Alternative strategies are coming into focus increasingly as the economic cycle enters the late innings. One of the most powerful tools investors can add to their portfolios is what’s commonly called a market neutral strategy. It was once reserved for hedge funds and their exclusive clientele, but innovative solutions are now giving everyday investors the chance to access the strategy in easy-to-use mutual fund and ETF formats.
Frank Maeba is one of the portfolio managers at Neuberger Berman Breton Hill ULC who runs Purpose Multi-Strategy Market Neutral Fund (PMM). A number of new alternative-strategy mutual funds and ETFs are coming into the marketplace, but PMM is the only one with a strong track record of performance. We spoke to Frank about all the moving pieces in the strategy, how they fit together and how investors can use a market neutral strategy such as PMM to build a resilient portfolio.
Q: “Market neutral” is one of those terms that can have different meanings to different people. How do you define it?
It’s keeping a low net exposure to whatever market you happen to be trading. It could be a low net exposure to equities or commodities or currencies, like we have in PMM. Underneath the covers, what makes up the net is a long position or long exposure coupled with a short position. So really, if you take a low net directional exposure, you’re trying to make money off of your long exposure going up and your short exposure going down. In this particular fund, we do that across multiple classes.
Q: How is market neutral different than trying to time the market?
When you’re timing the market, you try to pick tops and bottoms and you’re taking more directional exposure. In market neutral strategies, you tend to have more static exposure made up of longs and shorts. You’re not really trying to make money so much on your net exposure. It comes down more to a security-selection bet.
So, you want to pick good longs that you think are going up and you want to pick securities that you think are good short candidates. I would say that security selection plays out over a bit of a longer period; it’s more of a medium-term trade. And you’re trying to hold those long and short positions because you think the combination can add alpha or absolute return in more of a medium-term sense.
Q: How do you decide how much weight to put into equities, commodities and currencies?
It’s a portfolio-construction exercise. We’ve done a lot of research and it’s our own personal experience about what asset classes we think can drive returns. When you set up market neutral strategies, what you’re trying to do is hopefully get the benefit of diversification across multiple asset classes with a low correlation or beta, usually to equity markets.
The way that we set up PMM is through a combination of equities, commodities and currencies. If there are four total units of risk, two units of that would be coming from equities, one unit from commodities and one from currencies.
Because we’re using many different types of securities or instruments across these asset classes, you get a big diversification benefit across the board. That’s definitely something we’re striving for across the portfolio.
Q: How do you decide which individual stocks, commodities or currencies to include, which to avoid or which to short?
We have quantitative screens that help us identify instruments that we want to take long positions in across each asset class. In equities, we want to be long stocks that offer good value or are cheap. Maybe they have good momentum, good cash flows or good balance sheets – quality-type metrics. In general, those are stocks that have performed over time and you want to be long those kinds of securities.
On the short side, we want to control market risk or beta using index futures. We couple this long position in individual equities with a short index-futures hedge. That can be dynamic in nature. So, if markets happen to be going down in a 2008-type scenario, we’re going to increase the size of that short index-futures hedge.
Conversely, if markets are going up and we want to get more return out of the long side of this trade, we’ll cut the size of that index-futures short. So basically, the net market exposure can vary a little bit, but really, we’re trying to drive returns from the alpha we can generate out of the long side of that equity trade.
In currencies and commodities, it’s a little bit different. So, we’ll go long commodities that we think benefit from two main drivers: long momentum and long roll yield. Momentum is basically that winners will continue to be winners and losers will continue to be losers. It’s a very powerful factor that can drive commodity returns. The second thing is the shape of the futures curve. If a commodity curve is downward sloping, in general you get paid to hold those futures contracts as they tick over to expiration.
Similarly, on the short side, you want to be short commodities that have a negative roll yield or are in contango and basically, you’ll be paying to hold them. In general, those are good candidates to short – you get paid to roll the exposure forward. Based on those kinds of key factors, momentum and roll yield, that’s how we set up the securities-selection process for our longs and shorts across commodities.
In currencies, it’s a similar process with slightly different drivers. We are looking for a shorter-term momentum signal across currencies – usually around three months, whereas in commodities we’re looking at around six months. Probably the most powerful driver for the currency-selection process is the nominal yields or interest rates across those countries.
Across time and through research and our own experience, what we see is that currency flows go into countries that have higher nominal yields in general. Outflows or currency depreciation will occur in countries that have lower nominal yields or even flat or negative nominal yields. In general, we want to be long currencies that have high nominal yields and positive momentum, whereas our shorts have low to negative interest rates and negative momentum.
Q: How different might the strategy look in the early part of a market cycle versus the late stages of the cycle?
It morphs over time. You can’t predict with certainty what is going to be the driver of returns across a portfolio like this. Part of the reason we trade so many diverse asset classes and instruments is that a subset of those in the portfolio can actually drive returns at any point over a cycle. So, you’re never quite sure, especially in the macro sense, what particular trade or strategy is going to be in favour at the time.
Over the last couple of years, the makeup of the book has actually been longer equities and not so heavy on the index-futures hedge. That’s really just because equities have continued to make new highs. Coming out of 2008, it’s basically just been a straight line up for the last 10 years. So, trying to identify good stocks to play the equity rally and minimizing the size of the index hedge has been generally a good way to play equities over the last couple of years.
