MASTERCLASS: Liquid Alts & Market Volatility - April 2020

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  • 01 hr 05 mins 44 secs
Two experts discuss the current market environment, the importance of diversification, and the role of liquid alternatives. They also look at performance spreads and hedge fund strategies have held up well so far during the Covid-19 crisis.

  • Brooks Ritchey, Senior Managing Director, Co-Head of Investment Research & Management, K2 Advisors
  • Sal Bruno, CIO & Managing Director, IndexIQ, A New York Life Investments Company

Channel

MASTERCLASS


www.franklintempleton.com

www.nylinvestments.com/investmentsgroup

Jenna Dagenhart:Welcome to Asset TV. This is your liquid alts and market volatility masterclass. In addition to the human toll, the coronavirus pandemic has had a shocking impact on the economy. Two experts discuss the market stress event and the role of liquid alternatives. Joining us are two expert panelists, Sal Bruno, CIO and managing director at IndexIQ at New York Life and Brooks Ritchey, senior managing director and co-head of investment research and management at K2 Advisors of Franklin Templeton Company and a hedge fund specialist. Gentlemen, thank you for being here with us.

Sal Bruno: Thanks for having me.

Brooks Ritchey: Yes, thank you Jenna.

Jenna Dagenhart: Yeah, thrilled to have you and we certainly have a lot to talk about when it comes to liquid alts and market volatility. First to set the scene, I mean how does today's environment for liquid alts compare to others and your many years of experience? Sal, do you want to start us off?

Sal Bruno: Sure. We're experiencing tremendous amounts of volatility. Some might call it panic selling. It's somewhat reminiscent what we saw in the depths of the crisis in late 2008 and early 2009, especially before the fed and the fiscal stimulus got involved during that time period as well. We saw a bit of a decrease in the volatility once the fed and we have fiscal stimulus in 2008. We've seen a similar results here. I think this is obviously very different drivers in terms of what's causing the draw down and the volatility, but I think we've seen a similar pattern play out so far.

Sal Bruno: I think the key difference though is we still don't have a good handle I think on some of the numbers and how long this will go on for given the pandemic and the virus, and the number of infections and testing going on. I think it's a little bit more open-ended at this point.

Brooks Ritchey: Yeah. If I could add to Sal's comments, first and foremost, it's definitely a global health crisis. At the end of the day, we know what's causing the short-term volatility. We know the approximate lifecycle of the virus, but the economic data is so fuzzy right now. The damage is unknown. We've got unemployment. We've got obviously people in a tough health situation. First and foremost, it's a health crisis. We'll figure out the economic impact down the road. Until then, there probably is going to be above average volatility until we get a bit more clarity on the virus cycle and as Sal mentioned, the economic damage.

Sal Bruno: Yeah, I would actually just add to that. I think that's a really good point Brooks, and I think part of the issue is if we look at how long this goes on for, I think the longer this goes on for, the worse it gets and the chance of the "V shaped" recovery diminishes. If we do see getting back to work and the world getting back to normal sooner rather than later, I think it's much easier to just reopen the store and bring everybody back that you hired. The longer that goes on, unfortunately get dislocations. People leave their jobs, maybe find other positions. Unfortunately, some businesses would go under. I think the longer this goes on for, I think the more difficult it becomes to see a quick snapback.

Jenna Dagenhart: We're already seeing some of that when it comes to the jobless claims.

Brooks Ritchey: Oh, absolutely, the recent reports and I'm sure upcoming reports Sal will agree will be very tough in terms of unemployment and whatnot. The short story is that what started out as a health crisis has become a bit of a mini financial crisis, and now it's really a main street unemployment crisis, and I'm sure Sal would agree.

Sal Bruno: Yeah, I do agree, and I think part of the challenge has been I don't think we've gotten a really good handle on the number of cases that are out there, the actual true mortality rate and what that's likely to look like. We're starting to see some numbers coming out from the federal government, but testing is really just getting underway in a very meaningful way here. I know we're looking at probably some period of time before we hit this call, the peak number of cases, but I don't think we really have a good handle yet. I think that makes it difficult for the markets to start finding a bottom because I think you need a little bit of certainty that okay; the worst is behind us.

Sal Bruno: I think as long as we're going through this rolling period where every day seems to get a little bit worse, I think you need to start seeing a slowdown in the rate of acceleration or the rate of new cases not necessarily. We can still see cases go up, but the rate that they're growing up needs to start declining, and we haven't seen that. I think that's what's causing a lot of the anxiety and volatility in the marketplaces. People don't know is it going to be an end of April event or does it start bleeding into May and if then, does it stop then or keep going, so that's what's made it really tough on the markets.

Jenna Dagenhart: Yeah, all eyes really seem to be on those case numbers and it's a wait-and-see thing at the moment. As you mentioned, first and foremost this is a health crisis. That being said, what happens to liquid alts when you get a market stress event like this one?

Brooks Ritchey: Well, I'll start, and Sal may have some thoughts here. We've seen that during a stress event, you do get a lack of alpha. You get a panic selling or even a panic buying type of situation. Hedge strategies, liquid alternatives, even the long-only world, the correlations between companies, between sectors, they spike to close to one where people aren't really focusing on underlying corporate fundamentals or country fundamentals in the case of stock and bond indexes. Short term, you can see a bit of performance pressure in liquid alternatives, but what we've seen in the past is very soon after the stress event, you tend to get people focusing back on the relative fundamentals.

Brooks Ritchey: Let's say, the airline sector may not snap back in terms of earnings or the energy sector maybe a permanently hurt by this event and the Russia, Saudi Arabia news, but other sectors like technology with the work at home cycle improving and some of the sectors that the governments will help subsidize to recover, they'll do better. The initial stress event, it tends to be beta driven. Oftentimes, we see a dash for cash. We saw a week and a half two weeks ago where people are selling pretty much anything they can without regard for fundamentals.

