FidelityConnects: The long/short method: 5 years of alternative investing

[00:04:32] Pamela Ritchie: Hello, and welcome to Fidelity Connects. I'm Pamela Ritchie. Today we're marking the five-year anniversary of Fidelity Long/Short Alternative Fund. Over that five-year period markets have thrown just about everything at investors, global pandemic and with it its extreme volatility of 2020, the speculative surge of 2021, the rate-driven reset of 2022, political change here at home and in the U.S., around the world, and a fresh wave of momentum certainly powered by AI enthusiasm. Before we dive into what's happening now we're going to rewind just a little and look at how the fund has navigated those very different market environments. What has our next guest learned along the way and how has it helped frame his strategy and position for tomorrow? Joining us here to unpack all of this and more is Fidelity Long/Short Alternative Fund portfolio manager, David Way. Warm welcome to you, David Way.

[00:05:26] David Way: Thanks for having me.

[00:05:27] Pamela Ritchie: Thanks for being here. I'll remind everyone that this is available with live French audio interpretation so join us in either official language. Can you please let us know how this all began? Fidelity was very good at finding the losers and avoiding them for a long, long time, a track record of it. Now suddenly you're using those. Just remind us how this came about.

[00:05:50] David Way: I started at Fidelity almost 20 years ago, it was the summer of 2007. Over my career as an analyst it was my job to do what all of our analysts do which is identify the companies that are going to outperform and make sure they end up in our portfolios, and also identify the companies that are unlikely to outperform and avoid them. One of the things that emerged from my analyst tenure was kind of a special interest in separating those companies that we should avoid and actually grouping them into what are just sort of middling, average stocks, not terrible but not as good as the winners that we can find, and then finding the companies where real problems were about to emerge, where you would see more material underperformance.

[00:06:37] Fast forward to 2018 and talking with Andrew Marchese, our CIO, about opportunities to try to use that skill and sort of demonstrated success that I had over my analyst tenure and really coming together with a long/short alternative fund where we could do what we do on the long side, get excited about opportunities, find the winners and capitalize on those, but also both enhance returns and reduce risk by taking advantage of that pool of underperformance and using shorting as a mechanism to find additional uncorrelated or less correlated sources of returns. That really came into the fund's objective of saying, hey, there's an opportunity to take advantage of what we do to have a different return stream and lower risk. When I started the fund that was my objective and I'm kind of sitting here five years later hoping to continue to kind of do the same.

[00:07:32] Pamela Ritchie: Well, it's incredible. There have been some stark moments where you've been able to sort of hold onto the handlebars and ride up and down some of these jagged market moves that have happened over the course of the lifetime of this fund. Are we in another one of those moments right now?

[00:07:48] David Way: I think the only constant in the market is change.

[00:07:51] Pamela Ritchie: That's a good answer. 

[00:07:53] David Way: If you look at a market chart over 100 years it kind of looks like a pretty smooth ride. The reality is there's volatility and it's really important that when the market is rising to capitalize on that, to capture returns, but I would also say that it's equally or even more important to protect capital during the periods where we do see that downside volatility. When it happens it can be big and it's important to stick to a long term process, protect capital and be ready for the other side.

[00:08:27] Pamela Ritchie: But you don't want to be too early calling a market downturn. That's sort of where we're sitting right now. I want to go back into history to sort of get us here. We are apparently grappling with whether it's too early to call a market top, aren't we?

[00:08:41] David Way: I think in some ways it's a fool's errand to sort of say this is the top, this is the bottom. The market is a big place with lots of different things going on, different sectors with different types of cycles going on. Before we launched the fund publicly I was running a pilot version of the fund.

[00:09:00] Pamela Ritchie: This is in COVID?

