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Defined Returns are brilliant, but…

• The Fortem Progressive Growth Fund is likely to produce positive returns in all but the very worst market conditions.
• Those conditions are significant falls (>30%) that, crucially, equities do not recover from.
• History would suggest that this is extremely unlikely – insert usual caveat regarding history not being a reliable guide to the future.
• However, there is still journey risk due to equity market exposure and the fact that capital protection barriers are only observed at maturity for the individual underlying strategies.
• Investors are potentially exposed to significant drawdowns over the short term due to Fund delta (sensitivity to the underlying indices).

Delta is Dynamic!

• Delta is not static and will move with markets and the passage of time.
• In fact, a fall in markets will naturally increase Fund delta and therefore sensitivity to the underlying equity indices.
• This would leave an investor even more exposed to a further fall in equities.

The Fund uses Diversifiers to counteract this and manage Delta more effectively…

• The Fund will invest a maximum of 20% in a portfolio of Diversifiers that will dampen down equity market exposure, as well as have the ability to produce positive returns in all market conditions, especially during a downturn.

How do they do that?!
• They are ‘Structural Alternative Beta’ strategies that are fundamentally uncorrelated to equity.
• Alternative Beta is just a piece of nomenclature referring to any source of return other than traditional Beta.
• This is already present across asset classes in portfolios, but by removing traditional Beta, it can be isolated
and taken advantage of.
• The Fund will only invest in Diversifiers that are either negligibly or negatively correlated to equities.

And what makes them Structural?

• The strategy will provide maximum diversification benefit if they are both statistically and fundamentally
uncorrelated to equity.
• The strategies are all based on the physical make-up of a market, rather than any macroeconomic influences
on it.
• Commodities are a good example – these markets are driven by ‘real’ players (OPEC etc) who dwarf investors in size.
• By ensuring the strategies are structural in nature, we further ensure that the Diversifiers are completely
unrelated to the factors driving price movement in the Core portfolio of Defined Return Autocall-like
strategies.

If they are so good, why not just do a fund of them?
• We do! The Fortem Capital Alternative Growth Fund.

Summary
• The fund is, and always will be, predominantly exposed to defensive equity linked investments.
• By employing genuine diversifiers we can improve the stability and consistency of the portfolio during times of equity
market stress.
• This should allow us to achieve the return objective with less volatility, a smoother journey for those who hold the fund, and easier conversations in meetings for our clients!
• We, along with our clients, would hope that the diversifiers are not necessary; history tells us that they are, and that our future selves will thank us for doing something today.

The financial system has been rocked in more ways than one in the early part of 2020.

The market in which we have seen the wildest swings has undoubtedly been oil, leaving investors wondering what has left it particularly exposed to the current crisis, the mechanics of investing in oil in general, and what the future holds for the commodity formerly known as ‘liquid gold’.

In crude terms, what has happened?

Significant price moves in oil are by no means a new phenomenon, albeit usually spread over more than a single trading session.

At the turn of the Millennium WTI spot (the price of physical, can touch it, oil) was priced around $25 per barrel. Then, due to a dramatic change in demand dynamics, led by an oil hungry, growing Chinese economic powerhouse, exploded to around $140 in 2008. The widely held consensus at this point was that the only way was up for this finite resource. The Global Financial Crisis promptly put paid to that theory, sending oil crashing back down, before a recovery to over $100 by 2011, where it remained fairly rangebound, at least by today’s standards, until 2014.

Just as China had dramatically shifted demand dynamics in the noughties, by 2014 the oil landscape had changed significantly on the supply side too; OPEC had long since become worried about the US’ increased shale production and the effect this would likely have on the oil world order, and OPEC members’ place in it, moving forward.

With this in mind OPEC decided to combat the US shale boom by launching a price war, flooding the market with oil and depressing the price, a problem for US shale due to the higher breakeven cost of producers – OPEC were and are attempting to run US shale out of town. Cue a very sharp drop in the price of oil, from which it has never truly recovered, as the war has never truly ended.

Enter 2020 – while previous shocks have tended to be either demand or supply driven, the combination of demand destruction brought on by Covid-19 as well as a renewal of the price war between OPEC, Russia and the United States has made this round of oil price volatility truly unprecedented.

That potent combination sent oil plummeting over February and March, before a tweet from the US President, suggesting that a deal to cut production by 10m barrels per day was imminent, sent the price skyward 30% in a day. A production cut, all 10m barrels per day that was suggested, was agreed, but the price fell again on the back of the realisation that estimates of the demand shock were at 20m barrels per day. (There was still 10m too many barrels being produced per day)

Then, on Monday April 20th, the oil price dropped into negative territory.

How can oil go negative?

Up until this point, many believed that negative oil prices were an impossibility. However, we were now into the realms of the fundamental structural make up and mechanics of the market being tested.

The simultaneous combination of oversupply and destruction of demand that had characterised 2020 to this point led to the world literally running out of space to store oil, and therefore storing had never been more expensive.

We now come onto the mechanics of how one tends to invest in oil.

The majority of participants in the market will access oil through futures; a contract stipulating that one will pay $x per barrel for delivery on a certain date in the future. This allows producers and consumers of oil to hedge against price movement, and allows investors and speculators to try to profit from them. The futures price does not equal the spot price.