Brooks Ritchey: Once those correlations come down, once the VIX rolls over from high levels, once we get a bit more fundamental clarity on different sectors and in the economic cycle, you tend to get people focusing on where are the winners in terms of equity markets and bond markets, and what sectors or what securities may lag a bit. That's what we call the alpha opportunity cycle, that's what hedge strategies are actually looking for. Short term, you get this stress event, you get this dash for cash type of selling, but pretty quickly after the stress event, we actually started to see it in late March and early April.

Brooks Ritchey: You start to see an improvement in alpha where people are actually holding on to the securities they like and maybe they're not repurchasing or maybe they're continuing to sell the securities that they don't like. The hedge fund managers can use those laggard securities as a market hedge as they rotate to some of the winner, so that's what we've seen in the 25 years here.

Sal Bruno: Yeah, Brooks I think you're spot-on. I think in some sense, we do know that when things get difficult, correlations tend to spike and not just companies and sectors, but asset classes tend to move very, very much in sync with each other. A lot of it is just panic and people selling what they can and raising cash. Even things that arguably should be safer, we do see selling in those asset classes because again, people need to raise cash and they tend to sell what hasn't been down as much and maybe they could just save some of the value there. For example, we run a merger arbitrage ETF and a lot of times deal completion risk should be somewhat uncorrelated to what's going on in the broad market.

Sal Bruno: It's really related to the merits of a particular deal and that's one of the great selling points of a merger arbitrage strategy that tends to be very diversifying versus the equity piece of your portfolio. You get into a situation like we've seen where there is that dash for Cash that Brooks mentioned, and you also get this uncertainty and people don't know how to price risk, so they just start pricing risk at the probably worst case scenarios, just because they don't really know where it is. I'm going to set the boundary is very wide to try to protect myself, and so we've seen spreads in some of these deals go extremely wide and that puts pressure on the prices of these target companies, which actually leads to lower returns for a merger arbitrage strategy.

Sal Bruno: That tends not to last forever. I think you have to get beyond the initial the weave of the panic and get back to as Brooks mentioned, the fundamentals and you start looking through these companies, these deals. You look at them deal by deal and we tend to find as many of them still make a lot of strategic sense, and companies are still the acquires, are still very committed to getting these deals done. They may take a little bit longer to get done, but we still see many of them going through as announced, and those actually represent some really interesting opportunities because typically saying merger arbitrage, you're looking at maybe after deals announced, maybe at 2% to 3% premium or spread that you can capture once the deal is completed.

Sal Bruno: We're seeing those now and some of those being priced in at 10%, 12% which is actually really attractive return. Then that's really reflecting a lot of risk. If you're willing to step in and take some of that risk and assume that some of the fundamentals resume and these deals actually get completed, we think those actually represent some interesting opportunities.

Jenna Dagenhart: Before we get too deep into this conversation, I want to take a step back and have you defined liquid alts for some of the advisors, investors watching who might not be quite as familiar. Do you want to start us off Brooks?

Brooks Ritchey: Sure. It is a catch-all phrase, but we like to define it as active managers. In fact, some people call a double active management because not only are these fund managers looking for positive fundamentally driven securities, whether they're bonds, stocks, or even currencies. They're also looking for the laggards where they can actively sell short those positions to hedge out a lot of the market or interest rate risk. The best definition we like to use is it is a group of fund managers investing in a set of various hedged strategies, long-some positions, short-some positions with the goal of generating performance, responsible performance without too much dependency on the trend, in the stock or the bond market.

Brooks Ritchey: Alpha is a fancy term. I'm sure some people watching the video are familiar with that term. That's really an overly complicated term for trying to generate returns without worrying about whether the stock market is going up or down, the bond markets going up or down, et cetera. Liquid alternatives, hedge strategies, they're double active. They're their managers, men and women looking for good ideas to purchase for their fund, and they're looking for not so good ideas mediocre or laggard type fundamental situations where they can hedge out most of the trend, most of the risk in the stock and bond markets.

Sal Bruno: When we think about alternatives, liquid alternatives, we break it down into its two pieces, liquid and alternatives, and it starts with alternatives. What do we mean by alternative investment? I think Brooks hit on the key theme there in the sense that you're looking for returns that are somewhat uncorrelated or not very much dependent upon the direction of either the stock market or the bond market, so that really can run a very wide range.

Sal Bruno: It could run very low volatility type strategies, like maybe tail hedging where you're really just trying to protect against extreme down moves in the market, all the way through hedge funds and merg arb strategies and long short type investing, more in neutral which I think is what Brooks is talking about here, all the way up to private equity investing and venture capital where you really trying to get out size returns from company specific. It really runs a wide range from across the risk return spectrum from very low through lowish to moderate volatility with hedge funds, and then very much higher volatility in the private equity venture capital.

Sal Bruno: Then you take the second part of that and that's liquid, and so that is a lot of these strategies are being done in illiquid form, in private hedge fund LP structure, limited partnership structures. The key we're talking about here is how do you capture the essence of those strategies in a liquid vehicle, whether it be a mutual fund or an ETF. Generally, 40 Act vehicle is what we're talking about. We think of it both ways. It's capturing that alternative investment risk return profile, that range through liquid instruments.

Brooks Ritchey: Mm-hmm (affirmative), and you bring up a good point too about diversification. I mean why is diversification so important during volatile times?

Sal Bruno: Well, diversification is really the key to I think portfolio theory and portfolio construction, and what you're trying to do is when you're constructing a portfolio is to try to put together a bunch of different investments or asset classes that have different expected drivers of return. You want them not to have positive expected return, but you want them to be dependent upon different things. Maybe that you're a betting on a certain group of securities long relative to another group of securities short, and it might be within a particular sector and maybe it's higher quality companies versus lower quality companies, or maybe one sector versus another sector.

