#16 Kevin Gray - Smart Beta

The Nalu Finance Podcast

In this episode of Nalu Finance, we sit down with Kevin Gray, CIO at Fortem Capital to explore the world of alternative beta and factor investing.

Kevin dives deep into the philosophy and construction of Fortem’s Alternative Growth Fund, including:

• Why traditional equity exposure may no longer offer diversification
  

• How factors like value, momentum, carry, and volatility can deliver persistent returns
  

• The process of screening over 500 strategies to build a low-volatility, uncorrelated portfolio
  

He also explains how the fund performed through extreme market conditions, staying resilient even when traditional assets faltered.

🎧 Listen Now On: Apple Podcasts | Spotify | Youtube | Podomatic

🎙️ Transcript:

Stefan Wagner: 00:41 I'm here with Kevin Gray, who is part of the team that manages the Fortum Capital Alternative Growth Fund. The Alternative Growth Fund invests in alternative beta strategies sourced from across the asset class spectrum. Nevertheless, there are many different descriptions around for alternative beta like smart beta, quantitative investment strategy, factor investing. But what is your definition, Kevin, regarding what the Fortum Capital Alternative Growth Fund does? Sure.

Kevin Gray: 01:08 I mean, thank you very much for having me. Firstly, and I think the most important point to appreciate when it comes to factor or beta investing or even risk premium investing is that it already does and always has really underpinned the investment management industry. So a factor or type of beta is simply what we would use to reference a specific driver of return. And historically, portfolios have really been anchored in a single factor, the growth factor, or what has come to be known simply as beta. And the most obvious manifestation of that is with regards to companies. So companies that extract growth from the economy and return it to shareholders in the form of dividends and capital appreciation of those companies' share prices. And the fundamental pillar around which the investment management industry as a whole is built is this narrative that if I am long equity for long enough, then I will make positive returns to some degree or other.

Or another way, on average, I'll be rewarded for taking risk over the long term. Hence, you get to that standard model asset allocation. of 60% allocated to equity, or what we can call the growth factor. And the long-term assumption is that this should be the main driver of any portfolio's returns. And indeed, that growth factor has been really persistent and rewarding. You only have to look at the returns or the long-term returns of equity markets over decades to see this. And when you do look at those returns, I guess it might also beg the question, well, why does anyone invest in anything other than that growth factor that they're accessing through equity? And the simple answer to that is, well, some don't. Some do just purely invest in equity.

And obviously, I think most retail portfolios would fully be exposed to equity. But for the most part, especially when considering the more institutional side of the industry, the profile of equity returns is inappropriate for the vast majority of investors to be fully exposed to. And of course, when we're talking about risk tolerance, it's going to be a function of ability and willingness to bear risk. So when you look at an individual, and particularly those whose money is being managed by a professional third party, and so has a regulator looking over their shoulder with a much keener eye on suitability or appropriateness than was the case pre-2008. Things like time horizon, liquidity needs, and the overall asset base are going to dictate that ability to bear risk, while more psychological factors are going to determine willingness.

So equity itself happens to be pretty volatile and also has this undesirable trait in that its returns are negatively skewed or in other words that the crashes and the clue there I guess is in the nomenclature tend to be short, sharp and very painful. So 2020 being a prime example while recoveries on the whole maybe except this year tend to be more gradual and a bit more measured relatively speaking. So when you look at you know, equity crashes of the past, how many investors that had 100% equity portfolios in March 2020, or 2008, would have decided that enough was enough, and crystallized huge losses.

And that unfortunate trait of human nature is that those same investors that called it a day would likely on average, finally succumb to reentering the market at a later date at much higher levels. Because nobody likes seeing their neighbor getting rich while they're not. So you've got to this point where the industry as a whole is desperately searching for ways to meaningly diversify its exposure to equity beta or to growth. And this is where we come to these alternative sources of beta or just alternative beta or factor investing.

Stefan Wagner: 05:02 And what kind of other factors are there out there?

Kevin Gray: 05:06 So the other factors, I think listeners will have certainly heard of them and likely be familiar with a number of them. But you've got things like value, momentum, quality, carry, volatility, and then perhaps maybe less familiar with some other risk premia like curve trades and congestion trades. The overarching point is that there are these alternative sources of beta that do share that similar persistence quality to equity or market beta but that have no correlation whatsoever to it or indeed to each other. And as the industry as a whole grapples with the fact that its go-to diversifier no longer actually diversifies its major exposure, it makes sense really that this form of investing and all of these sort of buzzwords are gaining in popularity and notoriety.

Stefan Wagner: 05:54 How do you then apply this into your Fortum Capital Alternative Growth Fund and what kind of sources of beta do you try to tap into to generate these returns that you are trying to achieve here?

Kevin Gray: 06:10 I think the first thing is that what the fund actually aims to do is to provide a positive return. And that would be in the region of four to five percent annualized over the medium to long term with low volatility, which we would consider to be two to three percent realized and crucially negligible correlation to traditional asset classes.