The ‘front month future’ i.e. that closest to expiry, at which point the holder is delivered the oil, will be priced closest to the actual spot price of physical oil. In normal market conditions one would expect the futures curve to be upward sloping (known as contango) i.e. it costs a little more for each additional month you lock in the price for – this makes sense as you are effectively transferring the cost of storage to somebody else; if this is charged on a monthly basis, then the further out on the curve, the more months of storage you are paying for.

For investors, who don’t actually want to take delivery of the oil, they will need to sell their futures contract before expiry; in normal market conditions not a problem, someone will want the oil. However, when storage space runs out to the point that it costs considerably more to transport and store the oil (especially in the case of land-locked WTI) than it would possibly be worth, we enter an environment where the holders of the WTI future about to expire last week were willing to PAY $35 per barrel purely to not have to take actual delivery.

This sums up 2020.

What an entry point! I’m buying. How can I do it?

‘Ladies and gentlemen, if I say I’m an oil man, you will agree.’ Daniel Plainview – There Will Be Blood (2007)

The obvious answer would be to buy an oil ETF – and many have; ownership of the United States Oil Fund (USO), the biggest oil Exchange Traded Product in the world, is up 500% month on month on trading platform Robinhood. Retail investors are piling in.

USO is ‘designed to track the daily price movements of West Texas Intermediate (“WTI") light, sweet crude oil.’ These words are taken directly from the USO website.

HOWEVER, herein lies the issue on how investors, including ETFs, access oil – by buying futures.

There is ordinarily an upward slope to the futures curve to reflect the cost of storage. It would therefore make sense that as the cost of storage increases, so too does the steepness of the curve i.e. the difference in price between the June future, July future etc etc.

The curve has never been steeper (known as supercontango); there has never been more of a difference in price between the contracts as one goes further out into the future.

This is especially important when considering an oil ETF.

As the ETF, and therefore in effect the investor, will not be taking physical delivery, the front month future will be sold before expiry, and the next month future purchased (depending on the roll mechanics of each individual ETF).

On the chart below, we can see the effect of this:

Source: Fortem Capital, Bloomberg

If the June contract were expiring in the next few days, in order to avoid delivery while maintaining exposure, the ETF must ‘pay-to-play’ by selling June and buying July – a loss of $5.26, and as long as the curve remains this shape, it will take a similar loss on each roll, each  month. If this loss is greater than any corresponding increase in the front month contract it holds over the month, the ETF will lose money even as the oil price increases – this current figure corresponds to a 43% increase in the front month future before you would actually make any money!

Incidentally, this ‘cost of carry’, even in more normal times, is why oil ETFs are notoriously poor at tracking the spot price of oil:

Source: Fortem Capital, Bloomberg Data from 01/01/2015 – 31/12/2019

This constant bleed is why the United States Oil Fund (USO) was trading at $2.50 early this week, when oil was trading closer to $20 per barrel, having begun its life priced the same.

On Tuesday April 28, they announced a 1 for 8 stock split i.e. replaced investors’ 8 shares of $2.50 with a new share valued at $20; this makes the product look more like it is tracking oil, as it is now priced roughly the same as a barrel – do not be fooled.

Ladies and gentlemen if I say I’m an oil tracker, you will not agree.

But surely there is some way to profit from all this? More than one…

Commodity Curve Strategy:

If the curve is upward sloping, there is a negative yield to the holder of a futures contract as it ‘rolls down the curve’ towards expiry. However, as can be seen from the previous charts, steepness of this negative ‘roll down’ is not equal between contracts

If one were to be short the contract with the most negative roll yield, and long the contract with the least negative roll yield, the difference between them (which has never been more) can be harvested, while insulating the strategy from parallel shifts in the curve as a whole.

SIMULATED PAST PERFORMANCE: Past performance data shown in this communication includes performance data derived from back-testing simulations. This is provided for illustrative purposes only. Details of the index methodology are available on request.Priced in gold, the MSCI World is down over 10% YTD, and back to the same level it was in the mid 1990s.

Commodity Congestion Strategy:

As discussed, oil (and other commodity) ETFs must roll their futures contracts in order to not take physical delivery.
They do this on pre-defined dates. The very act of selling the front month future will put downward price pressure on
it, and similarly buying further out put upward price pressure on that contract. One can trade ahead of this process,
shorting the front month, and going long further out in order to profit from the phenomena, while again not taking
on overall long exposure to oil.

SIMULATED PAST PERFORMANCE: Past performance data shown in this communication includes performance data derived from back-testing simulations. This is provided for illustrative purposes only. Details of the index methodology are available on request.

And is anybody doing this?

At Fortem Capital, we employ both strategies, amongst other structurally uncorrelated strategies, in the Fortem Capital Alternative Growth Fund as well as in the Diversifier Portfolio of the Fortem Capital Progressive Growth Fund.

Both funds have enjoyed an outstanding start to the year when compared to their peers.

Please do not hesitate to contact the team for more information.

Past performance is not necessarily a guide for the future. Forecasts are not reliable indicators of future performance. The value of investments, and the income from them, can go down as well as up and the investor may not get back the amount originally invested. The data is sourced from Fortem Capital Limited and external sources. The data is as of the date of this document and has been reviewed by Fortem Capital Limited.