[00:09:01] David Way: It was 2018 through 2020. As we got to the end of 2019 one of the things that I started to see emerge was some overheating in parts of the consumer environment, some overheating in the financial sector where credit risk was growing. I didn't know that COVID would be the catalyst for those shorts playing out but, ultimately, when things are just really good sometimes bad things happen. What I try to do is look at the market on a bottom-up basis. The top-down tells me what's the weather, what should I wear outside, but you go outside and you look for ideas and try to bottom-up stock picking and look for stocks that might be priced for perfection where there's things that could go wrong and then you try to execute on the short portfolio, while at the same time being open to the fact that whether valuations are at concerning levels at a market level or things seem too good, there will always be idiosyncratic opportunities to find companies where things are getting better.

[00:10:06] Pamela Ritchie: You're known for that, I mean, that's an area. Give us just sort of some broad examples of that time. Yes, as you say, COVID ended up being the catalyst of all catalysts for everything but what did you do specifically in that moment, and then coming out the other side?

[00:10:24] David Way: In 2020 as COVID was happening really it was harvesting profits on the short portfolio. Then as we approached a market bottom, no one really hung a sign saying, this is the bottom--

[00:10:47] Pamela Ritchie: This is it, today's the day.

[00:10:47] David Way: --you've got to get out and buy. Some things happened. I think one of the big catalysts for me really changing my positioning was not just necessarily stocks getting really cheap but the Federal Reserve coming out and saying we'll take any kind of collateral. Some of the stocks that I've been short experienced some significant upside which told me that things were going to stabilize. Having lived through the 2008 downturn the importance of credit and liquidity in the system really is paramount to creating the conditions for a recovery. Then we sort of ran with that until the end of 2021. We got to the place where we had the meme stock bubble. Fortunately, the fund had navigated that by avoiding shorts that can double on you overnight. The opportunity to short sort of became ripe again and really lasted until the end of 2022 when sort of the current bull market started.

[00:11:43] Pamela Ritchie: Okay, so let's go into sort of the 2022. This is where we've seen rates do what they're going to do. The concern is the massive monetary change and also the run-up of what we call the Mag Seven now and then, of course, their demise initially. Again, what were sort of the beginning signs of the marketplace in there that are analogous to times like this.

[00:12:07] David Way: I think in 2021 we kind of got to the middle of the year where we saw conditions like we see now, where you have profitless companies that are leading the market. You have companies with no or very little revenue enjoying market caps of 10 to 20 billion dollars while there is probably widespread agreement that many of these stocks are speculative and unlikely to grow into their valuation so they could be good shorts. If you were too early you could have lost a lot of money shorting those stocks because momentum at some point becomes a lot more important than valuation and underlying fundamentals. Then as we got into late 2021 it became clear that momentum was sort of breaking down. I think part of my process is really respecting momentum when I'm looking at shorts and doing the work ahead of time so that when the conditions are more ripe you can really step in with conviction and short these stocks.

[00:13:07] Pamela Ritchie: That's interesting because sometimes if you don't want to be too early what that can mean is that you're actually in the stocks with momentum. Would you then turn to short them?

[00:13:19] David Way: Typically what happens in the fund during periods like this is that there may be stocks that I own for fundamental reasons that then appreciate quite meaningfully on the long side and then become momentum stocks. It's possible that I'm still enthusiastic about the company, the fundamentals, the earnings growth but I start to get worried about how far some of these stocks run. One of the unique things that's available to me as a short seller is that I can actually identify companies that might be exposed to the same trends and I can go out and I can short a less well positioned company. Actually, even before I've fully sold a position that is currently generating profits for the fund I can start to hedge out that risk. It's just important for me in particular to be able to do that just because of my temperament. At the end of the day you have to manage a fund the way that you believe is right and really fits your investor psychology, in my case preference for being able to underwrite companies using valuation principles. It's part of why I wanted to start a fund like this because it really matches how I think.

[00:14:31] Pamela Ritchie: Take us through ... 2022 everything slid together. There go the stocks and bonds which was very painful for a lot of people with 60/40 approaches to the market. As a result of that, or at least one of the results of that, seems to be that alts have a new place in a portfolio that could be on the 40 side. This is discussed greatly. Ultimately, what you offer is equity so it is not fixed income at all. Tell us just a little bit about how portfolio allocation and construction has changed. It doesn't mean that you need to tell us how everyone should construct their portfolio but what are you noticing as changes?