Stefan Wagner: 06:33 And that I think that compares very starkly to an equity portfolio that maybe it makes seven to 10, but has probably 17 to 20 percent volatility.

Kevin Gray: 06:41 Yeah, completely. And also, I mean, One of the reasons you can do this with low volatility is some of these strategies inherently are very low volatility, but the lack of correlation of the individual strategies within the fund brings the volatility itself down. I think you mentioned equities and that volatility, and as with any investment, I think it's worth mentioning that it's highly unlikely that our alternative growth fund would achieve its objective in a straight line. you know, we would expect more like 2% in a liquidity driven bull market, four to five and more normal markets if that sort of makes any sense anymore, and six to eight in a bear market.

But if there was to be one thing I would say that the fund's overall objective is aligned with, it's to be nothing other than a true diversifier. So it sits squarely in the alternative space. And although clearly not riskless, the key point is that its risk contributors are entirely different through these investments in alternative sources of business, alternative factors to those risk contributors driving the rest of a multi-asset portfolio.

Stefan Wagner: 07:52 Can you maybe briefly walk us through the investment process or how you construct a portfolio of the fund?

Kevin Gray: 07:59 I know we're all at Fawson pretty firm believers in the beauty of any investment process being really in its simplicity. And it's definitely something that we try and keep in mind with regards to how the funds run and how the portfolio is constructed at really a holistic level. But as with any process, you start with the universe. So we have over 500 strategies across factors and asset classes that we're tracking on a daily basis. Um, as you would hope the growth factor is not in our universe. So it's excluded even before the universe stage. And then we employ two major screens.

So the first screen is a correlation screen. And sort of when we look back at that overall fund objective, which is to produce positive returns, low volatility, negligible correlation to risk assets, including equity, then naturally any individual strategies correlation to equity is really going to have to form a cornerstone around which the overall fund is going to be built. And when looking at those top level factors and premier that I kind of mentioned before, there are some that are clearly correlated to equity. The obvious examples being short volatility and certain carriage rates. Again, this should intuitively make sense. If you're short volatility, you're for want of a better sort of way of putting it, short the VIX, short the fear index.

So we can easily say you're long confidence, which is going to be highly correlated to risk assets and equity. And then the classic carry trades of borrowing and developed market currency to invest in an emerging market currency for a yield pickup will do particularly well when there's also relative appreciation in that emerging market currency. And that is typically a phenomenon that's going to coincide with strong global growth and a supportive environment for equity. And again, with Carrie, you say the same about IG and high yield credit.

So by screening core strategies that are outside of our desired correlation range, at the very sort of first hurdle, we can ensure that the fund is statistically uncorrelated to risk assets. And then we go one step further with a second screen. So our preference would be for, it would be for strategies which, in addition to having that statistical lack of correlation, also have an underlying structural reason why any particular persistent return or premium exists.

Stefan Wagner: 10:26 I have a question for me. You mentioned 500 strategies that you monitor on a daily basis. I presume these are provided from different providers, but obviously there's overlaps or similar strategies on the same factor that you're trying to access. How do you, in a sense, pick the best one out of this?

Kevin Gray: 10:48 So after the screening process, we're obviously going to be left with a load of strategies that are of interest. any that are of particular interest and this is where we get to sort of a an experience and common sense overlay are put through a rigorous due diligence process including correlations to the current portfolio and individual portfolio constituents we do scenario analysis and modeling and any new strategy requires complete sign-off by each member of our global risk committee but the strategies themselves as you said there are numerous strategies or ways of implementing a strategy per factor and each one will have its nuances but preferably we would like to have at least two different ways of implementing a strategy per factor and simply that is in order to diversify within our own fund model risk.

Stefan Wagner: 11:42 Now, you ran us through how you actually go into or take a position in one of these strategies. When do you decide to get out of them? When do you decide, you know, there is no opportunity anymore?

Kevin Gray: 11:54 So that quote sort of would come down to the more construction side. And I think, you know, assuming that we have a bunch of strategies that one work, two are uncorrelated to traditional beta, three are uncorrelated to each other. we can then look at that construction both in terms of adding positions taking away upsizing downsizing and here there is another really useful characteristic that many of these alternative sources of beta have and that is that while they are uncorrelated to each other and to market beta They are what's known as auto-correlated. In other words, their time series of returns is correlated to a lagged version of that time series. But what that actually means for us is they tend to work for fairly long periods and similarly not work for fairly long periods. And I guess the classic example of that currently would be equity value, which hasn't worked for 15 years.

