Transcript
Speaker: Welcome to Bonnie and Capital Management's What's the Alternative podcast. Joining host Sheena Orsik -Sicil, the queen of alternatives and founder, CEO of Bonnie and Capital Management, as she interviews leaders in the alternative investment space. Learn more about their firms, their passions, and about the many different ways investors can use alternative investments to add value in their investment portfolio.
Speaker: Hi everyone to what's the alternative meet the manager here with Bonneune Capital Management. As you know, the focus of this podcast is to introduce advisors and clients to the many different options and array of offerings in the alternative space available on Bonneune's platform.
Speaker: And we are very pleased to have with us today, Bill Daroche, Head of Quantitative Investing at AGF Investments. AGF, as you may be aware, has got a soft spot in my heart. Anyone who's followed me for any considerable amount of time knows that I am a huge fangirl.
Speaker: of their product, BTAL. It's a product we've highlighted in a number of our web series episodes. You're doing it all wrong. And so we're very pleased to have Bill here with us to talk about BTAL, about AGF, about what they're doing, and about the overall market for liquid alternatives in general. So without further ado, I'd like to introduce everybody to Bill Daruff. Thank you, Shannon.
Speaker: We are so happy to have you here. And I think I'd like to start out. Our audience always loves to learn a little bit about how people get to where they're going. And I'd love to hear sort of how you ended up where you're at today and how you kind of got into the world of alternatives and liquid alternatives in general. Yeah. I had a very unusual path to the industry, Shana.
Speaker: My previous life, I attended college at the United States Naval Academy. I did learn the math first. I was an electrical engineer as an undergrad. But upon graduation, I actually went down to flight school.
Speaker: And I became a Naval aviator. You were like top gun in real life. I was. Yes. We used to think of it as top bomb. The aircraft I flew, which is retired, was more of an air to ground platform.
Speaker: I flew, I got a couple of thousand hours, I got almost 500 carrier landing. So yeah, I was out at sea flying around for many years. To make a long story short, around the 10 year point, I opted to get out of the Navy to leave and I attended business school up at Dartmouth College, the Tuck School of Business. One of the professors
Speaker: I was fortunate, took a liking to me. He was like, you know, math, you should get into finance. Fortunately for me, he actually left academia the year I graduated. He started a quantitative research group at Putnam. Uh, so I got, that was my first job in the business a long time ago. I actually started out in fixed income, which I thought from a, from a quant perspective,
Speaker: was a great place to learn. Eventually, most of the business that was growing was on the equity side. So eventually transitioned over, but I've spent my entire career in the Boston area on the buy side of asset management.
Speaker: and on the quantitative side. More recently, it's been on the equity side. And a lot of what we've done as a client is to try to create different types of return streams. So a lot of it is involved long, short, or what we think of as structuring.
Speaker: But that's really interesting because when you think about the alternative space, there is a lot of quants in the space. There's a lot of math background behind the rhyme and reason behind everything. So what kind of made you go from like fixed income to equity to now this more complex type of equity and what about it do you think is most interesting for investors today?
Speaker: Yeah, I think when I first started in the business, I was much more of a generalist. So even on the fixed side, a lot of what we were doing was in risk management. The firm very much liked that what we were doing it with regards to risk.
Speaker: So eventually transitioned over to the equity side from a risk perspective and then got more involved in generating alpha returns. When I was at Dartmouth, Professor French was there, so I was pretty well schooled in the whole factor investing, which was somewhat new back then.
Speaker: At the end of the day, that's how I cut my teeth. If you think about pure factors, they were always going to be long and short. A lot of the product that we generated was product that was both long and short where we were looking to take or to get very specific exposures versus just a broad market exposure.
Speaker: Yeah, that makes a lot of sense. You know, I kind of got my own start and the alt space sort of similarly.
Speaker: I'm not going to go there. I say it worse than you. Maybe it's the Boston accent thing. I can't physically say the word. Our enunciation is not great. But I think that from my standpoint, I was not a quant coming into the alt world. And my first foray into alternatives was doing more quant -related work. In my case, I was doing regression analysis to try to replicate return streams so that we could hedge.