Disclaimer

At a time when every aspect of life is being governed by the output from various models, it seems apt to talk about one in particular that has had a marked effect on the structured product industry so far this year

Dividends as an asset class

It was not too long ago that a dividend was something that came in the post as a welcome distraction from the pile of letters demanding one payment or another. Not only do dividends no longer tend to be delivered in paper form, but their role in the financial system has also evolved significantly. Derivatives now give investors the opportunity to gain exposure to dividends without actually owning any of the associated shares; dividends have become their own asset class.

Dividends with regards to structured products

The majority of structured products purchased in the UK are autocallables. An autocall gives the investor exposure to a set of pre-defined payoffs, if certain pre-defined conditions are met. These conditions are linked to the performance of underlying securities or indices.

At the beginning of the product’s life, the investor will be long delta (sensitivity to the underlying securities or indices), short volatility (due to holding a net short position in options), and short dividends (as the underlying is referenced in Price Return rather than Total Return terms). Therefore, the bank issuing the product will take the opposite side of the above, including being long dividends.

It is not the role of a bank to be a dividend storage facility, so they will naturally hedge out this long dividend exposure, effectively by selling them. But they will have to estimate what level the dividends will be for different market levels and the different years associated with the product.

Where do those estimates come from?

Models.

A couple of things to note about dividends:

1. It is seen as a positive signal to the market for them to be stable + vice versa
2. They tend to be directly related to a company’s most recently available financial report 

Clearly it is therefore easier to predict dividends to be paid in a year’s time, and these tend to be modelled as constant, the idea being that companies will exhaust all other options before cutting their dividend in the near term. Longer term they are modelled more in line with equity market levels. 

One can see this model working well during the Eurozone crisis of 2011:

Source: Bloomberg

During the 2011 crisis, the 2011 FTSE dividend futures (UKDZ11) were stable and unaffected, as the model would have suggested. However, as one moved out on the curve (UKDZ12 etc), they moved more in line with equity. Again, the model would have predicted this.

Roll on 2020, and not for the first, nor likely the last, time models have found things much harder to predict:

Source: Bloomberg

This creates a problem for the bank hedging for two reasons:

A combination of the fact that implied dividends that had already been purchased, but were yet to be voted when the crisis hit, as well as significant political pressure thereafter, has caused many dividends that were thought a lock for this year to be cut or cancelled all together. The FTSE 100 2020 dividend futures (UKDZ0) have sold off heavily as a result, and this has caused significant mark to market losses on the banks’ dividend books. In addition to this, as the market sells off, the banks’ dividend exposure increases, so they need to sell more dividends to hedge; not an issue so long as they will be selling at levels at or around where the model predicted. However, if one is selling at a discount of over 40% to where it was thought (the dashed white line), further losses can, and have been, racked up.

Models are great, but mind your eye if you are wedded to one.

Disclaimer

The debate around value and growth investing is one that will be very familiar to readers; value has gone through a notorious and prolonged period of significant underperformance.

May saw a value (cheap stocks versus their fundamentals) revival compared with growth (stocks with rising earnings), after lagging for over a decade. This led to a multitude of commentaries suggesting that, after numerous false dawns, an inflection point for value had finally arrived; Messrs Buffet and Ackman were poised to claim victory…

Source: Bloomberg

A month on and value investing, and indeed Buffet himself, are being questioned possibly more than ever before, being outperformed by a guy picking scrabble tiles from a bag at random. May and early June’s sizeable value rally has faded and retraced much of its progress,  hile growth has continued to defy gravity.

That more growth-oriented view can be expressed simply by buying the index in the US currently. The current weighting to Microsoft, Apple, Amazon, Alphabet and Facebook is over 20% of the S&P 500 so, by owning the index, one is automatically taking a very growth- riented view.

How much those tech behemoths are currently driving the index is also giving some investors cause for concern, especially given the scope for increased regulatory burdens moving forward and how much further the sector potentially has to fall from its heady valuations:

Source: Bloomberg

There is also a large and growing school who believe that when value does finally start to show itself, it is likely to be an extremely profitable trade; the question is when. Currently, expressing that view in the form of long only equity, in place of a more growth-oriented  allocation such as an S&P 500 tracker, is a risk in itself.

For those investors looking at fundamentals (the clowns!), for years the mega-cap growth companies in the S&P 500 (FAAMG) have provided the growth that was lacking in the economy as a whole, and while growth has been hard to come by, investors have been happy to pay a heavy premium for it:

Look familiar?

Source: Bloomberg

However, whether one is predicting a significant recovery in activity from here, or growth to remain muted/negative may be irrelevant to the fate of those tech stocks in the near term; a pick up in growth would likely lower the premium applied to those companies’ future  growth prospects (when growth is less scarce, investors will pay less for it), while markets coming back to fundamentals would likely hit them hardest with their stratospheric valuations and discretionary nature.