[00:15:10] David Way: I think when people started to adopt this fund in their client portfolios the initial piece was looking at taking from the equity allocation. In the end this fund does have equity exposure. I have 100% of my money invested in this fund because I believe in equity markets long term and I think it's an attractive place to invest. Where the lines start to get a little bit blurred is if you look at the downside protection of the fund. If you look at moving from, as we did in 2022, from a zero interest rate period to a something interest rate financial conditions are relatively easy today. We have fiscal deficits, we've got monetary policy that is easing.

[00:15:53] Pamela Ritchie: There's money sloshing around out there.

[00:15:54] David Way: We have tight credit spreads, it's very easy for a lot of companies to raise money. If we see those monetary conditions tighten, and that could be something that we do see in 2026, we could see a similar environment to what we've seen in 2022. Now, we might not but as an investor you have to position your fund for not only the things that can go right but the things can go wrong. If that were to be the case I want to make sure that the fund is positioned to protect capital as it did in 2022.

[00:16:25] Pamela Ritchie: Let's dive into the question of AI, where it belongs. You can't get too far without talking about this, it's very important. For instance, software, traditional software, to a certain extent there's been some leapfrogging there because you can just do it with AI instead. How do you look at certain areas of the market like that? Do you make big calls, do you just wait?

[00:16:46] David Way: I think on the software side AI is a very big theme. I think that's the starting point.

[00:16:52] Pamela Ritchie: Don't get in the way.

[00:16:53] David Way: Over the next 10 years it is very likely to be part of the one or two or three things that materially shape how we live our lives, how we work and how we interact with other people and information. When you have a major theme like that the world is going to change a lot. It's going to create new winners, it's gonna create some losers out of existing incumbents who fail to adapt, but it does create a window for people to use technology in their business. I think one of the mistakes people make is that they're like, okay this new AI company is going to do this new thing and nobody else is going to change how they do their business. In strategy it's always important to understand the initial action and then what the reaction's going to be.

[00:17:41] Pamela Ritchie: And that your competitors are all working on fitting it in.

[00:17:43] David Way: Everybody's doing it. What you have to think about are the companies that are endowed with the right positioning. Nvidia was a graphics gaming company and they just happened to be in the business that has become very important. The company has executed well, they've managed to stay ahead of their competitors but they are very well positioned to benefit from growing AI spend in the U.S. but, in particular, rest of the world where growth has materially lagged.

[00:18:12] Pamela Ritchie: Let me just ask you on that. You have the ability to go outside of North America if you choose. Is there, while we're on the topic of AI, interesting opportunities for AI around the world? Lots of countries have to catch up, ultimately, build their own, are there opportunities?

[00:18:28] David Way: There's a lot more companies involved in AI infrastructure than Nvidia. What I've tried to do is ... at various points in time I have found enthusiasm for a stock like Nvidia to be high, perhaps too high. I owned the stock in 2023, sold it in 2024 and then, fortunately, in the downturn we saw in April the stock fell almost in half so it was a chance to revisit a company that I sold that I was optimistic about but I thought had got too expensive. Similarly, there are other global players with really excellent and hard to disrupt franchises that are involved in AI infrastructure. Even within the Mag Seven I don't really feel a need to own the Mag Seven. I generally believe that over time we should see more opportunities to be different than the market outside the very largest companies. The reality is over the last few years the biggest earnings growth have come from the biggest companies. It's my job to be flexible and not hold to a hard and fast belief about where I need to invest. You can think of companies like Meta, Google, Amazon and Microsoft that are beneficiaries. From a fund perspective I have tried to take advantage of those opportunities. You can see big changes in views because the technology is quite emergent. Earlier this year a lot of people felt that Google was the big loser.

[00:19:58] Pamela Ritchie: It flipped.

