First Trust ROI Podcast
On the ROI podcast, we discuss some of the most important questions facing investment professionals today, ranging from macroeconomic views, to perspectives on the equity and fixed income markets, to insights on practice management. We aim to cut through the noise, examine the data, and provide fresh insights to investment professionals as they help their clients find better ways to invest…seeking to generate attractive returns on their investments.
First Trust ROI Podcast
ROI Podcast | Episode 19 | Rethinking Diversification: Are Stocks and Bonds Enough? | John Gambla | April 22, 2024
In this episode, we explore why more and more investment professionals are allocating to call-writing funds, long/short strategies, and commodities.
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Hi, welcome to the First Trust ROI podcast. I'm Ryan Isakainen, ets strategist at First Trust. Over the last several years, we've seen an increase in the number of financial professionals that are incorporating alternative strategies into their client portfolios. Well, today I'm joined by John Gambla, co-head of Alternatives at First Trust. We're going to discuss some of those strategies. We're going to talk about commodities what's driving returns and how they fit into an investor's portfolio. We're going to talk about call writing strategies, harvesting volatility in the form of options, and how that fits into the overall investor landscape. And, lastly, we're going to talk about long short strategies what exactly a long short strategy is and how it fits in your client portfolios. Thanks for joining us on this episode of the First Trust ROI Podcast. So, john, thank you for agreeing to come on the podcast. Glad to have you on, glad to be here. So you've been a portfolio manager for how long?
Speaker 2:Well over 25 years. Let's just leave it at that.
Speaker 1:So the market environment that we're in today we're recording this in the beginning of April. It'll drop sometime in the next month or so. It'll drop sometime in the next month or so Do you remember in your career any time period which was, as I think, of this environment as somewhat confusing, because there's all sorts of relationships that don't necessarily seem like they've been what I've experienced in my 25 years. So what's your take? Do you think that there's any similarities to previous periods that you've been a portfolio manager?
Speaker 2:I can't think of an exact match, but there are threads or elements that remind me a little bit of the late 90s, with the run-up in the dot-com boom, and then also the mid-2000s and the run-up in the great financial crisis, and I'm not trying to forecast, but some elements of credit spread, tightening valuations, the really aggressive moves in the market, one way or the other.
Speaker 2:I think it's every other week we get a headline. We either hit a historic high or low in something and just kind of the contrasting opinions, but it just the risk assets tend to keep powering on and the data is surprising everyone, despite the really aggressive rate moves. So to me that's, you know, again, threads of those periods, though I'm not sure the outcome is going to be exactly the same.
Speaker 1:Yeah, history never repeats it rhymes right.
Speaker 1:Exactly exactly, and I think most people last year weren't necessarily positioned for a 26% run in the S&P 500 in 2023. And I think so far this year again we're recording this in the beginning of April the market has been stronger than most people expected as well. But again, who knows what happens between now and the month that we drop this particular episode? Well, one of the things that often happens during periods of time of uncertainty or market volatility is that investors, investment professionals, start to look towards alternative ways to get exposure to stocks as well as alternative asset classes, and that's one of the reasons I wanted to have you on the podcast. So, again, thank you for coming on, and one of the things I wanted to talk with you about is long-short strategies, because your team manages some long-short portfolios, so I kind of want to dig into that a little bit. So I guess, to start off, can you tell us what is a long-short portfolio?
Speaker 2:Sure, and like a lot of alternatives, they come in a lot of different varieties, flavors and strategy approaches. So I'll kind of go 30,000 foot, keep it kind of very simple, because you can just really get deep in the weeds. And I like to think of long, short strategies, particularly say in the equity space, in sort of three different buckets. There's sort of the equity market neutral, where your longs and shorts are approximately equal in their notional exposure. You're trying to get to a beta of kind of zero-ish. Then there's at the other end so let me unpack that.
Speaker 1:So the market risk basically for your long and your short portfolio essentially cancel each other out.
Speaker 2:Right, that's what you're going for, and the shortcut people will say is your notional. It's not exactly how you get to zero. You know beta, but if you're 100% long and 100% short, the kind of the shortcut language is okay, really don't have a lot of beta exposure. That's more equity market neutral.