S&P 500 Equal Weight Index

Here at Fortem Capital, we constantly look for ways to bridge the ‘normal’ investment world with that of our derivative world. A rather neat way one might look to edge value into a portfolio, without completely forgoing those tech behemoths, would be to tweak the S&P 500 as an underlying within a typical structure. The S&P 500 is a growth index by virtue of its largest constituents being highly growth-oriented companies. However, by equally weighting the index constituents, one can express more of a value-tilted view. For example, exposure to those largest five companies, which is over 20% in an S&P 500 ETF, would be nearer 1% in an equally weighted index. Similarly, exposure to the smaller value names in the index would increase.

For an autocall, the equally weighted index also gives a pick-up on the coupon. For a supertracker, added participation would potentially compensate for any continued underperformance of value versus long-only S&P 500 market cap weighted exposure. With both shapes, one also gains the benefit of some conditional capital protection not afforded to those owning long-only equity.

There are few certainties in life; death, taxes, and the debates around active vs passive and value vs growth continuing to rage. It is likely too early to hang one’s hat completely on either side, but the time to start edging into value may be drawing near.

Disclaimer

Inflation is a phenomenon that most finance professionals have not needed to deal with in their career-todate. It has in some ways become a conspiracy theory, purported by crackpot economists who are yet to accept that inflation is dead, no matter how hard monetary policy tries to revive it.

There are three levels of monetary policy:

1. Interest rate changes.

Old school, pre-Global Financial Crisis monetary policy. Lower rates, stimulate borrowing; expansionary policy. Raise rates, encourage saving; contractionary policy. Theoretically, rates are an effective way to control inflation.

2. Quantitative Easing

The second level is asset purchases (QE), made popular by Ben Bernanke post-GFC. A popular school of thought at the time was that QE had to be inflationary, but inflation has failed to materialise, leading to a more modern, more dangerous school of thought that QE is in fact not inflationary; money printer goes brrr, stocks go up, inflation stays low – into perpetuity.

However, in order for QE to be inflationary, it must first increase the money supply. This might seem an obvious point as ‘that’s what QE does, right?’

Not necessarily.

The difference with the QE of the western world post-GFC, and Japan long before that, is that they did not increase the money supply, and therefore were not inflationary. In the aftermath of the GFC, QE was mostly just central banks interacting with commercial banks, this is in effect just an asset swap and has little effect on broad money supply. In order to increase broad money supply, purchases of longer-dated assets are required from non-banks in order to credit bank deposit liabilities i.e. create money.

The GFC was also a huge deflationary shock to the system as the combination of house and asset price falls caused US household net worth to fall off a cliff, and not fully recover for years. The Fed’s increase in its balance sheet in the proceeding years did not even actually offset this loss in net worth to the population. There was no significant money creation, and asset price inflation rather than any consumer price inflation was the result.

So what is different this time?

3. Direct injections of capital into the economy (MMT/Helicopter Money)

This time the Fed and US Government have come together in monetary and fiscal union, and the money is getting to the real economy:

$1,200 direct into bank accounts, unemployment benefit raised by $600 pw – meaning that 80% of the newly unemployed are earning more than when they worked, PPP loans, large corporate bailout packages, the Fed stabilising the junk bond market etc – more stimulus has been provided in three months than in the six years post-GFC, and there is another $2.5trn to come before the election.

Personal income in the US was up YOY through April and May, and asset prices have recovered quickly. There has not been such a loss to net worth, and when added to the fact that monetary and fiscal stimulus dwarfs what we have seen in any prior peacetime period means money supply is increasing, fast.

Source: Bloomberg

Neo-Keynesian economists would argue that this increase is still not inflationary with an output gap, there needs to be cost push-from wages, which looks unlikely given employment conditions. One might be forgiven for assuming that the bond market must be exclusively populated by neo-Keynesians, given where yields are trading currently.

Monetarists, on the other hand, see inflation in terms of how much the growth in money supply exceeds the growth in the real level of GDP, in other words whether more money is being created to chase a fairly fixed, or at least slow and linearly growing, amount of goods.

There is now 23% growth in the money supply concurrent with a short term drop in CPI, one is likely to have to give. It should be noted that it is relatively easier to raise prices than to get rid of money, which would require Quantitative Tightening (highly unlikely), or a loan loss collapse larger than 2008.

Is this what is driving gold higher?

Gold does serve as an inflation hedge, but it is slightly more nuanced than that; the gold price is closely linked to real yields in the sense that real yields are an opportunity cost to holding gold, normally.

Into the 2020s huge deficits have been carried, and the Fed have made it very clear that rates are being held at zero for the foreseeable future. The usual opportunity cost of holding gold as an inflation hedge could turn out to be just an opportunity if inflation ticks up and real yields fall further into negative territory. Gold could well have further to run.

Source: Bloomberg

Disclaimer

‘The measure of intelligence is the ability to change.’ – Albert Einstein

‘The price of doing the same old thing is far higher than the price of change.’ – Bill Clinton

‘You’re afraid of change. I don’t know the future. I didn’t come here to tell you how this is going to end. I came to tell you how it’s going to begin’ – Neo, The Matrix

‘You miss 100% of the shots you never take.’ – Wayne Gretzky

Change is a funny thing.

Sudden and drastic change can challenge the human psyche’s perception of self-determination and control. The importance of that perception is no better illustrated than by self-determination being a cardinal principal of modern international law, a jus cogens rule, from which no derogation is tolerated.