Speaker: And what I didn't realize at the time was that I was basically doing hedge fund replication before hedge fund replication was like trendy. But it helped me understand sort of how that world works and more importantly, the esoteric aspects of hedging, not just traditional investments. In my case, I was actually trying to hedge
Speaker: fairly illiquid fixed credit investments and trying to find exposures in ways that we could use derivatives that were pretty liquid to hedge what we could, but you can never truly hedge against illiquidity. That is not really a hedgeable risk in portfolios, which I think brings me kind of to the next part of my question, which was the liquid alternative space. So as you and I both know, it's a fairly
Speaker: new area of investing. It only really became possible in 2007 with the changes to the FCC regulatory framework of the 40 Act, and it has boom and busted quite a bit over that time, you know, after 2007 we saw
Speaker: tons of liquid alternative mutual funds, in particular could ETFs weren't really trendy back then makes me feel old but it's true. But you saw just a huge array, everybody and anybody was trying to put a liquid product in their hedge funds.
Speaker: traditional asset managers with 130 -30, 120 -20. You had the larger asset managers that had hedge fund divisions take their hedge fund offerings, put them on their JP Morgan, most notably. So we've seen a boom and bust. There were thousands, then they all couldn't gather assets during that 10, 15 year bull market.
Speaker: So a lot of them closed. Now ETFs have become a thing. Can you talk a little bit about how you kind of came into being with AGF? And AGF's experience in this liquid alt world, because it's an interesting one.
Speaker: Yeah, I think, you know, you touched on a lot of, you know, the exact same things that we were considering when we got started, you know, having lived through the whole crash of 08. I think a lot, it reopened a lot of people's eyes to the idea that the core equity is probably, you know, the most reliable way for people to create wealth.
Speaker: it also is going to have situations where you're going to experience significant drawdowns. Whether it's once every five or ten years or so, the market tends to correct. Having just lived through that enormous correction in 08, there was a lot of interest in product that had different types of exposure beyond just market exposure. That's when we all kind of got started. I think
Speaker: to your point, when the response that central banks had to that OA correction, which was interest rates to zero and flooding up the market with liquidity, we ended up with that zero interest rate environment, the whole TINA, where there was no alternative to equities, and that fixed income basically had a zero expected return. So there was a lot of money flowing into equities. The market was
Speaker: very consistently just moving upward. And over that 15 year period, say from 2008 to just recently, before last year, you really didn't need anything except say core equity with some long duration fixed income. And why do I say long duration fixed income? Regardless of what central banks were doing,
Speaker: or even fiscal policy for that matter, inflation was pretty much dead during that period. So the only real concern for investors was economic growth. So everybody was focused on economic growth. When economic growth was, you know, there was concern that it would go down, central bank response to that was to cut interest rates. So if growth was forecast to be lower,
Speaker: Yeah, that would negatively impact your equity investments. Oh, but you had the long duration treasuries to protect you. So when central banks reacted, cut rates, your fixed income portfolio would do very well. So it was really a nice hedge. It worked exceptionally well over that period. There was a lot of discussion about the 60 -40 portfolio being back.
Speaker: Unfortunately, at some point, you know, all good things come to an end. And I think, you know, a year and a half, two years ago, we all kind of saw what happens when that inflation genie gets let out of the bottle. So folks that had portfolios that were just focused on core equity and core fixed income suffered dramatically, you know, with that
Speaker: significantly rising rate environment that we saw over the last two years that punished equities as well as punished fixed income. And for the first time, you know, that 60 -40 portfolio had its worst return, you know, in history. So all of a sudden now folks needed something beyond just fixed income, beyond just equities. I think the good news is one,
Speaker: Core equity is still a very reliable way to create wealth. I think also it's nice to see that there's some income back and fixed income, which is encouraging. But at the same time, though I do think the central bank is very committed to getting inflation back in that, say, 2 % area, which will take some time, it isn't going away like it once was.
Speaker: If you think about some of the secular trends that were driving inflation to be subdued, whether they be supply chains, access to very inexpensive labor, then we can go on. I think a lot of those secular trends, we've moved past them. So I think people need to be thoughtful as they move forward around both concerns about growth
Speaker: which will always be there obviously, as well as inflation, which means you're going to need more than just a fixed income and equities in your portfolio.
Speaker: And it's so interesting when you talk about inflation. You know, I used to work at a firm and we used to debate all the time if CPI and some of the other common inflation metrics were appropriate. Because, you know, the inputs to traditional CPI are kind of archaic, if you think about it.