Currency wise, it’s been a little choppier. The biggest trend has really been long US dollars and long emerging market currencies over the last two years. But that dynamic can also change. Emerging market currencies right now seem to be under a bit of pressure. So, what we’re trying to do is maximize our longs in the US dollar versus currencies such as the euro, for instance, which is negative yielding and has been under pressure for a couple of years. And then going long selective emerging market currencies that have high nominal yields and positive to flat momentum in this environment. That position in particular has seen volatility up and down.
We saw shocks in the Swiss franc three or four years ago and we were able to navigate through that position fairly well. The key to playing currencies is not only identifying things you want to be long and short in, but also sizing it properly so that you’re never overly concentrated in just one position. We really try and diversify across these kinds of trades.
Commodity returns have been mostly driven by what’s been happening in the energy complex lately. During the big selloff in 2015 and 2016, the returns were really driven out of a short posture across energy. But lately, commodities have been performing well and we’ve flipped to a more risk-on posture where we’re long a lot of the energy complex.
That gives you kind of a feel for why we add commodities. You can make money on the long side or the short side. That is very diversifying, especially when you’re trading it in a basket.
Q: How much research overall goes into running a market neutral strategy like PMM?
The partners who created this Fund, in one way or another, have been trading these types of strategies for over 20 years. We’ve been managing this particular type of strategy since 2006. In terms of the quantitative and research horsepower behind it, we have a fairly large team.
There are 15 people involved in quantitative research. We have a 40-person analyst team which provides fundamental insights. We have a five-person team of data scientists which is really keeping us on the cutting-edge of technology and alternative types of research.
It’s an evolutionary process. The core construction blocks of the Fund remain constant over time, but if we can find incremental improvement, that’s something we always strive to do.
Q: What’s the benefit of adding a market neutral strategy to a portfolio?
Over the last decade or so, you pretty well had to be invested in equities and bonds. They both rallied together and that’s not usually par for the course. Usually, people have bonds in their portfolios to hedge against equity risks. But, in the case of the last 10 years, it’s been a special period for risk assets, mostly driven by central banks. And now we see that times are changing.
The US Federal Reserve is hiking rates, central banks are removing stimulus policies, equities are pretty well at all-time highs and you can no longer count on bonds to be your incremental hedge against risk assets because bonds are also at all-time highs and coming off them. There’s been a huge drive over the last couple of years to find what will be core absolute-return drivers across a portfolio.
Many investors don’t want any more exposure to long equities and don’t want any more long exposure to fixed income or credit. So, they ask, ‘what other asset classes can give me a non-correlated absolute return with a low beta to the equity market?’ That’s why we’ve come out with this Fund.
It’s been out for a number of years, but I think now is really sweet spot for it. It’s had fairly strong returns over the last couple of years. It has really low correlation to equity markets. People are looking for different ways of generating returns.
We’ve seen in particular this year, commodities are the best-performing assets across the Fund. Previously, it was currencies really driving it. The ability to identify trades or strategies that can perform in markets that don’t include equities and rates is going to be in high demand in the near future.
Q: Some investors may not be comfortable with the idea of owning or shorting currencies or commodities – why is it important to include those asset classes?
That’s where your diversification benefit really comes from. Even being long commodities and long currencies will offer some sort of diversification benefit but being able to short adds to that. And to be honest, that’s actually how you protect yourself in part if you do see a larger pullback in market.
I think back to 2008 and I look at some of the core things that performed for us in our previous portfolios, and it was short wheat and short energy. They were two of the best short performers, even outperforming short equities. The best currencies were long US dollar and in particular short British pound. Even though everyone associates 2008 with the credit crisis when equities went down substantially, there were other parts and other instruments in the market that were even better short candidates that helped drive decent returns in a pretty tumultuous period.
With asset values inflated to where they are, the ability to short and be able to identify securities that may be vulnerable in a downturn – that’s a big addition to any type of 60/40 asset mix.
Q: How do you risk manage the Fund?
We’ve built out a ton of technology and systems that helps us manage the complexity of it. It’s fairly straightforward and seamless to us, even though from the outside it might look like a lot of positions. But the complexity is actually fairly easy to manage. There’s not too much touching of the portfolio on a daily basis.
In terms of larger decisions, we do use quantitative tools but sometimes we do have to step in and make more of a qualitative decision. For example, when the Swiss franc peg blew up a couple years back, the Fund wasn’t in a huge drawdown, but we decided to trim our Swiss franc exposure back a little bit. That was more of a qualitative-type decision that we felt best suited the overall risk profile of the Fund. From time to time, we’ll step in and manage risk actively.
Q: How would the strategy react in a major market decline?
The equity side will get impacted, but as markets sell off and continue to sell off, we’ll try to minimize that net long-equity exposure to the minimal amount that we can. In terms of commodities, we will short the more cyclical, risk-on types of commodities – usually energy and base metals that are in general associated or correlated to global growth. I’d imagine we’d migrate short across the board. In currencies, we have the ability to increase the Fund’s long exposure to US dollars versus more vulnerable currencies – and that’s a big hedge as well in those scenarios.
We can’t promise returns, but that’s how the portfolio would probably migrate. With those kinds of tools at our disposal, with the ability to get outright short, we’re going to perform much better than an outright long position in the S&P 500.