Speaker 1:Right. So that's not necessarily going to give you the S&P 500 return. It's going to give you that non-beta excess return alpha, something like that Exactly Portable alpha. Is that the?
Speaker 2:And you can use it that way, and certainly in this space you have to have some sort of an edge, because if you're long 100% of the market and short and you don't have any edge, you're just canceling out and you're getting a risk-free rate when the presumption is you do have an edge to either pick stocks better on the long side or the short, or both. But equity market neutral is kind of a call it a lower risk or again portable alpha type strategy where you transport that on to say an S&P futures or a Russell futures Okay. At the other end of the spectrum are what are known as 130-30 or short extension funds Okay, where you're getting significantly more exposure on the long side. So what you typically would do is you would have a hundred percent exposure, you know fully invested on the long side, and then you would short stocks. You sell short stocks, say 50% of your notional portfolio, and you take the proceeds from the short and instead of letting they just sit in cash, you reinvest them in long side. You so you get maybe a hundred and fifty percent exposure or 130, depending on how much you short.
Speaker 2:What you're trying to do there is approximate a beta and kind of have market beta, but if you're adding value from your stock picking Then you should have better than market returns with roughly the same risk. So those are the sort of two ends of the spectrum. And then right in the middle are what we would call long bias, where you want to have a beta of less than the general market call it 0.5 to 0.75, by going long certain stocks and short certain stocks, but you're not trying to cancel out fully like market neutral, so you do have some beta, but you're not reinvesting your short proceeds, so you don't have more than 100% long exposure. And so that's kind of each each end of the spectrum. And then right in the middle is the long bias.
Speaker 1:We're talking mainly about equities. Can these be applied to other asset classes as well?
Speaker 2:Absolutely so. It's very common in the commodity space to be long and short or flat, which means you have no position. It certainly can happen in the fixed income market by effectively you have a bond portfolio and then they'll short out. Treasury futures play the spread. So long-short investment has applications across multiple assets. I think many people think of it mostly associated with equities or commodities because they tend to be more prevalent and more pronounced.
Speaker 1:And in terms of the vehicles that these are delivered in. I would imagine there's probably some hedge funds that use these sorts of strategies and, on the other end, there's more liquid alternatives. Am I missing anything in between the use case typically?
Speaker 2:I think that that's a really good representation. In fact, the term hedge fund actually really was the origin of long-short investing. They were long an asset and then they hedged it via shorting, and so what you've had is a progression where it typically was only occurring in hedge funds and then the general market. As futures contracts became more ubiquitous and options, you were able to kind of tailor your shorting in a very liquid 1940 Act world. And so then you've had an explosion of strategies in the mutual funds and now, as you've evolved, into ETFs, which again the ETF wrapper happens to be extremely well suited for long short equity investing because of tax.
Speaker 1:Why is that?
Speaker 2:There are tax ramifications. A lot of long-short strategies tend to generate gains from both sides of the portfolio at times and they tend to be a little bit higher turnover than typical buy-and-hold or beta exposure. As we say, there's really no beta to hide behind in long-short, so you really do need an edge and they tend to have more turnover so they generate more taxable kind of events. Well, in the ETF structure you're allowed to actually wash away those tax consequences. So it's a great, great vehicle for equity long short investing. In fact, we think it's the best structure out there from a tax perspective for sure, and people love the transparency. You can see your holdings every single day. So we really like the ETF structure for long-short equity.
Speaker 1:Is there a concern about having that transparent portfolio, as you're trying to? You talked about finding an edge. Is there a concern about giving away your edge if you have the transparent portfolio, or are you comfortable with that structure?
Speaker 2:Personally, we're comfortable because of the way we build our portfolios. They tend to be very diversified, large number of holdings. They do shift a little bit more frequently in the commodity space, less frequently in the equity space. So in the equity space we tend to be I don't want to say value-oriented, but it takes a while for what we consider to be the alpha to kind of come to the top, whereas I think some people they are not transparent, don't want to be so. The ETF structure wouldn't work for them. Our approach, from the best thing, which tends to be very statistical based, quantitative we don't have a problem at all with the transparency, though I do know there are plenty of investors that don't have a problem at all with the transparency, though I do know there are plenty of investors that don't want that. They want the opaqueness because they think their edge is pretty significant. They really aren't interested in sharing it with anybody or having anyone look at it and try and understand what they're doing, and I completely understand that.
