#1 Toby Hayes -Alternative Beta

The Nalu Finance Podcast

In this episode of Nalu Finance, we sit down with Toby Hayes at Fortem Capital to explore the world of structural risk premia and alternative beta investing.

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🎙️ Transcript: Intro: 00:00

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Stefan Wagner: 00:16 I'm here at the Fortum Capital office in London with Toby Hayes who is the fund manager for the Alternative Growth Fund and we're here to talk about Alternative Beta today.

Toby Hayes: 00:27 Hello.

Stefan Wagner: 00:28 Hi Toby. What actually is Alternative Beta or Quantitative Investment Strategies, Factor Investing, Risk Premier? All these worlds are floating around and nobody really knows exactly what is what.

Toby Hayes: 00:42 I don't think it's my position to define all of them simply because everybody has a different version of what each individual strategy means. However, there's a broad theme that encompasses all of them. And what it is that there is, these are all describing return sources that are embedded in traditional asset classes. They have always been there. They're not new. What is new is that there are now various techniques to isolate and access those return sources on their own, where before you would have to have bought the asset class and all of the residual risks that came with it. And the various terminologies that describe it are really just focusing on this issue that there are now embedded sources of return that you can access separately and then put in a portfolio separately.

Stefan Wagner: 01:33 And how do these alternative beta strategies work? How do they create the value? How do they extract the return?

Toby Hayes: 01:41 Each strategy is different in its own right, but I think there's maybe three broad camps of styles of return, shall we say. The first off, I'd say, is what I would call structural factors or structural risk premia, structural alternative beta, to take your pick. These are return sources where the return is due to some structural phenomenon in the market, some regulatory aspect or some flow aspect where the return source is in many ways independent of macroeconomics, cyclicality and due to the very nature of the market itself.

The second source I'd say what I describe as behavioral. These are return sources that play on investor psychology, psychosis, take your pick. A good example of this would be momentum strategies. Momentum strategies There was no real fundamental reason why they should work. They really just play on the fact that investors chase past returns. And there are many similar behavioral strategies available, but they would sit in that bucket.

And the final one I'd broadly class as insurance-style strategies. These are strategies where you are paid a coupon, a premium, to bear some sort of market risk. And examples of this would be selling volatility or carrier strategies. These are clearly correlated with market, broad market equity beta, or behavioral strategies can be correlated or can be negatively correlated, and structural strategies tend to be completely independent because their return source is really due to the idiosyncrasies of each individual market and the structural phenomenon therein.

Stefan Wagner: 03:29 And when you identify such a strategy, how do you evaluate the strategy that it's the right investment to you? How do you compare them with each other? Do you ratio sharp?

Toby Hayes: 03:40 One of the characteristics of risk premium generally is that they tend to have a return profile that is different from equities. Equities and bond returns and for that matter tend to be more normally distributed. They're not perfectly normally distributed, but tend to be more normally distributed. Risk premium or alternative beta tend to have more fatter tails distribution what that means is they can have very steady returns and sometimes quite sharp losses that are disproportionate relative to the Steadiness of the daily return.

So when you're analyzing them typical metrics that use normality as their assumption, so I'm talking about standard deviation in particular, are not really appropriate. So you need to really look at risk metrics that adjust for fat tails. And in particular, VAR is the obvious one. And there's various tweaks on the VAR statistic, called modified VAR, which takes account of the non-normal distribution. And I find that these adjusted statistics that actually account for the fat tails are much more accurate in assessing the risk of these risk premia.

Stefan Wagner: 04:49 Now many of these strategies obviously when they get developed by the providers feel sometimes they are optimized for back testing. How do you make sure that you don't invest in a strategy that's very sensitive to the backtesting assumptions?

Toby Hayes: 05:05 There's no surefire way of doing it. The obvious one is to only invest in strategies that have got a significant track record. The other sort of telltale technique, I suppose, is to keep it simple. These strategies and factors are not new strategies. They've been written about in academia for nigh on 80 years or so. And so when you're assessing a strategy, you've really got to see, is it really accessing the factor itself, or does it have some newfangled technique to extract value? If there's complication, if there's convenient switches and threshold values which allow it to get in and out of exposures, these are all telltale warning signs.

And it's not that these more dynamic allocation methods can't work. It's just that if you are looking at a strategy that has a more dynamic allocation process, it really needs to have a long track record to justify its investment. So in that regards, if you stick to very simple, pure, clean strategies, you are halfway there to separating the wheat from the chaff.

Stefan Wagner: 06:20 You mentioned one was the track record and how long it has been in place, but if it has been in place for a while and successful, is there not the risk of crowding and then reducing the opportunity?

Toby Hayes: 06:32 It again depends on the strategy. There are some strategies that are very prone to crowding and basically being arbitraged away, where some are Actually, the quantity of flows that go into them from the quantitative investment strategy universe dwarfs, is tiny compared to the flows in the actual market. I use the commodity example the best. Most commodity flows are due to real world producers and hedges looking at various aspects of commodity markets. The flows that come from the risk premium world are tiny in reference to the real world flows.

And the shapes of curves that give you the return source are due to the, as I say, the real world participants. So it's very hard for, as I say, large flows in the risk premium world to distort that return source. Because as I say, the return source is there to actually more due to structural reasons. But again, on the opposite side of the fence, there are plenty of risk premium strategies that do get crowded and can actually get so expensive that can adopt a completely different return profile than you would expect due to the crowding. So it really depends on the exact on the risk premium question and an understanding of what the risk premium is doing and the understanding of the underlying markets as well.