Sal Bruno: What you're trying to do, and we talked a little bit earlier about merger arbitrage that has a totally different set of return drivers, and maybe commodity has a difference set of return drivers. To the extent those are all somewhat independent from each other, that makes a much more robust portfolio because if one thing happens, it doesn't the whole portfolio down. It may affect that piece of the portfolio, but the other sections of the portfolio that are really dependent upon other drivers of return should actually perform well even if that one leg of that stool didn't work out particularly well.

Brooks Ritchey: Yeah. There's some very interesting points to be made about diversification. You asked when the best time is to diversify and how does it help. The best time to diversify is before a stress event. One of the catch phrases we tend to remind the investment team about over here is when the VIX is low, get ready to go, get ready to cut your risk and increase your diversification. On the flip side of that, when the VIX is high get, ready to buy in the sense that a lot of the fear is priced in and a lot of people have tried to diversify through put options and other protection items, that's why the VIX is high. There's a key element of diversification now and I think Sal will agree with me.

Brooks Ritchey: Hedge strategies are targeting conditional diversification or even conditional correlation. Everybody says they want diversification until the market goes up 30%, and then they say they want correlation. Well, the key to a well-built liquid alternative’s ETF or liquid alternatives mutual fund is it actually does make money when risk assets are rising, when equities are rising. It's got a nice participation rate. It might not help perform the S and P 500 or the Fang index, but it has some nice responsible returns when equities are rallying. More importantly, the diversification is needed during the stress events or not even the stress events, during a standard market pullback.

Brooks Ritchey: I would definitely stress everyone out there to focus on conditional correlations and conditional diversification. The time to diversify is yesterday. The key to a well-run ETF and a well-run mutual fund is if it's offering upside participation and a bit more downside diversification.

Sal Bruno: Yeah, I mean I totally agree with what you're saying Brooks and that's been one of the challenges for the last called 11 years now, up until the more recent period where the equity market has been in a one-way direction and interest rates have been going down going on for years now. We've had is the benefits of diversification and hedge funds has been less apparent, especially over the last 10 to 11 years because the equity markets have been going off, because you've gotten good returns out of fixed income. It has been a bit of an uphill struggle to tell that diversification story, and we feel a little bit sometimes like a broken record and 2013, 14, 15, now is the time to diversify and of course, market just keeps going up and up and up.

Sal Bruno: We're continuing to tell the story and maybe with more recent events, that story starts to settle in a little bit, but I think you're right. I think when markets are really ripping higher, it becomes a much more difficult story to tell. I think when you look at alternatives and this gets back to the range of products I think in the alternative landscape, I think there are different alternatives maybe for different points in time. It's great to have a tail hedge strategy in place, especially for periods like this and really heightened volatility and maybe selling puts or some other way or buying puts I should say or some other way of diversifying the extreme downside.

Sal Bruno: Those can be expensive to hold during normal environments and over an 11-year period, the mark keeps going higher and higher and higher. Really, you're just shelling out money for puts that just keep expiring worthless. That's tough to stick to that strategy. Market timing is really difficult, but maybe there's a time for some of those tale strategies. We think hedge funds are an evergreen that really make a lot of sense for the reasons Brooks mentioned. They should have some upside participation and capture but provide some of the downside diversification. I think having a number of different options across the risk return spectrum within alternatives, we think is really important for end investors.

Jenna Dagenhart: I'm sure a lot of people are wishing that they had puts though at the beginning of 2020.

Sal Bruno: Absolutely, but again market timing is difficult and going into 2020, we put out our outlook and we said we were pretty positive on the general economic outlook, but watch out for externalities, exogenous shocks. Never imagined that we'd be in a position where we're maybe missing 80% of the economy is shut down three months into the year, but that is why you do want to have some alts in the portfolio because you don't know when those exogenous shocks are going to occur. It is very difficult to time and that's why I think Brooks' point earlier on was spot-on. You want to buy that diversification when it's cheaper and hold onto it.

Sal Bruno: It helps if it has some positive return associated with it and it's not just a constant cost, and I think that's why hedge funds in particular I think would be pretty interesting.

Brooks Ritchey: Yeah. There's an interesting statistic that we call quite often the HFRI hedge fund benchmark index. It basically only outperforms the stock market and the bond market about 16% of the time in the last 20 years since the year 2000. Seventy-six percent of the time, hedge strategies and I imagine Sal's ETF is quite similar. I did take a look at it, 76% of the time, hedge strategies and liquid alternatives perform in second place. Some years and some months, the stock market beats liquid alternatives. Other months and other years, the bond market beats liquid alternatives, but on a return to risk, on a Sharpe ratio basis, on a consistency basis, 76% of the time liquid alternatives and the hedge fund research index is diversifying either stocks or bonds.

Brooks Ritchey: It's really a smoother path type of diversifier. Hedge funds are normally not home run hitters. These are not the hedge funds of 25, 30 years ago. This is a strategy that's trying to make money regardless of the equity market trends, the bond market trends and yes, preserve capital during a stress of event.

Sal Bruno: Yeah, and I think you raised a great point there exactly what hedge funds and alternatives are trying to do, and I think part of the uphill struggle that we face in terms of educating investors is the media tends to report the great managers and it's coming out now manager A, B, C, manager X, Y, Z made 15% because they were short at the market. That's great. Maybe that's not every manager. Maybe it's one or two of them doing it. What we're trying to say is people like to hear the great story, and so that gets highlighted in the media sometimes.