The world is currently experiencing its biggest change in a generation. Individuals’ relationships with their surroundings, with governments, and with each other have changed immeasurably, and likely permanently. As far as democracies are concerned, curfews and lockdowns were previously the stuff of Orwellian myth; he continues to look prophetical.

The global economy, and the businesses operating within it, have been affected in ways that before this year would have been unimaginable. The hospitality, leisure and travel industries in particular, that rely on the free movement of people, have been significantly impacted. But, the human ability to adapt never fails to amaze, and those companies in the worst affected industries that have been able to pivot and change, in light of their new environment, are surviving, and in some cases flourishing. Those that shut up shop and are waiting for a return to normal, in many instances, will not be reopening.

It is this ability to pivot and make changes, often small, in order to make things work in new environments, that will surely be one of the good things to come from an otherwise miserable year, and it is something that can be applied in the relatively niche world of derivative finance also.

The pricing environment for autocallables has deteriorated significantly in recent years as rates have come down, credit spreads narrowed, volatility fallen to all time lows before a brief spike this year, and now even previously sacred dividend forwards have been slashed. It must be noted that this deterioration in pricing is not exclusive to autocallables, one only has to look at the bond market to see how little one can now expect to be paid relative to recent history.

However, investors can look to be similarly nimble and use slight changes to flourish in this new environment:

Between February 19th and March 23rd of this year, the MSCI World Index lost over a third of its value. What has followed must rank as the most extraordinary recovery on record, leaving the index up over 10% overall for 2020, with the traditionally buoyant December still to come. Here is to hoping that investors have been good this year. 

The meteoric rise of risk assets at a time when fundamentals have seldom looked more dire over the short term has caused yet another existential crisis amongst those finance professionals, and there are still a few, that rely on ‘old fashioned’ fundamental analysis to formulate their view of the world. They would question whether, even with what is highly positive yet fairly early stage vaccine news, the underlying economic fundamentals justify a rise in global equities that at the time of writing leaves them 7% above their previous all time high. 

What is going on? 

The chemist Antoine Lavoisier in 1789 discovered that in any chemical reaction mass is neither created nor destroyed; atoms themselves just move through chemical compounds in cycles. This same logic can be applied to the financial world. If one assumes that the mass of assets in total remains fairly constant (in the absence of productivity growth), and perceived value flows seamlessly between the different assets that make up that total mass, then the fact that value is looked at through the prism of fiat currency – ‘how many dollars does it cost me to buy asset X?’ – means that as the amount of dollars in the system is increased, those assets will cost more dollars to balance the equation; asset prices goes up. 

This is the basis of monetary theory; inflation is seen in terms of how much the growth in the money supply exceeds the growth in the real level of GDP, in other words whether more money is being created to chase a fairly fixed, or at least slow and linearly growing, amount of things.

Money Supply Matters

The world finds itself in an unprecedented environment of ultra-loose monetary policy. Central banks are printing more money, at a faster pace, than ever before. The adoption of Modern Monetary Theory in the CARES act, under which the US Federal Reserve monetised $2.2trn of fiscal spending, means the printing presses are remaining firmly open for the foreseeable future, and possibly into perpetuity. This past week Jerome Powell called on the US Government to increase fiscal spending dramatically. MMT is here, it just passed through congress under the political cover of a pandemic.

Source: Bloomberg

Just how great the increase in US money supply has been post-GFC is illustrated above. The accompanying
decrease in money velocity (how often those dollars are circulating around the system) goes a long way to
explaining why CPI has not risen; the money is stuck on Wall St and has not found its way to Main St.
However, in order to balance the equation, dollar inflation must be expressing itself somewhere. And it is;
on Wall St, in asset prices:

Source: Bloomberg

Rather than thinking in terms of ‘how many dollars does it cost me to buy asset X?’, but instead ‘how many
dollars can I buy with asset X?’, it becomes far more reasonable, when considering the incredible central
bank action to make dollars less scarce, that equity has risen to the levels it has. But the crucial thing to
appreciate is that this is specifically relative to dollars

Looking at the 2020 return of the MSCI World in terms of a currency which has finite supply, gold, paints a
different picture of how the market has fared this year:

Source: Bloomberg

Priced in gold, the MSCI World is down over 10% YTD, and back to the same level it was in the mid 1990s.
The narrative around stockmarkets being at all time highs completely depends on what they are being
measured against, it is all relative. Looking at a newer perceived finite store of value in Bitcoin (21 million
can be mined in total), the MSCI has plummeted:

Source: Bloomberg

The fact that the global stockmarket index is at a record high against the dollar therefore says as much about the dollar as it does about the perceived prospects of the underlying companies. And the dramatic increase in the likes of gold and digital currency that have been seen this year are undoubtedly in part an expression of investors’ views on fiat currency as an attractive store of value moving forward. Tell a citizen of Venezuela, Russia, Brazil etc that gold is an ineffective inflation hedge. The dollar has simply not been there in terms of debasement, yet.

What now?