Speaker: And there are a lot of technology that actually has reduced the cost of a lot of things as a result, if you think about computing, and none of that shows up in CPI. But at the same time, the only real things that matter to the underlying consumer are like the two things that they remove, which is food and energy, right?
Speaker: So, you know, if people talk about CPI and it's like CPI X food and energy, well, I'd argue the only two things that matter are food and energy at the end of the day, because some of the other metrics in addition to be archaic are poorly calculated. Like if you look at how they attempt to focus on the cost of housing, which is owner's equivalent rent, which is nothing close to actual rent trends.
Speaker: So there's a number of issues with inflation, but to your point, the things that matter the most are food and energy. That's the impact on the underlying consumer, because those are the things they need every single, they're not buying furniture every day. They are not buying cars every day. They are not going to events every day. They are not flying places. They are buying food and putting gas in their gas tank or paying their electric bill or paying their gas bill every single month.
Speaker: every single week in the case of food and even more than a couple of days a week in the case of gasoline in the car or whatever. So I think that's a valid point. I think people got really used to this super low inflation environment, which was not actually normal, but because it lasted for what is a lot of people's professional lives, if you think about it, that's all they know.
Speaker: So I think that's a valid point, and I think it gets to kind of what you're talking about, which is that I don't like to say the 60 -40 is dead or the 60 -40 is back. And I think Phil Tay is one of our other clients would argue that the 60 -40's worst performance was during the Great Depression, where if you kept it, you would have run out of money. Because it was such a long period of downturn for the market, and you had both fixed income and equities doing poorly at that time, hence the money under the mattress kind of scenario.
Speaker: But I think now advisors and investors in general have a much broader universe of offerings that they can select from was larger 10 years ago, but still today I see more thoughtful offerings and
Speaker: You know, AGF in particular has been a leader in this space. They have absolutely introduced product and closed product that didn't work or wasn't working right. And a lot of it is throw something at the wall and figure out what sticks. But one of your more successful products is VTOL, which is your equity market neutral anti -beta fund, U .S. equity market neutral anti -beta fund. So let's start by explaining to our audience what market neutral means. Yeah, you know,
Speaker: In this particular instance, the product was named from the index. Market neutral, in this case, may not be the best descriptor. For most people, when they think of market neutral, they think of beta neutral. So any long beta exposure is offset with short beta exposure. In this instance,
Speaker: you know, the nomenclature actually refers to the dollars invested. So in this particular fund for each dollar invested long, there is a dollar invested short. The whole idea behind the strategy is we're looking to capture that anomaly between high beta securities and low beta securities. Academia has shown that
Speaker: low beta on a risk adjusted basis tends to outperform high beta. There's a bunch of reasons for that. We can kind of talk through them here in a little bit, but the strategy that we manage is a dollar neutral strategy. So for every dollar we get in, we invest a dollar long
Speaker: We then go sell a dollar short which then generates a dollar of short proceeds. So we end up with $2 in assets and minus $1 in liability which equates to the dollar of money that we invested, that we started with at the end of the day.
Speaker: Now, if you think about that, if we're buying low beta securities with that dollar and we're shorting high beta securities, that would by definition mean we're going to be short the market because the high beta names that were short are going to have higher betas than the low beta names that were long. So, this particular strategy
Speaker: is consistently through this particular type of implementation is going to have a consistently negative beta.
Speaker: Now, if you look at the academic implementations, they tend to do it more beta neutral so that you end up capturing, call it the alpha component. We chose to implement it on dollar neutral. And the reason for that is if investors, typically, their biggest exposure is going to be to the market. And if they could only buy one, say, alternative investment, we thought that
Speaker: we wanted to make sure they were getting something that could help hedge against that drawdown event that everyone experienced back in 08. So by basically making sure that the product had a negative beta, we created much more of an insurance strategy. So at the end of the day, what you tend to see is if the market goes up, this fund goes down,
Speaker: But if the market goes down, the fund goes up. What's interesting is high beta names tend to have quite a bit of leverage. So there's three characteristics that we see. They tend to have higher financial leverage. They tend to have higher operating leverage and much more variability in their revenue streams. As a result,
Speaker: When the market goes down, they tend to significantly underperform. So if you're looking at, say, a portfolio of high beta names, and the portfolios that we tend to manage, we typically calculate beta just using a 52 -week historical covariance with the S &P 500. Based on that, our typical high beta portfolio has a beta of around 1 .2.