[00:19:59] David Way: There was a material drawdown in the company. At the time if you did the work on where AI was potentially going Google's fully integrated full-stack approach, even though their search business was at risk and something they needed to deal with you could see that Google was very well positioned. The stocks doubled off the low. In big companies they're still very divergent opinions and it's important to invest with conviction and a lot of research behind your views.

[00:20:31] Pamela Ritchie: There's also discussion about how policy has driven investing over the course of the last year. Lots of U.S. policy, some of it reverberating, obviously, in countries around the world with tariff policies. I mean, when you watched Canada go through some of this, lots of other countries going through it as well, do you take a look and say, gosh, this is an area where something can't be sustained, a particular sector is going to get hit with tariffs. Do you wade in there so that you can have conviction in other places?

[00:21:01] David Way: I think if you look at the bigger geopolitical events going on clearly we're moving from more of a free trade environment to a more restricted trade environment, more tariffs in the U.S. That has led to some uncertainty, some friction in terms of consumer spending. Tariffs at some level are working their way through consumer wallets and constraining purchases. You can look at any number of consumer companies that have reported this quarter and they are seeing just a more careful consumer. Although spending remains resilient, even within Canada the consumer has been more resilient than I probably would have guessed two years ago if you had laid out this scenario.

[00:21:46] Pamela Ritchie: Two years ago we thought in Canada everyone would be really hit by the mortgage renewal wall. It's not to say people aren't suffering at all but it doesn't seem to have had a contagion.

[00:21:58] David Way: Obviously, the housing market is in a downturn, it's a very important part of the market, but we have avoided, thus far, the bigger mortgage renewal gaps that we were talking about [crosstalk].

[00:22:14] Pamela Ritchie: And the reverberations, ultimately.

[00:22:15] David Way: Absolutely.

[00:22:15] Pamela Ritchie: Actually, let's put this question to you, this is a great question. Could you, David, talk about some protection strategies that are in place for the long/short fund? Just the volatility, market movements, how does that work?

[00:22:29] David Way: There's really two tools available to me to protect capital ahead of if we do see any kind of market drawdown. First, in terms of picking securities on the long side, companies that might be less economically sensitive or they may have some economic sensitivity but some degree of self-help or improving cyclical backdrop. U. S. housing, for example, is in a multi-year deep recession. It is arguably at a cyclical trough. We are at a record low in terms of the number of resale homes that have traded in the U.S. this year. I think it's 2.8% of existing homes were sold this year versus longer term above 4%. It's hard for things to get worse. Even though we have broader economic concerns looking ahead to lower interest rates in the U.S., perhaps even quantitative easing to bring longer term interest rates down to enable people...

[00:23:29] Pamela Ritchie: Why do you say that, perhaps even quantitative easing? Is that circling as a possibility?

[00:23:34] David Way: I would say that it is not a consensus opinion.

[00:23:39] Pamela Ritchie: We cannot print more money, can we?

[00:23:42] David Way: I think if you look at the U.S. economy one important driver of growth would be a more resilient U.S. housing market. It is a big part of the economy.

[00:23:53] Pamela Ritchie: And one the Treasury Secretary is very focused on.

[00:23:55] David Way: Precisely. Lowering interest rates helps the financial markets but people need more compelling 10 and 30-year mortgage rates in order to feel more comfortable selling their house which might have a 3% mortgage attached to it and then moving into something that maybe has a 4% mortgage.

[00:24:14] Pamela Ritchie: That is fascinating. When you look at that and sort of the rumblings of that changing of the guard, perhaps, how do you enter that derivative investing?

[00:24:26] David Way: I think one of the things ... it was similar to 2022 where even though I was not as positive about the economy there were a lot of companies pricing in sort of a full multi-year recession. You lean on valuation. Valuation protects your downside. We've seen a number of building product companies report this quarter, numbers are terrible. Volumes are down double digits year-over-year. The stock prices are quite resilient because we're at a bottom, everybody knows that things are bad. What you try to do is you try to have some part of your portfolio that is exposed to these types of companies that are at a cyclical bottom where there is lots of room for things to get better even if the rest of the economy is a bit shakier. AI has probably single-handedly kept the U.S. out of recession. Statistically, it has. If we do see any kind of slowdown, or at least slowing growth, there are other parts of the economy that have been effectively crowded out that we could see reemerge stronger.