Sal Bruno: What we're trying to tell is a similar story to what Brooks is saying is you want to keep hitting those singles and doubles, and not necessarily try and hit the homeruns because people hitting home runs today maybe the ones that are striking out tomorrow. We're trying to aim for much more that middle-of-the-road consistency risk profile I think that Brooks was alluding to.

Brooks Ritchey: Winning with the Sharpe ratio. I mean you both alluded to this, but would you say that there is a performance spread between liquid alts and other asset classes?

Sal Bruno: I think what we've seen is liquid alts and the numbers are really coming in of liquid alts relative to illiquid alts hedge funds, and they report typically on a monthly basis. It's the curse or the blessing, depending on how you want to look at it for ETFs and mutual funds is outperforms that every day and people are judging us in real time and measuring the performance of these liquid alternatives. As hedge funds and return stock to become available, I think the early indications are our liquid alternatives are actually right in the mix, doing pretty close to what the private LP structure is doing. I think from that standpoint, I think they have looked up to what they're supposed to do.

Sal Bruno: I think we look at spreads versus other asset classes. I think Brooks was spot-on on that when he was saying it may not outperform equities drawing down markets. We expect hedge funds and liquid alternatives to outperform equities. I think we have definitely seen that. Now fixed income happens to be doing a little bit better, especially certain parts of the curve. If you take out the credit piece, then it's really just focusing on the treasury zest doing a little bit. We think there are some spread in some opportunities versus some of these other asset classes that have been really sold off, and I think managers who are executing these hedge fund strategies I think should continue to do well on a moving forward basis given some of those opportunities.

Brooks Ritchey: Yeah, Jenna if I could add to that, look, asset class performance we all know, I'm sure most of your viewers know that the bulk of performance is derived from asset allocation, how much stock exposure do you have, how much bond exposure, 60/40, 70/30, yada, yada, yada. Well, the problem is interest rates are now zero or close to it. The equity market has shown that valuations and earnings growth does matter. We've got an aging demographic in the US, so yes, the performance dispersion that the variances between asset class performance is here to stay, although it may not be as positive as retirees and investors would like to see going forward.

Brooks Ritchey: The liquid alternatives are a cash plus target type of product class. Alpha tends to be generated independent of what's going on in stocks and bonds. If we can outperform cash yields and interest rates by 3%, 4%, 5% in a year or annualized, then that's fine. We're the boring product class that's designed for an aging demographic that just wants to preserve capital, make a little bit of money. Maybe they've done very well in the bond market. Maybe they've done okay in the equity markets until recently, but yes, the performance will vary between us versus stocks versus bonds, but we're in it for the long run.

Jenna Dagenhart: Are hedge fund managers seeing any outsized opportunities as a result of some of these recent market pressures?

Brooks Ritchey: Well, I'll start there Sal if you don't mind because we have money allocated out to the traditional hedge fund managers in our mutual fund. We have some separately managed accounts with 16 or so managers, and they're calling the last two or three weeks an alpha reset cycle. As painful as it was, the active traditional hedge strategy managers that are buying individual securities long and short, they're seeing a nice reset an increase in opportunities.

Brooks Ritchey: Now no one wants to gloat about a health crisis and there's still a lot of uncertainty involving default risks for the credit space and earnings and whatnot in the equity space, but the hedge fund managers are basically doing their homework and setting up for a very nice long versus short alpha opportunity that quite frankly hasn't been above average for maybe a few years. Now they're looking for some substantial returns from beaten up equities that shouldn't have been sold in the dash for cash.

Brooks Ritchey: Structured credit, some of the high-yield securities out there of the higher quality, the yields are quite attractive, but they want to see a bit more clarity before they put investor capital to work, but absolutely, the opportunity set coming out of this virus is going to be stronger in the near future than it has been in the recent past.

Sal Bruno: Yeah, I agree. I think whenever you get into a situation where you've seen some panic selling and things are sold off indiscriminately just because either people need to raise cash or they're really not sure how to price risk, so they give it the highest price they could think of, I think that does create opportunities. Whether it be credit opportunities, long term investing I think that Brooks is talking about, I go back to the example we gave earlier of merger arbitrage where a lot of these deals will continue to move forward and close almost all of them that we've heard so far on their original terms, but the prices have gotten beat up so much.

Sal Bruno: If you have a stock that has a cash offer for $23 a share and it had been trading at 22, people expect them that it was going to complete pretty easily. The stocks are now trading at 15 or 16. If that deal closes a $23 a share and it's a cash deal, you still get paid. You get paid a lot more than a dollar. You get paid $5 or $6 on that. I think those opportunities are there and I think as people start to realize that, the risk will settle down at some point that these deals will still go through. I think that would be such a tremendous opportunity for that particular type of strategy.

Brooks Ritchey: Yeah, let me just add a bit more to that. The economic impact on a lot of equity sectors, it's not going to be a V-bottom. This is a main street crisis as much as it's a health scare and crisis. There are going to be vastly different fundamental outlooks going forward for different equity sectors, different credit sectors. If the government's going to help subsidize and stabilize certain sectors, then they're going to have a bit of a recovery tailwind. Other sectors maybe energy related. They may come under pressure for quarters if not years. It doesn't really matter whether it's a hedge fund manager with a long short strategy.

Brooks Ritchey: I agree with Sal, the merger deal spreads are going to come back in from a nice opportunistic widening that we saw a week and a half ago, but there are going to be other sectors out there and an asset classes. We're not sure interest rates are going to rise for years. Is this the Japanification of the United States in terms of what we call noflation, no inflation, no yields, low to no growth? If that's the case, you're going to have to find a way to make money, picking the winners, and hedging out the losers or jumping in after an opportunistic alpha reset as Sal mentioned in merger arbitrage, hedge fund strategies or equity long-short strategies.