Speaker: And what we see when the market's up 10%, that high beta portfolio is up about 12, so it performs in line with expectations. But when the market's down 10, that particular portfolio tends to be down about 16%, and that's that leverage really coming into play there. Whereas the low beta names, using the same rules, it's usually around a 0 .85 beta.
Speaker: So when the market's up 10, it's up about eight and a half percent, so it lags a little bit. And when the market's down 10, it again performs in line with expectation. So it's typically down eight and a half. So at the end of the day, you end up with this asymmetry in the up capture and down capture ratio. So
Speaker: The expectation, if you look at the historical numbers, is that when the market's up 10%, when you combine the long and the short, the fund is down about 5%. Think of that as the cost of the insurance premium.
Speaker: But when the market's down 10%, the fund typically is up about 8 % to 9%, which is the payoff that you're getting from that insurance. So the way we tend to structure the strategy, just to make sure that we're not getting a lot of sector or industry biases, is we do it sector neutral. So we basically start with the 1 ,000 largest equities in the US. We basically stratify that by sector.
Speaker: And then we basically will go long the top quintile of the lowest beta names and we'll go short the bottom quintile of the highest beta names. We do that by name count. So if there's a hundred securities in the 1000, that means that 10 % of the portfolio will be in that sector, both on the long side as well as the short side.
Speaker: when the fund reconstitutes and rebalances, we equally wait each position. So we'll have 20 names in the long portfolio at 50 basis points, and we'll have 20 positions in the short portfolio of high beta names at 50 basis points. So that's the whole thesis. It's a little bit different.
Speaker: As I said, in that since it is dollar neutral, you're going to end up with that negative beta. And again, the whole idea here is to allow you to have that core equity exposure, but to protect you when there are those significant left tail events that we've all experienced in our equity portfolios.
Speaker: You've done a great job explaining the basics of it, but there's some things that I kind of want to ask about. So the first thing worth noting is, as you pointed out from the academic research, there's a ton of research that shows that actually consistently over time, lower beta names do outperform higher beta names. So one of the things that I've noticed with your product over time
Speaker: is yes it is negatively correlated and yes if you use the general rule of thumb of that your negative beta you will see the exact return pattern that you have and I think everyone should go in eyes wide open with that but I also think it's worth noting that because of the persistence of the relationship between high beta and low beta
Speaker: there are actually times where the market can go up where this fund actually performs very well and a time that kind of stands out to me was kind of that 1819 period of time where the fund was did great even comparatively to a market that was going straight up because the relationship between low beta stocks and high beta stocks um held and low beta was outperforming high beta
Speaker: which at the time was like low beta was like technology and names that you wouldn't necessarily equate with low beta and high beta were things like energy and materials, which went through an extended period of very poor performance. So can you touch a little bit about understanding not only the dynamics you just talked about, but just the underlying dynamics of the relationship between high beta and low beta that actually can lead this fund to do okay in certain types of environments, even when the market does go up?
Speaker: Yeah, so you hit on a bunch of really interesting points. You know, the market at that point was a little risk averse. So people were looking to become a little bit more defensive in their equity posture. So as a result, as you described, there was a significant outperformance
Speaker: of low beta versus high beta. We can all talk about the whole COVID environment exacerbated quite a bit of that. So yes, it's not unusual to see that happen as people become a little bit more defensively postured.
Speaker: We can go back and we can look at lots of periods. I do think one of the things that got reinforced to us during that period is that, as we've seen time and time again, and you can pick almost any factor and there is no difference between low beta versus high beta, trees don't go to the moon. So at some point it becomes overextended.
Speaker: And we did see that. So one of the things that we try to manage better from a risk management perspective is just that momentum exposure. So if you think about, you know, low beta was consistently outperforming high beta for such a long period of time. So if you think about it,
Speaker: That's the definition of momentum. So we went from having a fund that had very little exposure to momentum to a fund that had a pretty large one. And one of the things that we learned, you know, call it the hard way is that
Speaker: when the vaccines were shown to be efficacious back in November of 2020, that whole momentum portfolio flip -flopped, and we saw pretty large drawdown in this particular strategy. So as a result, one of the things that we try to manage more closely is how much momentum gets into the strategy.