[00:25:30] Pamela Ritchie: Fascinating. Just to sort of stick with this policy theme for a second, one component of the Big Beautiful Bill, so-called, has been the tax cuts and taking a look at how depreciation could be entered in but also this deregulation. Based on it it looks like there could be a whole bunch of regional bank mergers, for instance, a consolidation. Is that something, a merger acquisition environment that you can enter as a long/short manager? Is it of interest to you or not really?

[00:25:59] David Way: Certainly the potential for consolidation in an industry can be interesting. In the case of regional banks these are businesses that are not as strong as money centre banks. Their balance sheets are less resilient than J.P. Morgan or Wells Fargo might be. There is, clearly, a consolidation story. I think the rise of AI and technology as a backbone to kind of any business is going to increase the minimum efficient scale of operations. I think technology and regulation will create more consolidation in regional banks. We've got a great bank analyst who's always trying to find ideas for us. It does become kind of one part of the thesis. Even within industrial sectors where perhaps you have multiple competitors in an industry that they might have struggled to consolidate three or four years ago that could potentially consolidate now, those can become even more interesting because as you move from four players to three players or three players to two players the economic profit and sort of share of the profit pool that these companies can get can go up a lot. That certainly fits into our analytical approach to looking at these companies. Hey, if these two companies were to merge how would that change the industry.

[00:27:24] Pamela Ritchie: If I were to ask you a little bit about the performance of gold and also the relation of, we'll say Bitcoin particularly because as Jurrien Timmer likes to mention they play on the same team, different positions often, are these of interest to you? Do you take part in, for instance, the gold rally or Bitcoin or any other crypto interests?

[00:27:45] David Way: I think with gold it's not a natural asset class for me to own because I generally prefer productive assets that generate cash flow. Gold does play an important role in a portfolio because to the extent we do see inflation coming from interest rates falling, fiscal spending remaining high really globally as well as geopolitical uncertainty. We first saw gold emerge as an asset class that was appreciating in the aftermath of Russia's invasion of Ukraine. The seizure of Russian assets really led many actors to decide that rather than hold U.S. Treasuries they preferred gold because they were worried about their ownership of the assets long term if geopolitical winds changed. We've seen meaningful central bank buying of gold. That has been a big driver of the gold price rising. Now we have these other things emerging, potentially quantitative easing, lower interest rates, possibly inflation increasing, that would be a positive setup for gold even from these elevated levels potentially.

[00:29:01] Pamela Ritchie: Is that a yes or a no it's of interest to you?

[00:29:04] David Way: The fund does have more meaningful gold exposure than it had even two years ago. It is a downside protection thesis where if some of these risks don't emerge then there's other parts of the portfolio that I expect to perform well. If these risks do emerge there are some aspects of the fund that may require some hedging so gold is a very useful tool. As someone who used to cover mining I generally prefer multi-asset operators where you've got five or six different mines where you're not exposed to operational problems in any single asset--

[00:29:40] Pamela Ritchie: Where they've got copper and silver as well or something.

[00:29:43] David Way: --or tax increases.  You can even look at the streaming companies or the commodity itself to get that exposure to the commodity without taking the operational risk.

[00:29:53] Pamela Ritchie: Before I ask you to kind of wrap up with some final thoughts we are discussing right now on Budget Day in Canada so we don't actually know ... well, there's been a lot of things announced, there's some things that have been pre-announced, ultimately, for your investing, for the economy and ultimately how you would enter certain companies and markets and so on what would you like out of the Canadian budget? Any comments on that?