The pandemic, and the fiscal and monetary reaction to it, could well mean that the Rubicon has now been crossed. Further money printing, coordinated with increased fiscal spending, is set to characterise the next period of policy. Increased money supply means that a continuation of asset price inflation is likely. Add to this increased fiscal spend funnelling money into the real economy, alongside what Fed Vice Chair Richard Clarida calls ‘an enormous quantity of pent-up saving’, means that reopening is likely to bring about a rise in consumer spending, with the end result being the long awaited rise in CPI too. Fiat currency is likely to continue on its downward trajectory, that is the aim after all. Despite the moniker of ‘long-only’, most multi asset portfolios are in fact, for the most part, long various

asset classes and short fiat currency; one sells their dollars / pounds / euros to buy assets.

Therefore, holding the right types of equity, equity-linked investments, commodities, gold and alternatives may be no bad thing. ‘How many dollars will I be able to buy with the above assets?’ Likely more than now, the equation needs to be balanced. But, the ride will be a lot bumpier for some assets than others.

It is the bond market that should be giving real cause for concern, as here the investor is effectively long fiat currency. Real yields have never been lower and negative yielding debt has reached a record $17trn. ‘How many dollars will bond X buy me at maturity?’ the same number as when it was bought (credit risk aside) and, with yields and credit spreads being at record lows, the income on offer is minimal and the ride could get bumpy. What is more, those dollars at maturity could be worth a lot less than they are today.

It is all relative.

Disclaimer

Alternative Beta, Risk Premia, Factor Investing are nomenclature that have been gaining in prominence in the financial media for a number of years, and have also been growing in popularity amongst institutional investors. They are once again coming to the fore and gaining traction within the industry; as they should be.

What is Alternative Beta/Risk Premia/Factor Investing?

Beta or factor investing has always underpinned the investment management industry. A factor or type of beta are simply ways of referencing a specific driver of risk and return. Historically, portfolios have been anchored in a single factor; the growth factor or what has come to be known as beta.

The most obvious manifestation of the growth factor is with regards to companies that extract growthfrom the economy and return it to shareholders in the form of dividends and capital appreciation of the share price. The fundamental pillar around which the investment management industry is based is the notion that if one is long equity for long enough, then positive returns should be made to some degree or other. This leads to the typical portfolio having 60% allocated to equity or the growth factor. This factor has been both persistent and rewarding over time:

31/12/1984 – 31/12/2020
Source: Bloomberg

However,

in addition to the growth factor’s undeniably attractive trait of persistent positive returns over time, it does have some less desirable attributes. Firstly, it is a volatile factor in isolation; an annualised volatility of 20% over that period is too rich for the vast majority of investors. Secondly, its returns are negatively skewed; it tends to crash, and those crashes tend to be short, sharp and very painful, whereas its recoveries tend to be more gradual and measured relatively speaking. This leads to decision risk for investors; many would have decided enough was enough and crystallised huge losses in 2008 and 2020 if invested purely in equity. And an unfortunate trait of human nature is that those same investors would likely finally succumb to re-entering the market at much higher levels – nobody likes seeing their neighbour getting rich while they are not.

Therefore, an element of diversification is required away from the growth factor in portfolios – the 40 of the 60/40. Historically the bond market has been the go to tool in order to achieve this. However, in a post QE / Modern Monetary Theory World bonds no longer function as a diversifier to the growth factor in portfolios; this is an objective truth.

NB
This does not necessarily mean that bonds are going down, up or sideways over the next 1/3/5 years, just that they no longer diversify exposure to the growth factor in portfolios.

This has left the industry desperately searching for ways to meaningfully diversify its exposure to equity beta / the growth factor. There are alternative sources of beta and other factors that share that same persistence as the growth factor, but that are also completely uncorrelated to it, or indeed to each other, leading to portfolios with lower overall volatility and higher Sharpe Ratios. There are also a number of these other factors that have positively skewed returns, so whereas equity beta tends to crash downwards, they crash upwards, an incredibly useful characteristic when looking to insulate portfolios to some degree from the worst of equity market downturns.

What are these other factors or alternative betas?

If one is looking to alternative sources of beta to diversify exposure to equity market beta or the growth factor, then two clearly stick out as inappropriate from the above. They happen to be two of the most popular factors within the space. If one is short volatility, or betting that implied volatility will be lower than realised volatility, it can be thought of as being short the VIX index, also known as the ‘fear gauge’. To be short fear is to be long confidence, and that is of course going to be correlated to equity market returns. The classic carry trade of borrowing in DM currency in order to invest in EM currency for a yield pick up will perform particularly well in an environment in which the EM currency appreciates against the DM currency, likely concurrent with strong global growth and a supportive environment for equity
beta and the growth factor.

It would therefore make sense that any strategy that looks to diversify away from the growth factor or equity market beta in portfolios, should not be heavily exposed to factors that are correlated to it. However, due to the rewards that have historically been available in short vol and carry strategies, they are two of the most popular within the alternative beta fund space. This is likely fine if the objective is purely to produce positive returns, but is definitely not if it is to diversify. Screening those strategies from the core of any strategy should ensure that the strategy is statistically uncorrelated to the growth factor.