Speaker: We want to make sure that investors are getting, call it the factor exposure that we've advertised in a rules based way, but we want that factory turn to drive the performance and not have it say subsumed by say another factor such as momentum. Now, when you typically look at low beta versus high beta, you know, there are not,
Speaker: consistent factor exposure. So it's not like low beta is consistently cheaper than high beta or consistently higher quality. Those three characteristics I mentioned earlier regarding operating and financial leverage as well as earnings variability tend to be the three things that are consistent. But one of the things that we did see is, you know, momentum can build up.
Speaker: If you think about momentum, it works great till it doesn't. So you end up with these momentum crashes. Yeah, I think your Boston friends GMO learned that during the financial crisis. That's absolutely something you kind of learned only through experience.
Speaker: Yeah, so we're just trying to mitigate that by better risk management. I think that's one of the things as a quant investor, you're always looking to make sure that you have exposures that you want and you're trying to mitigate the ones you don't want. This is a rules -based product. We're trying to make sure that investors
Speaker: they know what they're getting. They don't have to worry about us constantly changing the way we do things. The way I describe it is get up in the morning and put our clothes on in the exact same manner every single day. We do make
Speaker: minor changes on occasion that we communicate to our investment community. And momentum was one of those things that, you know, we decided we needed to do a better job of making sure we were managing that exposure. And I think that's a valid point. You know, people think of quants as like, you don't want to have too much of a human element to it because the whole point of the quant is to take the human element out of it. But one of my favorite due diligence questions to ask quants is what you learn through, you know, stress periods.
Speaker: And it's always interesting to hear because you what you don't want to hear is that they changed the model in a meaningful way, which you know sometimes you do hear that and that's always a red flag, but you do want to hear a thoughtful analysis, where they kind of look at what happened, they review it, they figure out, you know, you know what.
Speaker: They could have done better or what risks they just didn't account for, which is more often than not what happens. And that's kind of what you explained risks that you didn't really think about or account for that were unintended consequences.
Speaker: that you can make an adjustment to reduce the exposure to that risk in an ongoing basis. So I think that's valuable, and I think that's helpful to help people have return expectations for a product like this. Which brings me to my next question, which is one I hear a lot from advisors, and I'd love to get your thought process on this. A lot of advisors say, well, why would I use this product, which will have negative returns at times versus cash?
Speaker: And I think that is always an interesting one, because you start to get into things like risk adjusted returns and sharp ratios and things of that nature, which I think are important components to understand that sometimes having a low to no correlation
Speaker: diversifier in a portfolio is actually a better solution than cash, despite the fact that at least on paper, when you compare one to the other, you couldn't understand why you would use anything but cash. But can you kind of touch upon how you address that pushback from advisors when they look at this product and see kind of, you know, the fact that you really don't get the return on this necessarily until a drawdown happens.
Speaker: Yeah, so I'd say there's a couple elements that we think about. One is it's a much
Speaker: more effective insurance policy than say cash. So if you think about it, if you do the arithmetic, you can effectively reduce the portfolio's overall market exposure with less dollars. If you were to use this versus say cash, you'd need to have less market exposure and more cash exposure than you would if you did say a combination of this particular strategy and core equity.
Speaker: So that's one. I think number two comes down to this thing can hedge against other things, but besides an equity drawdown. So if all you're doing is allocating to cash, you're out of equities and that's the assumption is that you're going to reduce the exposure to the market, which effectively is reduced exposure to economic growth. But if you do have, say, some fixed income exposure, you still have that risk.
Speaker: If you look at this particular strategy, it actually does well when rates are rising. And if you think about it, if you look at, say, high beta securities and the things that we talk about, they tend to be high beta because a lot of their cash flows are uncertain. And as we said, revenue variability, they tend to be out in the future more. And the way we describe that is they have a much higher equity duration
Speaker: than your lower beta securities. So as a result, when rates go up, that high beta portfolio, which is higher equity duration, tends to get hurt a lot more than your low beta portfolio. So another environment where this particular strategy does very well, it's not just when equities are under attack, but it's also when fixed income is doing poorly. So you basically have a tool now
Speaker: that can work against two issues. One is following economic growth, the other is rising rates, whereas cash isn't going to help you do that unless you're going to allocate away from both fixed income and core equity.
Speaker: And at the end of the day, that's going to take a lot more dollars. So again, much more efficient way, a much smaller allocation, and you can basically hedge against too significant risk in the portfolio.