[00:30:16] David Way: I think the greatest economic challenge Canada faces today is productivity. It's something we've talked about before which is that Canada's falling productivity is a headwind to durable growth. We've spent a lot more on housing than we have on building GDP enhancing and skill and value add type assets. I think some of the early messages we've seen from the government have been around trying to rein in government operating expenses and invest in productivity enhancing infrastructure. I think that would be a welcome change from the past 10 years, as well as it could be opportunities for companies within the portfolio. If we're spending more on infrastructure...

[00:31:00] Pamela Ritchie: Do tell.

[00:31:02] David Way: Well, you can think about construction companies, equipment providers, those companies may benefit from higher infrastructure spending. Those things all need forklifts and bulldozers and people working. When those projects are completed if they shorten commutes, harden infrastructure, you can think of myriad reasons how spending this versus just on sort of personnel expenses can lead to economic growth, incentivizing, manufacturing, those types of things that is probably a necessary very timely type change in how we spend government money, I guess, our money as taxpayers.

[00:31:44] Pamela Ritchie: And hopefully attract more investment ultimately one day. Just to sort of wrap up for investors, the place, who is your fund for? I think it sounds like you treat it as core. Should many people think of it as core?

[00:32:00] David Way: I think if you look at the experience of the fund over time it has delivered strong returns, I would say compelling returns versus a lot of other equity funds and other alternative equity funds as well, with meaningfully lower volatility. I've taken a hundred finance classes through my undergrad and doing my MBA but I think it's a very easy and important lesson that if you can add an asset to a portfolio that has high returns and low volatility it is enhancing to your overall returns over time, not to mention making the psychology of investing easier, of staying invested through periods of volatility which I think is the most important decision an investor needs to make. When things are tough and you feel scared it's important to stay the course. We all have longer term financial plans that are counting on you to stay invested through those periods where the best returns might be just around the corner. I think this fund fits very well into an overall portfolio of helping to achieve that goal which is so critical to the success of a financial plan over 10 or 20 years.

[00:33:09] Pamela Ritchie: David Way, congrats, happy anniversary to your fund, to you, well done, and thanks for sharing your thoughts with us today.

[00:33:17] David Way: Thank you.

[00:33:18] Pamela Ritchie: David Way joining us here live in studio on Fidelity Connects. Coming up just a few hours from now, 4:30 p.m., live from Parliament Hill Vice President of Tax and Retirement Research, Peter Bowen, and Director of Tax& Retirement Research, Michelle Munro, are going to unpack the federal budget. They're in the lockup right now, or momentarily. Moderated by Glen Davidson this afternoon Peter and Michelle will discuss key themes shaping Canada's economic outlook including tax changes, spending priorities and what the budget ultimately may mean for you heading into next year. That will take place, as we say, just in a few hours from now. For our French language audience join us tomorrow at 10:30 a.m., Luc Godbout, he is researcher and Fellow at Cyrano and professor at the Department of Taxation at the Université de Sherbrooke. He will share his analysis on the federal budget, that's at 10:30 tomorrow.

[00:34:09] At 11:30 tomorrow, this is a departure from that discussion but you don't want to miss it. This is a special, extended webcast on AI and the possibilities that it offers to add value to your practice, so you personally, ultimately, the investment story. Portfolio managers Mark Schmehl and Darren Lekkerkerker are joining myself and Glen live in studio for a lively discussion on how they are playing AI in their portfolios. Ultimately, we'll be hearing more from the tech side. Tech analyst Ben Holton will be part of this discussion and Demand Spring Vice President Jonathan Milne, he'll be discussing how you can leverage AI for your business, sort of a B2B story. This webcast will feature not only live French audio interpretation but Mandarin,  Cantonese as well so do join us.

[00:34:58] If we move to Thursday, which seems like a long way away right now, the always exceptional Fidelity Director of Quantitative Market Strategy, Denise Chisholm. She joins us to discuss her latest sector thesis and dive deep into whether this is, in fact,  a bubble. She says no. Join us for that. Thanks for joining us today. I'm Pamela Ritchie.