Speaker 1:Yeah, so the long short structure in an ETF or another more liquid form has led to what some have described as the democratization of these strategies, or kind of going downstream to investors that aren't necessarily the larger net worth investors. I probably know the answer to this, but is that a good thing for investors to have that availability of these sorts of strategies?
Speaker 2:Oh, I always have felt that the more options for advisors to help their clients and for clients to have in their portfolio to pursue diversification and risk management is a very positive thing. Like anything, it can run awry or run off the rails, but I think without a doubt, it's been really good for investors. Now, the past 10 years, I think the single best approach to investing was put all your money on NASDAQ or S&P. Diversification be damned, but history really does show that Better yet, just buy NVIDIA right. Exactly, exactly. But I think the vast majority of history across all asset classes says that diversification really is the only free lunch and it's a real value add to investors who are pursuing wealth accumulation and terminal wealth is what I think people should be focused on that more choices and the wide variety of options and kind of long-short investing or alternatives is really a powerful tool and I'm glad to see it happen because not only am I involved in it, but I do really think it's a big value add for the general market.
Speaker 1:For those that are incorporating. You know you come downstream. Maybe it's a portfolio manager that's only used a 60-40 portfolio for his clients and that's kind of the traditional level of risk that they would take. How does a long-short strategy fit, and I know we talked about three different. You know the spectrum of long-short strategies, but either specific use cases or in general, where do they fit in an investor's portfolio?
Speaker 2:Let's talk about long-short equity, kind of the long bias, because I think that's the one that has the most use cases and I think illustrates the points best and people can kind of extrapolate from there. Okay, so for a long-short strategy with, say, a target beta of 0.5, 0.7, there's a lot of different ways that we recommend you use it, or we've talked to advisors on how they're using it. The first is they just want to de-risk the portfolio. They don't want to shed all their equity exposure, but they're either nervous about the market in general or their client has had an event. They need to lower the risk, and so a long-short strategy is a great way to do that. It keeps you in the market but it ratchets on your risk profile overall. So the overall portfolio call it beta or risk exposure is going to be lower, and that's a very typical use case.
Speaker 2:A second use case is what we consider to be the barbell structure, where the client or the advisor is really not interested in changing their beta profile, but they're kind of where they want to be in terms of beta or risk budget, in terms of beta or risk budget, but they see opportunities in other areas, say AI or high yield credit or depressed commercial real estate and they need to find a way in another area of the portfolio to take down risk so they can add that in. Well, a typical trade would be okay, I'm going to sell my S&P exposure or my Russell 2000 exposure and buy a long short equity with a lower beta profile and that I can go out and kind of pursue those higher beta, higher risk opportunities. That will also be hopefully higher return. But you're not changing the overall risk of the portfolio and we see that's very common also Sometimes we talk about you want to pursue the NASDAQ. Sell your S&P, buy a long short pair with the NASDAQ. It's a typical barbell and then another use.
Speaker 1:So that's a concept of basically budgeting risk. That was a term that you use. Where you've got a certain amount of risk, you lower the risk in this part of your portfolio so you can increase it there without blowing your risk budget right.
Speaker 2:Exactly, and we find that advisors and clients are becoming more and more sophisticated to the concept of risk budgeting and managing their risk and realizing that to pursue kind of maximum total return requires very savvy risk budgeting and risk control and kind of you know, the two are not mutually exclusive, they're actually very tightly related to each other. So, again, great use case there. Another use case would be kind of taking a segment of the portfolio that is already in defensive equity but the particular exposure, whether it's dividends or low volatility, either is not performing or the advisor is looking for a way to broaden the strategies. Because we do believe in diversification, not just at the security level but in from a portfolio context in terms of the strategies. So having a few different approaches to either defensive equity, low volatility equity, broadens the portfolio and actually should help diversify it. And so we do see people kind of reallocating within the low volatility or defensive bucket of their portfolio for equities with long-short equity. Again, diversification strategy, and that's another excellent use case.