Speaker: The other thing I was just going to say is that shop ratio matters, right? I know a lot of people say, oh, you can't eat shop ratios. And they're very return focused. But I think people forget that there is a drag associated with volatility. So if you have two return streams with equal
Speaker: average returns, the one with the lower vol is going to end up with a higher cumulative wealth at the end of the day. So the point here is if you don't need to take a particular amount of risk, there's no reason to do it. I think we all learned a very important lesson or relearned, I should say, about sequence risk. If you go through what happened, you know, a lot of people during the pandemic,
Speaker: They looked at their portfolios. They thought they had enough to retire. They basically opted out of the, you know, some well -paying jobs because they were late in their career. And then all of a sudden, you know, shortly thereafter, they got hit with the old double whammy and that, you know, one equity markets went down and interest rates went up, which means their liabilities did. And all of a sudden they're looking at their pool of retirement money.
Speaker: and it's just not gonna make it, right? And all of a sudden now they're trying to get back into the market. If you look at that, the term for that is sequence risk. And if you look at it, you're at the highest level of risk, just about the time of retirement to just shortly thereafter. And the idea there is you wanna mitigate any drawdown events that could occur
Speaker: during those particular timeframes. Because if you don't, and you do have a big drawdown event, you know, right around retirement to shortly thereafter, that's when you're going to experience the most pain in terms of making those dollars last throughout your retirement. So again, if you don't need to take a particular risk or don't need that level, I would suggest that you reduce it just to make sure you don't have that exposure
Speaker: to that sequence risk that, again, we tend to relearn things in this industry, what, every 10 to 15 years. Yeah, that's true. And it's funny, I just learned something. I did not know that that was called secret risk. I have always used the term point in time risk, but meaning the same thing. And I talk about that often with advisors when I talk to them about using alternatives and portfolios to reduce overall risk, addressing a lot of the things that you just touched on, which is that,
Speaker: A client will never fire you if you help them meet their goals and when they were able to achieve what they wanted to do and they were okay financially, you will 100 % get fired if you didn't. And to your point, if your client happens to retire at the exact worst time, like you just referred to, 2000 and then 2022 happens,
Speaker: You know, it is going to get you fired like 100 % of the time. So focusing on having less volatility, I think is the key there. And you just brought up that point. And I also wanted to touch on the point you made about cash because I think that is also an important one. There's two ways you can look at that, which is that.
Speaker: to the point you made, it requires less to be taken out of the areas of potential outsized returns, equity in particular, to get the same level of insurance, if you will. The premium is, by definition, lower. You don't require as much exposure in order to get the same safety. But the other thing worth noting, and this is something that's more in the institutional space,
Speaker: And I worked a lot in the LDI, liability driven investing space, where you talk about risk budgeting. And if you can reduce the risk of your portfolio below a certain point, that can allow you to be more targeted in the risks that you do take, where you have the higher potential for outsized excess returns.
Speaker: And those are two things I always like to know. So this product is the type of product where I know I personally have used it and then calculated risk scores. And it brings risk scores down so substantially that we can allocate a little bit more to a higher volatility but higher potential outperformance opportunity because we have
Speaker: a certain risk budget we can use and now we have more of it to play with because we use this product to help reduce the overall score. So just two different ways to kind of look at it and depending on how an advisor approaches portfolio construction, which is the
Speaker: approach of that sequence risk that you talked about. But also in the risk budgeting opportunity, there are two ways that a product like this or just alternatives in general can provide that additional opportunity for your clients and smooth the ride out in many ways. Because even though you may look at the return stream of say VTOL and be like, why in the world? Like you would never invest in VTOL in a vacuum. It's meant to be complimentary.
Speaker: Correct in my assessment there? Yeah, it's absolutely a tool and it's gonna be used in conjunction with something. The most obvious is to hedge that left tail risk from core equity, but it also is there to help out with interest rate risk from fixed income. So yeah, you'd never wanna own it as a standalone, given the fact that it has negative,
Speaker: you're betting against the market, which as we all know is not a great bet to make. So yes, it is a tool for sure. And just one of the last questions I wanna ask because I think you're uniquely, and I've sat on a panel with you where we discussed this. I talk to advisors a lot and they talk to their clients a lot as it pertains to liquid alts, ETFs and mutual funds. And they always get hung up on the cost.