Brooks Ritchey: This is going to be a thinking man's market going forward. Follow the fundamentals, follow the fed, and follow the stimulus package, but there's going to be winners and there's going to be I'm sorry to say lagging sectors and securities out there. That's the opportunity set that sets up for active management alpha, whether it's hedge funds or long only alpha.

Sal Bruno: I think that is an interesting view and I think one of the things we're going to keep a close eye on is how does the retail investor respond and how do they react in the short term and the long term. In the short term, we're still seeing flows into equity ETFs, broad-based indices that track the S and P 500. We think what we're seeing is individual investors are still trying to time the bottom and bottom tick at the broad market level, then they can add asset allocation call. Will they continue to do that? Will the market take another leg down and does that cause capitulation on the retail investor side? Is that what finally form the bottom? Then coming out of that, where the dollars flow?

Sal Bruno: Do people revert back to old habits and just by the broad market index, or do they start seeing the opportunities that the active managers see and start directing their cash flows there? I think that'll be something really interesting to look forward to. I agree with you, there will be opportunities and I want to see how the retail investor tries to capitalize them if they actually see the opportunity and the value add from active management of reverses what we've seen over the last called 15 years from a capital flow standpoint.

Jenna Dagenhart: Brooks, which hedge fund strategies have held up well so far during the COVID-19 crisis?

Sal Bruno: Sure, yeah. Similar to the past, we've seen some of the global macro and CTA futures trader type of strategies actually generates small gains. For the month of March, we've seen some of the fixed income long, short managers what many of you may know is called relative value hedge strategies. They were actually able to capture some small gains and actually maybe some small losses, but basically unchanged on the month as they caught some of the short side. On the high-yield sell-off and the investment-grade sell off, some of these bond markets were priced for perfection. I noticed in the May liquid alternatives masterclass on Asset TV, someone mentioned that the fixed income markets were Goldilocks.

Sal Bruno: Well that's fine, but that the Goldilocks story didn't end so well. A couple of our hedged managers were able to capture the short side in some of the investment grade in high yield bond, so they held up quite nicely. As you would imagine, the equity long-short managers, they do tend to carry some sensitivity to equities. They took a mid-month hit to performance, but much less than the equity markets. To answer your question directly, global macro managers that many of you know can really go long and short a lot of equity indexes and bond markets out there, a few of them had anticipated the pressure. Given the U.S. election year cycle, if you've looked back in history, there tends to be a pickup in volatility during a U.S. election cycle.

Sal Bruno: That was a tell that got some of our managers defensive and even short. Obviously, a low VIX is a porcine. Low credit spreads tend to be a sign of complacency. A lot of the behavioral indicators were pointing to a bit of complacency and Goldilocks type of thinking. Some of our really forward-looking managers had some nice short positions on and yes, a few of them were lucky enough to own some index put options.

Jenna Dagenhart: Yes, I agree with Brooks. I mean global macro I think has been a pretty bright spot relatively speaking for so many other managers saying we do hedge fund replication, so we try to how to piggyback off the exposures that active managers are doing. We have a macro-oriented strategy that was actually one of the better performance relative to some of the others. I'd say equity market neutral would be one that you would expect to do a little bit better on a relative basis as it tends to be close to market neutral, and doesn't have a whole lot of equity market sensitivity, goes along with short of basket and tries to stay pretty close to zero net exposure to the markets.

Jenna Dagenhart: That I'd say a little bit better on a relative basis and something like a long short that Brooks mentioned will carry some equity market sensitivity. I think the asset class that probably did the worst was event driven, and not just merger arbitrage, but just broad event-driven strategies as all kinds of deals got put on hold, whether they'd be merged or restructuring. We think that'll bounce back, but I think those got hit the hardest, and then also the tail head strategies, whether it be put buying or strategies that play different correlations for as they're able to get a little bit ahead of the spike and correlations. Those have done fairly well and actually generates some slightly positive returns.

Jenna Dagenhart: Before we get into correlations, you said there have been some bright spots. How are clients responding to the recent performance of your liquid alternative products? You want to start us off Sal?

Sal Bruno: Yes. Unfortunately, we've seen some selling in our merger arbitrage ETF. I think people were a little bit surprised at the level of negative returns at merger arbitrage strategies in general, whether it be an ETF, mutual funds, hedge funds. Actually, we're all down pretty substantially over the period again as it was a major re-rating of the risk of some of these deals completing, and so saw some outflows there. We have seen inflows into some other areas of the marketplace that were hit a little more initially but have stabilized some. I know sidled alternative, but muni bonds were hit a little bit harder at first, then we had the fed backstop coming in and buying muni bonds and that has stabilized that.

Sal Bruno: We do look at high yield and we have a strategy in place that tries to isolate the lowest risk high yield bonds, which tend actually to be underweight things like energy and financial and industrials, and so that's held up reasonably well. We've seen a little bit of flows there. While they're not quite the liquid alternatives traditional definition, they are somewhat differentiated from a risk return profile relative to straight asset class exposures. We have seen some interest in those types of investments.

Brooks Ritchey: Yeah. We've been on the phone basically every day with various institutional investors. We have a retail mutual fund product. We have been pleasantly surprised with the response from clients.. We've gotten through most of the client [ZK1] calls and maybe Sal has as well, where the clients are basically thankful that we're not as bad a stress event as their high yield, some of their investment grade, obviously their equities.

Brooks Ritchey: We're hearing more and more and really consistently you all did what you said you were going to do. We had a nice Sharpe ratio and a nice performance here last year. We've maintained most of that performance this year. We did have a tough March, but relative to what they've seen in their other asset classes, clients have been actually quite supportive.

