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The goal of a market-neutral investment strategy is to preserve portfolio value while delivering sustainable growth that is uncorrelated to the market. For investors, this defensive approach aims to provide smoother, more consistent market returns. The most interesting aspects of this risk management approach are in the investment methodologies and manager mindsets that have been developed to accomplish this pursuit.
While the category of “market-neutral” has tended to connote a specific type of hedge fund that can profit from increasing and decreasing moves in the markets by using quant techniques and complex financial instruments, there really exists a range of market-neutral strategies including one that is run as a hedge fund-of-funds curating smaller hedge fund managers that individually employ various hedge fund strategies and investment perspectives.
To better understand the implementation of this market-neutral approach and the investment mindset behind it, we were introduced to David X Martin, Chairman & CEO and Enrico Dallavecchia, President & COO and co-managers of Arctium Capital Management - a hedge fund-of-funds comprised of smaller, lesser-known hedge funds with a diversity of strategies that combine to deliver low volatility, uncorrelated returns.
David has impeccable risk management credentials and experience, including as a former Chief Risk Officer of Alliance Bernstein, the first Enterprise Risk Manager of Citigroup, and, besides his asset management work at Arctium, he is a Special Counselor to the Center for Financial Stability, an Adjunct Professor at the NYU Stern School of Business, a published author of cyber security and risk management books, and a former senior advisory board member of international management consulting firm, Oliver Wyman.
Enrico has equally strong risk management experience as the previous Chief Risk Officer of Fannie Mae and PNC Financial Services and spent 15+ years at JP Morgan, where he was a senior risk executive and co-head of risk technology.
We asked them questions to learn more about the structure and intricacies of creating and managing a specific market-neutral investment portfolio that they term as “uncorrelated alpha” and why they see their fund of hedge funds as a complement to any investment portfolio, rather than as a replacement for any other portfolio investment.
Hortz: Can you explain your approach to a market-neutral investment strategy and what it is designed to do for conservative investors?
Dallavecchia: The core idea behind running an uncorrelated alpha strategy is that when things go well, the markets are rising, and everybody is happy. But when markets go down, they can go down extremely fast and at a big clip destroying accumulated wealth. Another aspect to that is when markets change, they can change very rapidly giving you little time to appropriately respond versus just quickly reacting.
Conservative investors have voiced the need for an investment strategy that is resilient to big market drops and that generates adequate returns over time which can be defined as “market-neutral” or lacking correlation with the market. Our investment approach does broadly fall in the market-neutral category, but we pursue it in a differentiated way versus traditional methods as we do not run a hedge fund strategy. We have a fund of hedge funds structure that has multi-asset classes and we look for hedge funds that are uncorrelated to the market, rather than hedging away the market exposure. One could say: same direction but different road.
Martin: Traditional investment allocations, and even some alternative investments, are highly correlated meaning they move together with the equity, bond, and commodities markets. This correlation increases portfolio volatility and risk as all investments are affected by the same economic factors.
Many investors lack the necessary experience to navigate these volatile markets effectively and are seeking a more sophisticated approach to investment risk management which is often beyond the reach of average investors. To address this, uncorrelated alpha investment strategies are designed to diversify your portfolio with uncorrelated assets that attempts to provide more stable returns.
Hortz: David, please share with us some of your perspectives on risk management and what you learned are the most important variables in applying that to investment management.
Martin: If you go my website https://davidxmartin.com/ you will see countless articles and books that I have written and topics I have written around risk management.
One key principle of mine is that de-risking your investments requires knowing that there is much you do not know. The simple fact of why risk exists is because decisions are always based on incomplete information. In order to meet your investment goals over the long term, you must learn to manage the risks associated with a decision-making process that is by nature very flawed. My book, Risk and the Smart Investor, provides a framework for making such decisions that helps you manage the risk in every investment you make.
As the years went by in the risk management field, I came up with my own “Risk-Rules of the Road”. The appropriate rules here are: The best way to predict the future is to create it, risk should be fully understood and transparent, know your boundaries and stay in the lane and last, it is important to understand change/inflection points.
Hortz: Enrico, what perspectives can you share from your professional experiences during the 2008 financial crisis, and being a co-head of risk technology at JPMorgan?
Dallavecchia: For me, risk management is an ongoing culture where you develop processes that should be well thought out to give you the guideposts needed on how to deal with whatever crisis is thrown upon you. You do not want to end up with situations where you take risks that you really do not understand. You also need risk limits to be revised regularly, say every 6 months. You need to sit down and think about risks and continuously modify your processes rather than having to, all of a sudden, figure out from scratch what you are going to do. That is why I say that risk management should be a dynamic, ongoing process.
Another more general point is that risk management requires as much detailed information as possible. I learned when I started in the business that you literally want trade-by-trade level information. The level of details that you can accumulate allows you to have a much better understanding of your risks at the most granular level possible. This allows you the time to think about the risks ahead of time and not spend a lot of time just collecting information and trying to figure out what exactly your risk is when it rears its ugly head.
That is why we want to understand and evaluate the technology that is behind each of our hedge fund managers and the type of capabilities that they have as a critical part of our due diligence as to their level of sophistication. Technology and their use of analytics is heavily embedded in a number of questions that we ask fund managers.
Hortz: Is there a specific investment mindset or approach you need to run this kind of strategy?
Martin: There are a couple of key points and a clear focused mindset needed to get to our portfolio construction, manager selection, and ongoing management.