Speaker: the headline costs that they see, the expense ratios, how expensive these products appear to be. And the fact of the matter is, and we've done a couple things about this in our web series, you're doing it all wrong, but I'd love for you to also take a moment to kind of explain the factors that go into the calculation of the cost of these funds and what is real and what is not. Yeah.
Speaker: It can be confusing and it's worth spending some time to understand. With a long short product, any cash that leaves the fund is considered an expense. So when a fund has to pay the short interest expense, so if you're short of security that pays a dividend, that's something that comes out of the fund because you have to pay that dividend, that's considered an expense.
Speaker: Even though on the long side, you could be collecting dividend income, it's not allowed to be offset.
Speaker: What's even more frustrating at times is a lot of these products will track an index. Those indexes are total return. So the short portfolio is actually getting penalized by having those dividend payments leave the index. So at the end of the day, they're not being handled from an accounting perspective.
Speaker: according to the index in the fund. So a lot of times you'll look at fund expenses and you'll see that short interest expense, which is basically the dividend yield of the short portfolio being reported as an expense ratio for the fund.
Speaker: If you tend to back that dividend yield out, you tend to get a better idea as to what the actual expenses are. And for the most part, for our fund, the biggest expense will be the management fee. I think a lot of these liquid all products have
Speaker: had significant reductions in their management fees to make them much more reasonable. We're at 45 basis points. At the end of the day, it's just imperative that you understand how things are accounted for in these particular products. They're all handled the same way, but it's going to look very different than your typical long -only investment, which doesn't have that short dividend expense.
Speaker: I always tell folks two things. Number one, managing a long short fund is more complex. So the management fee should be higher and that shouldn't surprise anybody. It's not plug and play like an index fund or even a traditional long equity fund. There is a slightly higher cost to the management of these types of products. So you should expect to pay a higher management fee.
Speaker: But secondarily, I always encourage folks to look at the prospectus because in your prospectus or any prospectus, there is the SEC required calculation of your expense ratio, which has all the problems you just noted. And then every single product out there that has this
Speaker: the structure will have a page in their perspective, usually near the front, which actually shows you what the actual expenses of the fund is, not what they can advertise because the regulators don't allow it, but what actually your experience will be as an investor. And you guys are usually the ones I say to look at because it's so clear because I think your stated expense ratio as the regulators require it shows your expense ratio is like 2%.
Speaker: which is nothing close to what your actual expense is if you're an investor in the fund, which is closer to 50 basis points. So just an important thing to know. Um, don't let that upfront fee, especially in these liquid alts deter you from considering the investments because more times than not the expense ratio is not actually reflective of the investor experience. Yeah. It's a big education issue for us. Um,
Speaker: you know, especially like when we compare ourselves to folks that implement the exposures through derivatives. So those derivatives on many instances will pay out that, you know, cause it's a contract. So it could be a return on an index, which is a total return index that has the dividends in there. Um, but since it's not a, you know, a cash payout, like a dividend short dividend cost, it's not going to be reported in the same way.
Speaker: So it's strictly a reporting issue. And it's like I said, it's just important for us to make sure that we're out educating our clients and potential clients.
Speaker: Yep, I feel the same way. Well, I'd like to thank you for your time and for being with us today. I don't know about our audience, but I can say I even walked away learning a few things and I feel like I knew this product inside and out, but the whole sequence risk thing, I'm not familiar with that term, embarrassingly so.
Speaker: but it is a good term to know. So I learned a little something myself. And that's the point with these podcasts is to educate on the complexities of the space so that people go in eyes wide open because that is half the battle. So thank you so much for your time, Bill. Really appreciate having you on today. Thank you. It's always a pleasure. Looking forward to seeing you this week in person, but I thank you for taking the time.
Speaker: No problem. Have a great day, everyone, and thank you for joining us. Before I forget, I was about to just stop recording, but I forgot. Make sure you follow us on Twitter or X, whatever it's called today, LinkedIn, and our YouTube channel. Make sure you subscribe so that you get notified whenever we put up our latest episodes of both this podcast and the alternative, Mason, where my chief of staff, Brittany,
Speaker: Mason talks to practitioners about how they use alternatives and portfolios for their clients. We are very pleased to have you here listening to us and hope that you'll stay tuned for our next episode. Have a great day, everyone.
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