Sal Bruno:Yeah, and I think just to build upon your point, I think obviously we've been doing a fair number of client calls too. I think the calls that go the best are the ones where the clients really appreciate that you continue to execute your strategy and that you're thoughtful in terms of what's going on, what are the drivers. I think people just want to know they see headline numbers and they say, "This is not necessarily the number I expected. Can you tell me why?" I think that's the key is preparation.

Sal Bruno: You say you over prepare for these meetings and in the meetings I go the best are the ones where you can actually articulate to the client what happened, how risk got priced into the market, what do you think the opportunities are going forward and how you continue to execute your strategy and not have an emotional knee-jerk reaction and lose sight of what is it that you're trying to accomplish. I think those meetings go really well.

Jenna Dagenhart: Yes. Sal, what would you say is important for advisors and institutions to consider when they're evaluating liquid alternative investments?

Sal Bruno: I think the most important thing is obviously everybody is going to do their numerical and statistical analysis and look at Sharpe ratios and correlations and all that. The key though I think, and this goes for liquid alternatives, illiquid alternatives, I think that investor strategies understand what it is that you're potentially buying, what are the key drivers, who's managing it, how does the strategy work, when will the strategy work best, when will the strategy not work as well as other periods of time, and be able to understand what are the key risks that are embedded in that strategy and then what environment might those strategies get realized. Nothing goes up all the time.

Sal Bruno: There is no perfect strategy out there, but you have to understand if I'm buying something, I need to understand what the stress periods are and how will that be, well how will that materialize. I think that gives you comfort to get through those periods and say, "Yes, okay, I knew that I was taking..." Again, going back to merger arb. "I knew I was taking the risk that deals don't complete." Now we happen to see a systemic event where all deals got priced to not complete at one time. Normally, it's an idiosyncratic or very specific type of thing, but we know that that is a risk, right? If deals don't complete, you don't make money in merger arbitrage.

Sal Bruno: Understanding that that is a risk and understanding how that could play out I think is really important in the initial conversations articulating that when people are thinking about buying strategy, so that when those difficult times do come, you have something to go back to and say, "Yes, we know that this happened, but we said this was a risk in the strategy and sometimes risk realized."

Brooks Ritchey: Jenna, if I could add to Sal's comments the... As I'm sure most people would imagine, you've got to trust the people running the product, right? You've got to trust that Sal's model is being well executed, and that he's got good people behind him. You've got to trust the process and more and more, especially as we get into a post bull market scenario, pay some attention to the oversight and the controls that are in place. The larger organizations and the well-structured organizations that have regulatory oversight like an ETF structure or a mutual fund structure, liquid alternatives, you've got boards of directors keeping an eye on the portfolio management team.

Brooks Ritchey: We've got the regulators keeping an eye on the portfolio management team. There's leverage limits, there's security limitations. There's a lot of controls and oversight in place that keep a management team from doing something that's not responsible. I would stress the people that are important, are they answering your phone calls? Are they distributing update notes that explain why they lost money or why they made money? Their process, is it understandable and is it consistent and is it robust? Then is there oversight? Are there controls in place so that you don't get the rogue trader or the fat finger trade error type of situation? It's really a return to responsible understanding of hedge strategies and who's trying to do the right thing every day.

Sal Bruno: Yeah, I think Brooks that's a great point, and these things go in cycles, right? I mean these were the same lessons we learned in 2009 and 2010, 2008 even with Madoff. Is there oversight and are people watching it? The 40 ACT structures are great for that because it is SEC regulated. We're regulated by FINRA and look at the controls that are in place. I think this of all the times when things are going very difficult, you can't always control with how the market is going to price an asset. What you can control is that you faithfully execute the strategy that you said you would continue to execute. I think Brooks is spot-on with that comment.

Brooks Ritchey: Yeah. Look, laws and regulations are there to protect people from being silly. There's a reason there's a speed limit on the highway, so that you don't drive too fast and put yourself and others in an unsafe situation. We actually welcome regulations. I know that's going to raise some eyebrows, but it's okay to have a cap on leverage. It's okay to have a cap on the types of securities that are traded, especially in liquid alternatives. The reason mutual fund liquid alternatives are growing as it is and the ETF structures as well is because they understand that there's a regulator, a watch dog keeping an eye on people like Sal and myself, make sure we're not doing something you're responsible.

Brooks Ritchey: It's the over leveraging and the illiquidity reaching for yield and reaching for illiquidity that normally is the cause of many of these crises including two weeks ago. The regulated products, they're there for a purpose to protect myself and the investor.

Jenna Dagenhart: Sal, how are you watching the regulatory landscape and the amount of leverage in the markets?

Sal Bruno: Well, I think what's really interesting is we haven't been really a tremendous regulatory response on ETF side, but we have seen a market response in the sense that we've seen probably 30 or so ETFs from competitive firms that have gone out of business, closed up or significantly reduced their leverage. There are two- and three-times bets long and short on different asset classes. Some of those have closed. Some of those have actually limited the amount of leverage they're doing. While I don't believe that has been regulated from the top down, I think it's an innate response from the industry itself to self-regulate and say, "Do these products really make sense for our investors in this particular time period?"

Sal Bruno: I think it's interesting, it's been more of a grassroots type of response than it is a regulatory response, at least at this point.

Jenna Dagenhart: Brooks starting with, you how are fiscal stimulus measures impacting liquid alts?

Brooks Ritchey: Well, hopefully it's having a positive impact on everyone including down at the main street level. The estimates are that globally there's been approximately 15 trillion dollars’ worth of stimuli in various areas from interest rate debt moratoriums and obviously quantitative easing and whatnot. How is it affected liquid alts? I guess the short answer is it's going to probably add some positive tailwind to this alpha opportunity cycle. It'll probably stabilize some of the long only product classes out there as well.