Speaker 1:So another type of strategy, in addition to the sort of long-short equity strategies that your team manages, has to do with writing calls and capturing premiums, and I want to talk about that for a little bit because that, as I look at, flows into ETFs in particular. Over the last couple of years it's been wildly successful, bringing in billions, tens of billions of dollars in net inflows. So you run a couple strategies that employ that approach. So can you tell me a little bit about what actually how that works and what sort of environments that tends to work well in?
Speaker 2:Sure. Well, again, there's a lot of different approaches in call it the buy right space or the option selling space. Our approach is really space or the option selling space. Our approach is really we kind of view it as not necessarily an income strategy, though it does produce a lot of cash. It can produce a lot of cash flow for investors. I mean, ultimately you can only pay out the total return of your complete investment.
Speaker 2:And we view it from a portfolio context that we're trying to capture a volatility risk premium. When you sell a call, you're selling volatility and that isn't necessarily related to the underlying portfolio exposure and equities. So for us that's a strategy diversification and we think that combining the two over time produces a higher total return, certainly a higher risk-adjusted return, and I think the data from the SIBO and several other option writing indices displays that that they actually have very similar returns to the S&P, with lower risk or, depending on your strategy, higher returns with the same level of risk. So that was really our initial foray in why we got into the market.
Speaker 2:The market really likes income-driven strategies and I think that's why it's really adopted sort of option selling. But from our perspective it's really about portfolio diversification and managing again that risk budget with different exposures. We like it also because there's just a very long history of buy right strategies of all different types being very successful. Our strategies tend to be more active in nature and we'll move around the strikes, we'll move around the maturity of the options because we do feel that there's value added to active option strategies as an overlay in the buy right world. But we do know that a lot of people are very structural and not trying to add alpha but trying to effectively just structure trades. So both can be very successful and obviously the markets said they like both approaches.
Speaker 1:Why do you think that is in the last couple, three years that we've seen such an explosion in popularity for those strategies?
Speaker 2:I'm not really sure because I've been doing this a while, you know, going on probably 20 years, in the option override space and they were very popular in the closed end arena for a while.
Speaker 2:And you know, I think sometimes market cycles and market psychology goes in waves. I think part of it might have been that these really started to catch on, I think when rates were still relatively low, but then also the equity markets were starting to kind of falter a little bit and they tend to be more defensive in nature. If overrides are, call it, north of 50% of the portfolio, they tend to be more defensive in nature. And that's where I would say, when you look at option overwrite or buy write strategies, you really do need to look at what the beta profile of that so you understand what you're getting. Because some strategies have low overwrites and they tend to have betas very close to the just general market and in in our group we tend to do the higher overwrites which we're willing to give a little bit of the upside away for a lower beta profile. But I think that's why low rates in a combination and then in a combination with the markets sort of kind of faltering a little bit there, I think, caught the attention of the investor.
Speaker 1:So there is some level of trade-off as a manager using these strategies where if you overwrite more of the portfolio, you're capturing more income and maybe lowering the beta, and then you overwrite less of the portfolio, you're going to have more market risk and maybe a little bit lower level of income. Is that a good description? I?
Speaker 2:think that's a fair company. I think that's absolutely fair and, like everything, markets are very efficient. The market participants are not, let's just say, stupid individuals, and the portfolio managers are all working very hard to extract alpha out of the market. So they tend to be, again, very efficient marketplaces and there's always a trade-off.
Speaker 1:Typically, do you think and maybe this is not exactly knowable, but do you think that people, financial professionals are substituting those income-driven buy-write strategies for a part of their fixed income exposure because they want to get more income, maybe boost it, although rates are higher so they're able to get decent income now? Or are they substituting a part of their equity exposure or something else? What are they selling, in other words, to incorporate buy-right strategies into their portfolios?
Speaker 2:That I can't say for certainty, and the advisors that we talk to, our strategies are generally equity substitutes, because we do kind of work hard to have them understand the risk profiles and the up and down kind of tradeoffs For us, whether it's buy right strategy or anything else we manage. We want our advisors to understand them, we want their expectations to be met because, as you know, the worst thing you want is to have an unhappy advisor with a particular strategy, not understanding how it behaves or what really it's designed to do. And as long as they understand that, they're generally pretty comfortable with the outcome positive, negative or neutral because they knew that going in, what we don't want are surprises.