It can be taken further

In addition to there being a number of alternative sources of beta or factors, available across most asset classes, which share in the growth factor’s persistence, while being completely uncorrelated to it, there is another layer that can be added to increase confidence in a strategy’s persistence of return. If the very reason that a persistent return exists is due to the fundamental make-up of a market, rather than any macroeconomic influence over it, then one can reasonably draw a conclusion over that return continuing into the future while any structural anomaly exists. These structural returns arise as a result of an idiosyncratic risk that is independent of traditional macroeconomics, and therefore independent of the risks driving the rest of a multi-asset portfolio, as well as independent of each other. Examples of these types of risk can be seen below.

These types of strategies are by no means riskless, but their risk drivers are idiosyncratic; separate and different to the risk drivers of the 60 & the 40 of the traditional multi-asset portfolio (the 60 & the 40 which now have the same overarching risk driver in the Fed), meaning that they can provide uncorrelated returns and therefore genuine diversification.

Does it work?

Yes. The Fortem Capital Alternative Growth Fund is composed of a number of strategies investing in alternative sources of beta or factors to the growth factor. The Fund is designed to produce positive returns, with low volatility, and most crucially with negligible correlation to the growth factor that dominates investment portfolios. The Fund launched into the most remarkable market on record, but it launched into a raging liquidity driven bull market, only with a huge bout of volatility in the middle:

And in that environment, how might one hope an alternative might perform?

Ideally it should produce positive returns, with low volatility, in a completely uncorrelated fashion. If one were being greedy, possibly with some positive skew so that it crashes upwards at the same time that the growth factor in portfolios crashes downwards:

You never change things by fighting the existing reality. To change something, build a new model that makes the existing model obsolete.

– Buckminster Fuller

Disclaimer

Volatility is something familiar to all investors. It is somewhat akin to a distant relative at Christmas, often going unnoticed until *insert political conversation* causes an almighty eruption and ruins the day. The tendency for its spikes to coincide with large equity drawdowns has given it a bad reputation.

However, volatility itself is an alternative beta, a source of risk and return that can be isolated and invested in, and in the right hands it is an incredibly useful tool that fits into a number of different investment objectives, depending on the type of volatility exposure one takes.

The most established and widely recognised gauge of equity volatility is the VIX, which is constructed using implied volatilities of S&P 500 options. Sadly, as derivative geeks, much of our lives revolve around curves, and it is the typical term structure of the VIX that gives rise to the most popular risk premia trade there is, selling short-term US equity volatility:

The short end (0-9m) of the VIX term structure is typically upward sloping, or contangoed, reflecting the greater perceived uncertainty the further out into the future one goes. Short-term short volatility strategies monetise the fact that in general this increased fear tends not to manifest itself in realised adverse events. Therefore, selling volatility out at 9 months can allow the seller to ‘roll-down’ and earn a premium. The steeper the contango, the more premium that can be earnt. Currently the VIX is in steep contango.

However, curve strategies in general are susceptible to shifts in curve shape, and short volatility strategies are no different. Sellers of short term volatility will suffer in particular when there are spikes in volatility at the front end to which they are exposed – see March 2020 as an example:

Short-term volatility spikes tend to occur when risk assets also suffer for obvious reason. Moves tend to be sharp and severe, which is why selling short-term volatility has been accused of being akin to ‘picking up pennies in front of a steamroller.’ Incidentally, this is why many alternative strategies tend to become highly correlated in times of crisis; the allure of the persistent returns that selling short-term equity volatility has had historically is too tempting to forgo in order to maintain an uncorrelated nature; too many managers only cast for the White Swan –  and that change in the term structure would have had a very pronounced effect on any strategy aiming to be uncorrelated while selling short term equity volatility:

For volatility sellers, a way to control for those vicious spikes at the front end of the curve is to sell further out, exactly as structured product funds such as the Fortem Capital Progressive Growth Fund do. Further out, beyond the expiries that the VIX generally tracks, the curve is less reactive, and investors are less exposed. In addition, the PGF has the added benefit of in-built protection in the form of the conservative setting of barriers as well as a Diversifier Portfolio with a long volatility bias:

However, for any alternative fund that seeks to be uncorrelated to risk assets including equity, clearly selling short-term volatility is inappropriate (even though most do), as an alternative fund should cast for the Black Swan. Given that selling short-term equity volatility leaves one particularly vulnerable to big spikes in short-term volatility, then it might make sense to assume that long equity volatility strategies will give a defensive profile from which one should benefit in a Black Swan event. But, being long equity volatility is effectively funding the short trade and paying that premium that the sellers are harvesting, and with the VIX term structure as it is currently, and indeed tends to be, one might bleed to death waiting for their crisis:

Ideally, there would be an asset class for which the volatility term structure is downward sloping, meaning that one can take a defensive long volatility position while rolling up the curve to earn a premium; the strategy could play the part of both the White & Black Swan. There is one, in long term USD rates:

This upward sloping term structure alleviates the issue of bleeding while waiting for turbulence. But, as previously noted, curve strategies in general are susceptible to shifts in curve shape, in this instance to the curve moving into contango. Therefore, one would ideally like there to be a structural reason why the curve is shaped like it is, making it likely to stay that way. There are
two:

Firstly, due to the popularity of Formosas, foreign-issued bonds sold in Taiwan. Their popularity suppresses longer maturity US rates volatility as there is effectively a wall of volatility sellers further out on the curve matching the popular maturities of the Formosas.