Brooks Ritchey: I don't want to say it benefits only hedge strategies, but the yields that are available in some of the high-yield areas, the yields available in structured credit, the yields available in emerging market fixed income that hedge fund managers can dip their toe into on the long side, and maybe sell short something that's got a much lower yield. They can capture that yield spread and they know that they've got the Federal Reserve looking to buy investment grade bonds, looking to take some pressure off of some of the issuers in student loans and mortgage-backed securities. The net is a positive. We do believe that it's a positive for the world.

Brooks Ritchey: This is an attempt for the banks to be part of the solution this time. In 2008, the banks were part of the problem, but the Federal Reserve, the European Central Bank, they understand they've got to get the liquidity pipes flowing again that'll benefit yes, hedge funds, but not to any more degree than long only fixed income, down the road long only equity, but more importantly it should benefit mom-and-pop investor.

Sal Bruno: I think that was the main and the rightful purpose of the fiscal stimulus that was sought. I mean it really was to benefit the everyday person on the street who maybe a waiter or working in a casino or hotel or flight attendant that is suddenly out of work, and I think it's rightfully so that we had the size stimulus package that did come out. I think what was interesting is the fed responds very early on, even before we saw the fiscal stimulus, and Congress and the president act really to try to break some of the issues that was showing up on the short end of the credit curve.

Sal Bruno: We saw that there was a lot of issues there with funding and with these bonds trading, and it was really that the fed stepped in when they did and broke that logjam and allowed not just ETS, but the underlying assets themselves to price and start moving in a more free manner.

Brooks Ritchey: Yeah, and you know what this is going to do is it's going to generate a much wider variance, a much wider performance variation between sectors that had a nice balance sheet coming into this or maybe they're subsidized a bit by some of the fiscal stimuli that's been announced. Some other sectors may not be as well positioned. Trump announced on recently that he's talking about a two trillion-dollar infrastructure, almost like the works projects administration type of infrastructure package. Well, that'll benefit certain sectors while not helping as much some other sectors. Again, I can't stress enough about the active management alpha cycle, whether it's the long only space, the hedge fund replication space or the traditional hedged long short strategies.

Brooks Ritchey: They're going to see a much clearer vision going forward. When rates were low and quantitative easing was going on before the stress event, nobody cared about fundamentals. I know Sal and I talked about that earlier, but very few people cared about individual security and even country fundamentals. Greek came under pressure and they got rescued Italy on their debt service came under pressure, they got rescued. When rates are low and money was free and easy, then no one really cares about the mediocre companies because they know they're going to survive, but now that we've got what tends to happen during volatile events is people first and foremost try to get through the stress event.

Brooks Ritchey: Then right about now this week, maybe in the month of April, people will actually look at their fundamentals, will get earnings out, and we'll see who might benefit from quantitative easing, who might from a recovery in the virus cycles. The winners will win and the and the laggards will lag.

Sal Bruno: I think that's right. I think people will start looking at a more of the income statement. I think right now, people have been looking at the balance sheet and just saying, "Who has enough cash on hand to survive?" Apples got a boatload of cash as much as I've done reasonably well relative to many of those, and some of the other big tech firms. Amazon is included. Companies with big cash on the balance sheet, they can better withstand some of these short-term pressures, but I think you're right Brooks. That conversation starts to move from the balance sheet to the income statement. Okay, you've survived, now who's going to prosper? Who has the better growth opportunities going forward? I think that's where the market will start to look next.

Jenna Dagenhart: As we just discussed, central banks, governments around the world are stepping in with all kinds of stimulus measures to try to get the economy to recover. What indicators or hedge fund managers following that might alert an investor that the worst is over?

Brooks Ritchey: This is a sentiment driven market right now and recently the month of March and probably a bit into April. I can share with you the five or six indicators that our investment committee is monitoring, and they tend to be focused on the behavioral indicators. In no specific order, we need to see the volatility index, the VIX, the VIX continue to come down from high levels. That people call it the fear index, we actually refer to it as the greed index. When the VIX gets too low, people aren't worried about the risks. When the VIX is high, people have priced in a lot of the risks and the bad news. We're watching for a continuation of the downtrend, the reduced pressure in the VIX.

Brooks Ritchey: The second thing is clearly credit spreads. We want to make sure that corporations and governments, the financial liquidity pipes, the credit environment is stable, so we don't get a 2008 and 2009 part two. The fed as I think Sal mentioned has done a lot to inject the liquidity and we need the pipes to remain open. We think the banks will flow through that excess liquidity. We'd like to see credit spreads continue to come down. They were 11% over government bonds about a week ago and credit spreads have come down. That's a sign that the liquidity pipes are working. The third area is correlation. There's indicators on Bloomberg and you can probably search the web for implied correlation.

Brooks Ritchey: That is a sense of how sectors and companies are moving independently or together. A high correlation means that there's fear in the marketplace and people are selling anything they can find a bid on, and the correlations were all very high. That correlation has come down. We like to see that come down further. Then the fourth area is a bit outside the behavioral indicators, but we are following the ratio of a number of patients with COVID-19 relative to the number of available hospital beds and/or ventilators. We want to make sure that we're respecting this health crisis and the health impact on the economy and on sentiment, but the virus seems to have approximately a two-month cycle to it and we're watching obviously China and Korea who have gone through the virus cycle.

Brooks Ritchey: They seem to be behaving much better in terms of their stock market, and we're watching the patient count obviously in New York City but in the U.S. in total and as well as Europe. We want to see that patient count come down to a manageable level, so that there's enough hospital beds and ventilators to handle those that are ill. That'll give us a sense that the virus impact is mostly done, then we move to the economic impact, and we'll talk about that in a few weeks.