Speaker 1:Another asset class that your team manages portfolios in is in commodities, and commodities have been really interesting over the last few years, where, you know, there was a period of time where commodities were just, I mean, nobody expected much out of them, and then all of a sudden they surged and I think that probably had a lot to do with, you know, some geopolitical events and maybe some inflation, and then they've kind of come back since. So I guess let me ask you what drove the run-up in commodities and what has since kind of led to some of the pullback, and then I'm going to ask you about where we go from here. But let me put that one off for a second.
Speaker 2:Sure. Well, I think if you look at commodities historically and I'm talking going way back they generate a return of roughly 6% to 8%, so it's a reasonably competitive return. With other assets, though, they tend to be pretty volatile, and so managing that volatility in the commodity space is pretty important. What happened is in the early 2000s you had the growth of China right, and they were really large consumers of commodities, so they really drove that market up pretty quickly over a very long period of time as they kind of matured as a nation and became an industrial power. Then, after the great financial crisis, he went through a 10-year period where commodities did very, very poorly Probably one of the only asset classes that had negative returns on an annualized basis and part of that was the suppressed volatility. Part of that was all the central banks were cutting rates to zero and that propelled financial assets, but it really suppressed the returns on real assets, and they were doing that for the better part of a decade to try and restart the economies, make sure the banking systems globally were reliquified and solid and strengthened, and they also their balance sheets, all the central banks, the balance sheets basically exploded. Well, we think what happened is, ultimately, they continued to kind of keep the financial accelerator going and ultimately, as financial assets kept depreciating and you can't do it forever and we think COVID kind of accelerated the cycle. But we were really expecting inflation to kind of reassert itself, given all the financial stimulus that had gone on in a synchronized fashion globally. And then you had COVID and COVID is just an anomaly and it's hard to really predict that coming or even say what the long-term effects were that coming or even say what the long-term effects were. But certainly that was the match on the gasoline, on the kindling that really sparked inflation and commodities are very sensitive to unexpected inflation. And so that's when you had this really sudden surge and commodities reasserted themselves as a dominant asset class and had some pretty spectacular returns after COVID.
Speaker 2:And then you had, on top of that, the geopolitical event of Russia invading Ukraine, and Ukraine happens to be one of the largest producers of some very key commodities, as is Russia. So you had this geopolitical event that effectively started severely constraining key commodity markets. So on top of the raging inflation fire that was already going on, you had this event and it was just sort of commodities went to the moon and it wasn't sustainable. We kind of say that the Ukraine invasion pulled probably a year or two of four commodity returns into the period of about a month. And then you also had a very unique event with nickel, where there was a short and that caused a lot of disruption because that was a key metal going into a lot of EVs and a lot of sort of general electrification. So all these events, kind of the perfect storm for commodities, really forced them to heights they'd not been seeing in a long, long time, and then it all kind of paused and then you kind of had commodities pull back pretty sharply, which your commodities will do.
Speaker 2:As they say, in the commodity market, the best solution for high prices are high prices, meaning that as commodities get more and more high priced effectively people find substitutes or ways around it. Natural gas in Europe was a perfect example. Natural gas prices were crazy. They were up tenfold at one point and so they started finding substitutes around the globe. People started cutting back, using alternative sources of fuel, and so then that whole market started to attenuate and kind of normalize over time as people adjust their buying patterns.
Speaker 2:What we've seen recently is commodities reassert themselves, as it looks like global growth is not nearly as weak, as people anticipated, as inflation is proving a little bit harder to suppress to the levels that the Federal Reserve so certainly would like. So commodities are now kind of becoming a little bit more in favor, as it looks like we're not sort of call it one and done with inflation. This might look a little bit more like the 1970s and not saying we're going back to 9%, but it looks like inflation is gonna stick around at a significantly higher level than the Fed would like for a little bit longer, and that's a little bit more reminiscent of the 1970s and 80s.
