As the aging bull market in equities nears its 11th anniversary in March, North American stock markets have hit new highs recently, even as bond market yields remain low. That makes alternative strategies all the more timely, hedge fund managers say. Among the alternatives that have sprung up, mostly over the past year, are market-neutral funds.
The four market-neutral ETFs in the Canadian universe all hold combinations of long and short positions. Even within this small group, there are significant differences in their strategies, which affect how they’re expected to perform in rising or falling stock markets.
Sticking closely to the classic definition of market neutrality is Picton Mahoney Fortified Market Neutral Alternative Fund. Invested mostly in Canada, it holds long positions in stocks that managers identify as having positive fundamental changes that they expect to persist, and short positions in stocks with the opposite attributes. Though the portfolio isn’t sector-neutral, there are generally long and short positions in each sector.
The idea is to generate returns by “capturing a spread” between stocks managers like and don’t like, says David Picton, president, portfolio manager and a founding partner of Toronto-based Picton Mahoney Asset Management. “If you construct your portfolio properly, you should end up with very little exposure to the broad market and all of the exposure focused on stock selection, or as much as you can,” he says.
Picton says managers of market-neutral strategies must set tolerance bands. The Picton Mahoney fund’s tightly calibrated tolerance for exposure to beta, a measure of market correlation, is positive 0.1 to negative 0.1. (An equity index fund that’s perfectly correlated with the market has a beta of 1.0.) “You’re trying to add in more stock-selection risk into a portfolio and less stock- and overall bond-market risk,” Picton says. “And our belief is that by doing that you will generate a higher quality of return.”
Taking a rigorous approach to market neutrality by sector, as well as the market as a whole, are the managers of Desjardins Alt Long/Short Equity Market Neutral ETF. This fund’s portfolio consists primarily of pairs of Canadian stocks in the same sector, one of which is a long position and the other a short. At the end of November 2019, for instance, the ETF held a 1% long position in the pipeline utility Enbridge Inc., offset by a similarly sized short position in Pembina Pipeline Corp.
Managed by Montreal-based Desjardins Global Asset Management Inc., the ETF aims to neutralize market exposure by being long and short in the exact amounts in the same sector when possible, says Jay Aizanman, DGAM’s director of business development. He says the ETF seeks to maintain close to zero the correlation to its S&P/TSX Composite index benchmark. It’s also designed to have low volatility, while striving for a target return of the current cash yield plus 4%.
A more multi-faceted strategy is that of Purpose Multi-Strategy Market Neutral Fund. It employs long and short positions mostly in stocks, and to a lesser extent in currencies, commodities and interest rates.
In contrast to the typical market-neutral strategy, the Purpose fund will always have long exposure to equities, ranging from 10% to 40%. Elsewhere, net currency positions can range from plus 20% to minus 20%, and interest-rate futures from plus 15% to minus 15%. Commodities, though also having a mix of long and short positions, will maintain a net long position of about 10%.
With its multi-strategy, multi-asset approach, “this fund should deliver within anyone’s accepted definition of what beta constitutes market neutrality,” says Graeme Cooper, vice president of product with Toronto-based Purpose Investments Inc. “We’re going to capture some equity beta through the equity sleeve, but we think that’s going to be essentially neutralized over time.”
For instance, the fund’s managers at Toronto-based Neuberger Berman Breton Hill ULC have the flexibility to be exposed to long-term bonds. This exposure, says Cooper, is expected “to contribute positively in a negative market environment where there’s a flight to quality.”
As with alternative strategies generally, the role of the Purpose ETF is to enable investors to reduce portfolio risk without a proportional reduction in expected returns. “We’re strong believers that basically every portfolio should have a meaningful allocation to alternatives,” Cooper says, “with the key property of alternative obviously being market neutrality or at least lower correlation.”
Taking the goal of delivering positive returns in falling markets a step further is AGFiQ US Market Neutral Anti-Beta CAD-Hedged ETF. As indicated by its “anti-beta” labelling, its returns are designed to be positive when the U.S. stock market is falling.
The strategy is “dollar neutral” with its target weightings between long positions and short positions in U.S. stocks. But historically, the net exposure of the beta of the ETF’s underlying index has ranged between minus 0.7 and minus 0.5, says Bill DeRoche, chief investment officer and head of AGFiQ alternative strategies, with Boston-based AGF Investments LLC.
The reason for the negative correlation to the U.S. stock market, says DeRoche, is that the long positions in the sector-diversified portfolio are in low-beta stocks within their respective sectors, and the short positions are in high-beta stocks within these same sectors. With this asset mix, DeRoche estimates that if the market is down 10%, the ETF will be expected to be up about 10%. If the market goes up 10%, however, the fund will on average be down only about 5%.
This asymmetry of returns — the magnitude of gains being greater in a falling market than the losses in a rising market — makes this ETF an effective hedging tool, DeRoche says. “It’s designed to mitigate some of the drawdowns that folks typically experience in their equity portfolios, say over the course of a longer period.”
Equities should do well over the coming years, though not as well as over the past decade, says DeRoche, whose firm is a subsidiary of Toronto-based AGF Management Ltd. More concerning is the outlook for fixed income, he adds, since yields and expected returns are much lower than in the past, and there’s risk of capital losses if interest rates rise. “As a result, we’re looking for tools that we can use as risk mitigators to basically hedge some of that drawdown that you could experience in fixed income.”
As an illustration, DeRoche cites a historical allocation of 75% in core equities, and 25% in the AGFiQ ETF. He says that over the past 10 to 15 years, based on data for the ETF’s underlying index, this portfolio would have performed exceptionally well versus a combination of 60% equities and 40% fixed income. “You basically can capture about three-quarters of the return to the core equity market, and you’re able to cut your volatility drawdown almost in half. It’s a great tool for managing the risk in your equity portfolio.”
Common to all four market-neutral ETFs is that their diversification strategies cost significantly more than what equity index ETFs charge. The index-tracking AGFiQ ETF is the lowest priced, with a management fee of 0.55%. The management fees of the Purpose and Desjardins ETFs are 0.95% and 1%, respectively. The highest-cost provider is Picton Mahoney: in addition to its 0.95% management fee, this ETF will keep 20% of returns exceeding 2%, subject to a perpetual high watermark.
As for performance, three of the four market-neutral ETFs have 2019 start dates, so the only one with a multi-year track record is Purpose Multi-Strategy Market Neutral. In 2019, amid booming North American stock markets, it returned a clearly uncorrelated 1%. Since inception in October 2014, its compound annual return to Dec. 31 is 2.9%. Modest returns such as these aren’t attention-grabbing. Nor are they surprising for a strategy that is designed to have the best of times when equities are at their worst.