Stefan Wagner: 08:04 Now all your knowledge and expertise obviously is going into the managing of the Fortum Alternative Growth Fund. Could you a little bit explain what the aim is to achieve with the fund and how you manage the different exposures, the different factors and how maybe your macro view also plays into it?

Toby Hayes: 08:25 Well this is a very strange alternative product in the sense that We've deliberately avoided macro. I've been a macro manager for the last 20 years and I've chosen a product or designed a product that is deliberately trying to avoid all sources of return that are driven by macroeconomic cyclicality and in particular what the Fed does. The reason being is we want to have an alternatives fund that is truly uncorrelated from the main asset classes, equities and bonds. From most people's perspective, your alternatives bucket shouldn't be correlated. It's really there to provide diversification.

And in a world where both bonds and equity prices have been bid up by excess liquidity from central banks, most alternative sources of return in the risk premium space, as well as in traditional alternative space, such as property and real estate, et cetera, are becoming increasingly correlated and the function of the alternatives bucket general is becoming increasingly downgraded.

So the real rationale for the fund was to only focus on the risk premium strategies that are structural in nature and their return source and their risk is independent of macroeconomics and cyclicality. So for this fund, obviously there is behavioral and insurance-based risk premia. We're just focusing on the structural risk premia, because they are not only statistically uncorrelated, but fundamentally unlinked to macro. So therefore, we can hopefully fulfill our duty in delivering uncorrelated alternative returns.

Stefan Wagner: 10:04 And what is the reasonable expectation to have on the return profile for the Fortum Alternative Growth Fund?

Toby Hayes: 10:11 Well, in terms of risk and return, we're targeting 4% to 5% per annum in terms of returns. The risk on the fund will be probably in the region of 3% to 4% volatility. And I mention volatility because that, in terms of standard deviation, because that's what everybody uses. But obviously, the fund is actually managed to a vast statistic. But broadly speaking, we're targeting 4% to 5% returns.

Stefan Wagner: 10:39 And who is the strategy suitable for? Who is the target investor and what time horizon should they have?

Toby Hayes: 10:44 Yeah, well it's a UCITS fund, so we have daily liquidity, we have very reasonable pricing. Our initial target market is the UK DFM market. But because it's specifically designed to fit in within a traditional multi-asset portfolio, we think it makes perfect sense for various multi-managers and funder funds. It's currently not being targeted to retail, but that potentially may change in the future, but for the moment it's not. But it's really, we see this as a perfect filler for an alternatives bucket within any traditional multi-asset environment.

Stefan Wagner: 11:27 And when you actually manage the fund, can you walk us a little bit through your portfolio construction investment processes? So that's regular reviewing, how active is… Well, I think there's two parts to the fund.

Toby Hayes: 11:42 There's what I would say is the core portfolio, which is a selection of As I say these structural risk premia, these are return sources that are independent macro independent of the Fed and they're also totally uncorrelated with each other and They there are not if you think about it conceptually, there's not very many strategies that have no link to macroeconomics and yet are financial strategies. It's sort of an oxymoron. And if you look at the structural risk premium universe, it is relatively small, but One of the nice things about structural universe is that they tend to be one of the more consistent return strategies. So that would make the core of the portfolio. We've left ourselves a little space in the portfolio for what we call opportunistic structural trades. These are when you have, especially in derivative world, there is plenty of large flows into various structured products of various different types.

And these cause distortions in various different curves. These are, this gives the fund an opportunity on a broadly tactical basis to take exposure in, while still maintaining zero correlation, zero correlation of x's, et cetera, but allows to access a structural return that is temporal in nature. So, and this happens quite often. this happens quite a lot within structured product land and there's various factors that get distorted and that gives us that part of the portfolio will take up disproportionately more time as time goes by.

Stefan Wagner: 13:26 You probably answered partly already my next question actually. What makes the Fortum Alternative Growth Fund unique to other funds that claim to do alternative beta?

Toby Hayes: 13:37 There's plenty of factor funds around. There's far too many and it's probably led to a bit of a crowded space. But if you look at all the factor-based portfolios, nearly all of them, I would say, are in the equity factor space, which are long-short equity factors. And then the second sort of type of equity of factor fund, most of these guys are in carry and volatility strategies. If you know carry-in volatility strategies, carry-in volatility is highly correlated with equities, actually has quite good Sharpe ratios and there's nothing wrong with it as a risk premium per se. But if you want to build a fund that is uncorrelated with equities, it is not a particularly great idea to put carry-in vol in the fund.

So, we as a fund house are deliberately avoiding that aspect. If you look at the equity factor land as well, I believe that the equity factors are, well, one, they're highly cyclical in nature and they tend to behave differently depending on where you are in the cycle. But they're also fundamentally, I think they've been distorted by Fed liquidity to such an extent, I think allocating between equity factors is now nigh on impossible. such like I believe that asset allocation is becoming harder and harder and harder because you now have to second guess what the Fed's doing.

So, most of the factor, the risk premia universe sits within those two camps, the equity factor land or the carry and vol land. We have deliberately avoided both those sections and just investing in the structural risk premia. And this is the only fund I know of. My goodness, we've looked for it. What I would say is that the return sources are purely structural. There are funds, multi-asset funds out there that have small allocations to structural risk premia, but this is the only fund I'm aware of that is purely based on structural returns.

Stefan Wagner: 15:34 Fantastic. Thank you, Toby, for your insight and time.

Toby Hayes: 15:38 Thank you very much.

Outro: 15:47 Nalu FM, finance podcast.