Speaker 1:I think of certain trends that I expect over the next decade or so. For example, I think about the reshoring of manufacturing or reorienting manufacturing at different points around the globe and all the infrastructure and factories and things that could be built as a result of that. It seems to me that that would have an impact on demand for certain commodities. Thinking about the green energy or electric vehicles, even though those have pulled back, if you have a long-term shift over the next decade, it seems like that would cause more demand for certain commodities. How does that play into your thesis for commodities? Do you think that that will have an impact on demand? And also, do you think there's a commensurate supply response? Is do you think there's a commensurate supply response, especially when it comes to things like electric vehicles? Or, you know, it seems like there's a bit of softness there so people might step back. What's your take?
Speaker 2:Longer term. We're actually pretty bullish on commodities for a lot of the reasons you mentioned. You know, what suppressed inflation for a long time was globalization. What used to cost $5 ultimately got manufactured in China, with the third world, at $1. And that was really beneficial, supported a lot of growth. That absolutely is going the other direction, and whether we fully uncouple with China or not, I can't answer that. I don't know if anyone can, but I do believe that on-shoring, friend-shoring, ally-shoring, whatever you want to call it is absolutely in force. Just here in the US, they're spending billions and billions of dollars to bring chip manufacturing strategic assets back.
Speaker 2:Reworking and modernizing the grid is not just a renewable issue. It's a strategic initiative for our power supply in the country. And so all those elements and there's a whole host of others, and I do believe that transition to green energy, electric vehicles it won't happen overnight. You don't dismantle an infrastructure of fossil fuels that's been built up over 100 years in a decade, but technology moves forward, like everything else, and all those are very supportive of the commodity markets. And yes, you have a response to that, and so what you see is more investment going into commodities than you have, say, over the past 10 or 15 years, which is why you have supply constraints. But that response time is also very slow. You don't just open up a mine, you don't just start up a steel manufacturing plant, you don't just up your crop supply by 25%. So those things take time. We do think longer term call it the next three to five years should be pretty positive for commodities and they have a place in people's portfolios that they haven't maybe had in the past 10 years.
Speaker 1:I don't want to put words in your mouth here, John, but it seems like there was a strong period of time that you were describing from the 2000s leading up until the great financial crisis. Then there was a period of time where, you know, commodity prices went nowhere but down, it seemed, for a stretch. Are you suggesting that maybe we're at the other side of the cycle or we could start to see some decent returns from commodities?
Speaker 2:Yeah, I think we're probably. You know, if you just kind of want to simplify and you think commodity cycles run, you know, 7 to 10 years and they can, and we're not saying that that's necessarily always, but we do think the next three to five years are, yeah, it's going to be pretty positive for commodities. Mean, will they keep pace with, say, the nasdaq? Don't know, probably not, because the nasdaq's a pretty aggressive benchmark, but we do think they're going to be very attractive from an absolute return standpoint and we do think from a portfolio standpoint. You want to be exposed to that because there are a lot of tailwinds out there and we kind of like that profile Okay.
Speaker 1:Well, we have talked about a whole lot of different things here. John, I appreciate you coming on the podcast. I'm going to leave you with one more question that I ask all the guests of the podcast, and that is is there anything that you've been reading lately? Any book recommendations, Not necessarily market related, but what are you reading lately?
Speaker 2:Sure, there's actually two books. One is called Switch and it's by Chip and Dan Heath and it's really a self-improvement book. It really talks about the rational mind versus emotions and there is a very clear pattern and reason on how to make changes long term and it's really good. It's like. I love self-improvement and I think in our industry you have a lot of motivated people who are all about constant improvement. I think that's a really good read. The other book is called when Breath Becomes Air and that is a phenomenal book, very moving. It's written by Paul Kalanithi and he was a brilliant neurosurgeon who was diagnosed with terminal lung cancer, and it's a moving book. It's a powerful book and really gives you perspective on life and I would highly recommend it to anybody.
Speaker 1:All right. Well, it's always good to get perspective on what's going on around you and how your life fits into the context of that. So thank you for those book recommendations and I appreciate your breadth of knowledge and insight that you shared with Longshore, with call writing, with commodities we talked about a lot of different things. It's been fun. Thanks for coming to the podcast, I appreciate it and thanks to all of you for joining us on this episode of the First Trust ROI Podcast. We'll see you next time.