Sal Bruno: Yeah, I agree, especially on the last point about the virus indicator and we talked a little bit about it. I don't think we need to actually see the number of cases come down, but I think it needs to start going up a lot slower than it has been going up. Slowing the acceleration in the number of cases I think is really important. I think China and Korea offers some interesting examples of countries that have gone through it and have been able to reopen and hang out the open for business sign to a large extent. Obviously in Europe, they're not quite there yet. We still see Italy and Spain suffering and the human toll there is terrible, but we do want to see the rate of change, it starts slowdown in the US.

Sal Bruno: I think for stabilization, we want to see what some of the cash flows look like where our individual investors really still piling in or just oblivious to what might happen. Will those start to slow down at all I think it's an important thing as we talked about earlier. In terms of how the cash flow will moves forward, does it go back into active or does it just keep slashing back into passive.

Jenna Dagenhart: Yeah, a lot of people also watching to see that curve flatten as you said. I wonder looking forward, where do we go from here and what's next for liquid alts in the middle of this health crisis?

Sal Bruno: I can start on that one. I think once we get beyond the panic situation, what it seems to have gone, there's that initial wave who wants to appear to panic. We got fed response, we got the fiscal stimulus response. Nothing we're in the all clear out of the woods yet with markets can still go down. Hopefully, we've moved past the panic situation and become more of an orderly trying to really more accurately assess the fundamentals and price risk, more accurately as opposed to just wide scale blowing out spreads all over the place. I think hopefully we're at that stage, and so I think that sets up well for navigation. I think liquid alternatives can do well in high risk environments.

Sal Bruno: I think they have proven themselves to be great diversifiers and normal to high risk. Extreme risk and panic, when everybody's selling and heading for the doors at the same time, I'm not sure that... Unless you're short at the market, there's really no other way to navigate that for that short period of time with panic. I think hopefully we'll be on that and that we start seeing a more normal elevated risk as opposed to panic risk, but I think liquid alternatives will do really well in that type of environment for many of the reasons in terms of the opportunities that Brooks and I have spoken about already.

Jenna Dagenhart: Yeah. Brooks, any need final thoughts on your end about where we go from here?

Brooks Ritchey: Yeah, we've got a very clear scenario that we're managing to, so I'll try to be brief. This is not going to be an economic V-bottom. It's going to be an L-shaped bottom on the economy. We will get through the virus cycle, but there has been some serious damage that's hard to turnaround in terms of the economy. This ties in with your earlier question about what are we hearing from clients in terms of our positioning in the portfolio, our liquid alternative mutual fund, we are looking for increasing allocations to high alpha driven managers and maybe waiting a bit on the high beta driven managers.

Brooks Ritchey: For all the reasons that Sal and I mentioned, we really think the next stage in the asset management world is going to be finding the winners or survivors and avoiding the laggards, whether it's any mutual fund ETF or a hedge fund. We do think that down the road, there'll be a recovery in terms of GDP, but that recovery will be a bit stronger outside the US. We've still got a US election cycle with all the rhetoric and headlines that goes around that until November. We're tilting towards some managers that are high alpha. We're tilting towards global macro managers that can be nimble and capture some of the non-US recovery efforts that'll lead us out of the virus cycle.

Brooks Ritchey: We do like fixed income long short managers. We like the yields that have been opportunistically reset down here, and we like the fact that they're hedged out some of the interest rate volatility on our side. We're defensive, but we're moving out of our bunker and probably in the next week or two, we'll put some of this new investor inflow cash back to work with the managers, but more alpha driven. I can't stress that enough. It's going to be a busy summer, a volatile summer, but it will see sector rotation. A lot of clients are talking to us about lightening up on their recent bond holdings because they've seen such a rally, but they don't want to go into equities, right?

Brooks Ritchey: In the old days, you went from you took your profits and bonds and went into equities, and oftentimes vice-versa, you'd sell your equity profits and go into bonds. The problem is the equities are going to need an L-bottom, an L-shaped economic bottom before equities have some nice earnings growth, and yields are quite low, and cash is quite low. I don't mean to sound a bit biased, but the clients we talk to, they are looking at maybe trimming their bond allocations and looking at hedge strategies and other alternative type of investments.

Jenna Dagenhart: Sal, any final thoughts on your end?

Sal Bruno: No, I echo what Brooks is talking about in terms of the opportunities going forward. We think there are opportunities out there. I think when you look at active hedge fund managers and whether it be in the illiquid or the liquid space, we think that they have potential to add value. I think when we look at the hedge fund return opportunities, we look at how much of it is systemic exposure to different asset classes or different factors and how much of it is alpha. Our strategies tend to try to pick up on the systemic components of it. I think to the extent that hedge fund managers do well and deliver returns, I think a chunk of that, a portion of that return will be systemic in nature.

Sal Bruno: You capture that through the ETFs, and then it does leave interesting opportunities for active managers who are doing a lot of the research that Brooks was talking about to add alpha on top of that. When we think about the opportunities looking forward, we're thinking about alpha-beta separation and good managers who are doing many of the things Brooks was discussing to provide the alpha piece. We think that liquid alternatives primarily and hedge fund replication ETFs I think are well-positioned to deliver a lot of that beta exposure.

Jenna Dagenhart: Well, gentlemen, thank you so much for your time and your insight. It's really great to have you.

Sal Bruno: Thank you Jenna.

Brooks Ritchey: Thank you Jenna.

Jenna Dagenhart:Thank you for watching this liquid alts and market volatility masterclass. I was joined Sal Bruno, CIO and managing director at IndexIQ at New York Life and Brooks Ritchey, senior managing director and co-head of investment research and management at K2 Advisors of Franklin Templeton Company and hedge fund specialist, and I'm Jenna Dagenhart with Asset TV.