Secondly, the vastly reduced size of the MBS market post-GFC means that there is also far less volatility buying as a hedge against pre-payment risk compared to pre-2008.

These are both important structural reasons why the slope is backwardated, and gives an investor confidence to take advantage in the knowledge that the shape is not as a result of short-term macroeconomic drivers, and therefore immune to an extent from macroeconomic shifts.

The Fortem Capital Alternative Growth Fund employs such a strategy, as the particular profile fits neatly into the overall objective of positive uncorrelated returns. The return profile, as a result of the structural difference in the term structure, is entirely different to being long equity volatility:

It is clear that an investor does not suffer the same negative carry as they do when taking on the mighty VIX term structure, while still having a defensive profile that is highly attractive for an uncorrelated Fund. Given that the bond market might well be where the next major turbulence emanates from, the strategy potentially makes more sense than ever.

Careful picking up those pennies.

Disclaimer

Commodities are very much back in vogue.

After falling more than 25% in the midst of the Covid-19 crisis, the Bloomberg Commodity Index (BCOM) has since been on a meteoric rise of over 50%, stoking fears of inflation for those looking at price increases in actual ‘things’.

Of equal note is the shift in the shape of many of the futures curves of the individual commodities that make up BCOM. A significant amount of the risk premia universe is centred around curves; the shape of curves and shifts in the shape of those curves. Investors are able to largely hedge themselves against parallel shifts up or down in term structure, while taking on the risk of shifts in term structure over the short term in order to earn a premium over the medium to long term. Commodity curve trades are an example of a classic, structural risk premia:

While the strategy, as with many curve strategies, can be constructed in order that it is insulated from parallel shifts in term structure up or down, the investor does take on the risk of a change in the shape of the curve, which can be to the strategies’ benefit or detriment.

However, it is important to note that shifts in the shape of the curve only drive shorter term returns. Over the long term, the changes in timespreads (difference in price between futures contracts of different tenor eg September 21 vs December 21) average out, and the persistent long term return is driven by the natural concavity of commodity curves. But, over the short term, changes in the shape of the curve have accounted for 50 – 75% of the daily moves in commodity curve strategies.

Those strategies benefitted in early 2020 when the pandemic and ensuing crisis sent commodities, illustrated by BCOM, into ‘super contango’, in other words the spot and shorter tenor futures’ prices fell more than those of longer tenors – the front of the curve fell more than the back.

Fast forward less than a year and BCOM has travelled from near record contango to near record backwardation:

*Historical BCOM Index Backwardation from 15/01/2004 to 10/06/2021

Source: Citigroup, Fortem Capital, Bloomberg

This journey of travel has seen spot and front month futures’ prices violently re-rate upwards, far quicker than the longer end of the curve, to the extent that, on average, commodity curves now sit at levels of backwardation that do not come along very often. This record speed of curve shift has been a significant headwind to commodity curve strategies over the past year, as intuitively would make sense; the investor has been short the part of the curve that has outperformed and vice versa. But, what is interesting is where this leaves the strategy looking forward.

The outlook from here is likely to be pretty good for a number of reasons:

Speculator positioning is extremely long in commodities, which is fine until said speculators want to sell and there is no bid on the other side of the trade. Typically, extreme net long positions mean that any catalyst that brings downward price pressure at the front end is greatly exaggerated.

Secondly, the huge rally in the front end of the curve over the past year may have left them in a place where timespreads have gotten ahead of fundamentals when one looks at the inventory cycle for a number of the underlying components of BCOM. Ordinarily, one can rely on an inverse relationship between timespreads and inventories; many timespreads are stretched to the point of implying shortages where there are none, particularly in the case of energy.

Finally, as previously mentioned, contango or concavity is structural for most commodities over the long term due in the main to the cost of storage being more expensive for shorter periods than longer.

These factors have tended to mean that historically commodity curve strategies tend to go through periods of strong performance in the aftermath of extreme backwardation as curves normalise back  into contango, and in fact some of the highest returns have been realised after periods of highly stretched backwardation such as those currently being experienced.

The fact that commodities’ natural home largely resides in contango is also the reason why commodity ETFs tend to be poor trackers of spot commodity prices:

Source: Fortem Capital, Bloomberg

Looking at the period 2015-2020, during which WTI was in contango for the most part (as illustrated here by the front two contracts’ timespread being negative), one can clearly see the bleed that constantly rolling down the curve causes for the ETF – buyer beware. Read the risk warning on the products for further evidence of the lack of tracking potential to the physical commodity.

Back to commodity curve, and in terms of implementation, there are numerous options available to investors. In Fortem’s own Progressive Growth and Alternative Growth Funds there are four separate implementations. The differences between them are possibly for a future GHTTG, but the premise of long term persistent structural returns driven by the long term structural natural shape of the curves is common to all of them.

The strategy is a long running staple of the risk premia / alternative beta space that has delivered uncorrelated positive returns historically, but the current environment of extreme backwardation may provide a particularly attractive entry point. Exposure has been increased in Fortem’s own Funds over the past six months, but strategies can also be accessed in note or option form for those investors wishing to invest in isolation.

To learn more about accessing individual strategies or Fortem Capital funds:

T 020 8050 2904 E sales@fortemcapital.com

Disclaimer