is an inflation-linked ETF, of course. You probably believe we’ll see much higher rates of inflation ahead, especially given the big prints we’ve seen come down the wire lately. Can you share with us your expectations of future inflation?
Davolos: Honestly, I think one of the biggest difficulties when talking to people about inflation is: how do you define inflation? CPI is imperfect, at best. Between the substitution aspect of the methodology as well as the quality adjustments and the government’s influence over it, the CPI has certainly understated my living expenses over the past decade.
Inflation is probably not going to be a runaway scenario. But I do think there’s going to be discrete pockets of undeniable inflation, whether it be in energy, base metals, precious metals, agriculture, used cars…yes, some supply chains are going to get back in force quickly. But there’s going to be more shifts than are enduring. Take wages. You don’t raise wages to $18/hour, then a year later say, “just kidding, you’re back to $12/hour.”
When supply chains adjust to a higher clearing cost, then the entire network revolves around a new clearing price. With some things, if there’s a theoretical infinite supply, then the requisite amount of demand matters. But in other areas, where people are only looking at the demand side of the equation, supply will be more important for the long-term inflation trends. Specifically, I’m talking about labor.
A lot of these producer price inputs, you’re seeing the leading edge of inflation today. That’s how I see this is playing out most likely.
Crigger: What do you think most investors misunderstand or overlook about inflation?
Davolos: I think people commonly look at a company and say, “Oh, there’s the evidence of inflation.” Let’s look at a random example: Apple (AAPL). Of course they can raise their prices 4% a year, if their cost of goods sold goes up 4%. But they also have to pay their staff. They also have to do R&D. They have to go out and borrow in the capital markets at higher interest rates. So it’s not as simple as seeing who can raise prices should inflation go up. There’s a much bigger trickle-down effect.
The other thing that I think will be challenging is how sensitive a company’s valuation is to real interest rates. It might be a great company that can push out some prices. But all else held equal, if the 10-year Treasury moves out another 2% due to inflation, then if a company trading at, say, 30 times earnings goes back to 20 times or 15 times, then that’s a heck of a lot of room to make up with new found revenue on inflation. The duration or interest rate sensitivity of the market is another thing I don’t think is well understood.
Both these are systemic risks that aren’t properly appreciated when the word “inflation” is used in a sentence.
Swimmer: We think inflation is going to be a big risk and something that people will have to think about, not just through the end of this year, but probably for the next 5-10 years. I wouldn’t be surprised if, seven years from now, we’re going to be arguing about whether inflation is real or transitory.
But we also believe that given how the portfolio has been constructed by James, that INFL offers a full-cycle portfolio. It’s not just a straight bet on inflation. This is a portfolio that does well if the market continues what it’s going to do—you’ll get a nice dividend. But even if you don’t get inflation, you can still be very fine with this product.
Crigger: It’s unusual—and quite refreshing—to see a small shop like yourselves find so much success right out of the gate. INFL’s only been around for only a few months, and you’re already over $600 million in AUM. Part of that is that this is the right product for the right time. But you’ve also had to pound the pavement and fight for every dollar.
Swimmer: Sure. The firm has been around for 25 years. While we’re a niche firm, people know we’re good investors and that we do some things that are intelligent and different than most investors. We think differently than the rest of the crowd. That’s played into our success.
But yes, we work very, very hard to get awareness out. I’ve got a fair amount of experience in the business, working at Wall Street for over 30 years, as do Andy, James, our entire team. But we’ve done it unconventionally. We spent no money on advertising. That’s not who the firm is. We don’t do TV commercials or pay for SEO on Google. We just have been very aggressive on social media, and we’ve been fortunate that some really great people have invited us onto their podcasts. We’ve made friends. We’re not bashful.
Crigger: Any more ETFs in the works?
Swimmer: Not at the moment. We’re trying to do one thing really well first, before we do the next thing.
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