One, never get fixed to a view. I borrowed this from the White House situation room where they used to think about the future by doing scenarios to give you a sense of where you could potentially go. And then I also employed something called trip wise where you stop regularly to continually reassess your view of the environment. People get lulled into a view and in risk management, you do not want to be fixed to a specific view. Know what the shifting boundaries are. If these things happen, what should I be doing? What are my action plans?
Also, we do all the analytics to come up with an optimal portfolio but then we proactively and continuously adjust it as much as every quarter to refine what we think on a forward-looking basis, as opposed to many managers that have a backward-looking view of risk. It is fine to use analytics to understand the past, but we use it in a way to better understand the future. We do not assume that the future is going to emulate the past. That is the thing about our process of being proactive, of being on top of things, and always looking-forward.
Dallavecchia: As to finding sustainable growth that is largely uncorrelated to the market, first of all, you have to carefully look at and study the track record of the underlying hedge fund managers. We do not take anybody that has not been in business for less than 5 years. Secondly, they have to have a competitive advantage for lack of a better word. They need to have an investment niche and need to be very disciplined and focused on what they do. We ultimately invest with hedge managers that have historically done well in a specific niche over a long period of time in areas that have great potential.
One of the things that makes somebody good at determining good hedge fund managers is to be super inquisitive. We will open up the hood, get down into the inner workings of the firm, and look around to see how the engine is working. Guys like us want to know how things work and like to actively work with people who have specialized knowledge and experience in their niche areas of investing.
Hortz: Can you further explain how you as professional investors find, analyze, and select smaller hedge funds for your hedge fund-of-funds portfolio?
Martin: We want smaller, lesser-known hedge funds with consistent performance that is uncorrelated with the U.S. market over a long period of time. We find these funds through our extensive professional relationships across the hedge fund industry and proprietary research. We further select funds based on a set of parameters that include the size of the fund, the length that they have been in the market, understanding their investment approach, and studying their periods of strong and weak performance, along with their explanations on why they performed the way they did. Since we have been in the business of speaking with some of the top traders in the world on a daily basis, we can determine any irregularities or signs of concern pretty quickly because of our experience in doing these performance reviews. We have a good nose for understanding if the explanation does not really hold up or if it is a true account of events.
When we put these smaller hedge funds with a diversity of hedge strategies together, we do not focus on commonly used optimization processes. This is not the way we have put our portfolio together. We focus on their investment experience and making sure they are uncorrelated with the market and to each other. While there are these new techniques, including machine learning models, that are available now to optimize funds, we would rather talk to a lot of hedge fund managers directly to determine the appropriate mix ourselves. We look for the ones that speak to us better, where we like their experience, the nature of their returns, and the way they behave and respond to rapidly changing market and economic conditions.
Dallavecchia: When we do our due diligence and speak with the managers we are considering, we find that they love to talk about their trading, how they select a certain stock, why they go into certain types of products, or credit spreads in a certain area. And, as we are inquisitive by nature, we are good at asking questions. For us, it is important that the managers spend their time catering to their investors than constantly raising money from investors.
These smaller hedge fund managers may be very quirky or very technical, or they just love trading, and spending time with them allows us to see where they are coming from and how they have performed in a period of crisis. We want to understand how they were prepared, if they had a plan, how they dealt with adversity, and that is why, in general, they tend to be uncorrelated with the generic market. We talk to them fairly constantly because we do not just do the allocation and then go away. I love to talk to these managers because then I can go and speak with our investors intelligently about the sub-managers in our fund. It is a key differentiation for us in terms of finding these smaller hedge funds and maintaining our working relationship with them for our investors exhibiting a higher level of risk management process that we put in place.
Hortz: Why do you emphasize and recommend investors and asset allocators to deploy your fund as a complement versus a replacement?
Martin: It is really about this concept that we have thought about that we term “uncorrelated alpha”. It is like thinking about our hedge fund option as a vitamin pill. If you look at alpha itself, alpha may be defined as the excess return in relationship to a benchmark, and of course all benchmarks should be adjusted for risk. It is really the excess return minus the risk. So, what does “uncorrelated alpha” do? It increases your return and, in the purest form, reduces risk but not only the risk of what you are investing in with this product, but also the risk in your entire portfolio.
To further illustrate, if you take a look at a 60/40 portfolio and take a little bit off the 60 and a little bit off the 40 in terms of equity and bonds allocation and you add something like our fund, what happens is that you strengthen the consistency of your return and you reduce the risk in the overall portfolio. Therefore, it is not about replacing existing investments, it Is all about enhancing them. We should also note that no investment is risk-free, a fund of hedge funds is still investing in hedged funds where there is a non-immaterial chance for losses.
Hortz: What other thoughts can you share with advisors and asset allocators on how to deploy your hedge fund in investment portfolios?
Dallavecchia: Given the many market, macroeconomic, and global uncertainties concerning investors today, it is important to remember that equity markets have historically experienced swift and substantial downturns—18% in 2022, 37% in 2008, and three consecutive years of annual losses for a total of 37% between 2000 and 2003. These market fluctuations can be challenging, and many investors do not have the time, and likely the resilience to stay the course and benefit from eventual recoveries. It also provides a way to address your clients that ask: How do I invest so I am not as reliant on the market for performance?
RIAs need to differentiate themselves by offering new products that solve their clients' problems. Imagine your clients experiencing solid market returns with reduced risk by smoothing out cyclical market fluctuations.
This approach aligns with the principles of a market-neutral uncorrelated alpha strategy, where the Arctium Fund represents the alpha-generating component and the traditional stock and bond holdings providing the beta, or market exposure. By separating the pursuit of alpha from market risk, our goal is to enhance returns while simultaneously reducing overall portfolio volatility.