But the fact that these factors alternative sources of beta go through these long periods of working and vice versa means that we can implement a slight and it is slight momentum overlay in terms of sizing and gaining or losing exposure to specific factors on top of looking at weights on a risk basis are you looking at the risk weight of each factor in the portfolio so when we talk about. entering positions or upsizing positions or downsizing there's definitely an element of what overall factors are working and which aren't and kind of in relation to that is where we come to what we would call our common sense overlay which is just an acknowledgement that different factors have different preferred environments so some prefer high volatility to low some flat curves to steep curves and some sort of a reflationary environment to a deflationary one and so again there's a slight tilt towards the overall environment in which we find ourselves and that kind of ensures that the fund is gently tilted towards those different regimes.

Stefan Wagner: 13:54 I think you already highlighted quite a few things that make you stand out versus other ones, but is there other things what makes the strategy of the Fordham Capital Alternative Growth Fund different than what else is out there?

Kevin Gray: 14:08 So I think that first statistical screen makes it different to probably 90% of alternative beta strategies out there. and then that added layer of in addition to just simply screening out things that are correlated to uh to the growth factor in portfolios that added layer of looking for structural reasons for a return source that are independent of macroeconomic drivers i think is what makes the fund almost unique i mean we're not aware of another but I'm sure there must be somebody doing something along the same lines and if there isn't i think there certainly will be in the coming years as the uh as the problem that the industry has of bonds being an inappropriate diversifier kind of manifests itself maybe on the downside rather than the upside as it has for the last 10 years.

Stefan Wagner: 14:57 Next thing is how do you get exposure to these strategies? Can you buy it via an ETF? Do you trade it yourself, certain things? Do you do it via swaps? What are the options and what is the best?

Kevin Gray: 15:13 So I think this probably actually would be the other differentiator of this particular fund is how we actually structure it and gain exposure to these strategies. So the fund, as with our progressive growth fund, is fully backed by very short-term, high-grade sovereign debt currently extending to gilts, treasuries, and Japanese government bonds. So this, at its core, is what any investor actually owns. and any fixed interest is swapped for a liable stream, soon to be Sonia, and then that is swapped for exposure to the desired strategies. Those strategies will be executable daily, and crucially, any cost to exit them is contractually stipulated at outset, as they would be with a swap and a swap way of doing it. What that really means is twofold. Firstly, we know how much it would cost to liquidate the entire fund at any time. And secondly, that that cost does not change with either market conditions or with the size of the fund.

So capacity and liquidity, which obviously I think are often more important or more questionable in the alternative space than some others. But with regards to this particular fund, capacity and liquidity are incredibly high. And if the worst were to happen and literally the world were to end, then the swaps would simply be cancelled and the fund would be left holding just short-term high-grade sovereign debt and if that sovereign debt is worth nothing then I think we're all going to be looking for something else to do other than finance.

Stefan Wagner: 16:51 How long has the fund been going and how has it performed over that time?

Kevin Gray: 16:56 So it launched in May 2019 and I think in the first 18 months of its life it's probably been subjected to the most volatile both on the down and upside market that certainly I've ever seen, but I think is close to you would have on record potentially since the Great Depression. But I think there's no mistake to be made that it's launched into a raging liquidity driven bull market just with incredibly heightened volatility. And going back to those expectations that we have of it that I talked about at the beginning, sort of a liquidity driven bull market where you would expect to earn a region of 2% per annum. uh and to the end of December it was up just over three percent.

So the fund's kind of from a return perspective done exactly what we would have expected it to but I think of equal importance is that it's achieved that return with absolutely no correlation in fact a little negative correlation to equity and while negatively skewed equity crashed downwards in march the positively skewed strategies in the fund crashed upwards meaning that in addition to producing sort of positive absolute returns in what was overall it's least favored environment in which equity produced serious positive returns as well it did best at the time that that growth factor or equity and portfolios did worst and i think essentially that's exactly what you would want from an alternative so

Stefan Wagner: 18:21 We're pretty pleased with how the first 18 months has gone. Last question for you and I ask everybody this. What is your favorite Finance movie and also why is it your favorite Finance movie?

Kevin Gray: 18:38 It's a pretty easy but fairly unoriginal answer for me but I think it has to be the Big Short. I think it would be fair to say that I've always been slightly contrarian, possibly in most aspects of my life. So there's undoubtedly some effect from that. But I also think the premise of the film itself can likely be transferred on to the next crisis, the one after that, the one after that, etc. And actually, recently, I heard a I heard a quote from the ex-CEO of Nike, Phil Knight, applied to finance, and I can't take credit for it, but I thought it was such a beautiful way of illustrating the nature of crises.

So Phil Knight, the Nike CEO, said that everyone is, I think he said this in 2000, but he said, everyone's looking for the next Michael Jordan on the basketball court when he's walking up the fairway, obviously referring to Tiger Woods. And the comparison was made to investors constantly looking over their shoulder for the next thing that has upset markets previously, that's going to sort of manifest itself again. While I think in most circumstances, the cause of the next crisis is likely already unfolding under our noses.

Stefan Wagner: 19:51 Excellent. Thank you. Thank you very much for your time. Thank you, Kevin.