FidelityConnects: The pros of pair trade investing with Fidelity Market Neutral Alternative Fund

[00:04:00] Rory Poole: Hello, and welcome to Fidelity Connects. I'm Rory Poole. Many Canadians can attest that this summer has been red hot on a number of different fronts. What we've all felt in the pool or on the patio has, in a way, mirrored the heat that we've seen in equity markets since mid-April. With that in mind this week comes with no shortage of data, big earnings prints, a federal open market committee decision today, and jobs could all weigh on the market's trajectory in the second half of 2025. Here to unpack some of those themes and how he's navigating today's climate through a market neutral strategy is portfolio manager, Brett Dley. Brett, as always, great to have you in the studio today.

[00:04:44] Brett Dley: Thanks for having me.

[00:04:45] Rory Poole: Let's start with some of those themes that I talked about. We were actually just chatting before we came on air about the fact that this isn't typically a great time of year for portfolio managers or analysts to take vacation. We are right in the thick of the earnings season. We've had a swath of prints thus far. This week, in particular, tonight some of the big tech, wanted to kind of get your thoughts on what you're seeing throughout Q2 earnings and if there's anything that you're picking up on in terms of sentiment or what you're gaining from corporate leadership and how that's playing into your thoughts in terms of managing your fund.

[00:05:25] Brett Dley: That's a great place to start. We're kind of maybe 10 days into the earnings cycle. It's about to get really heavy kind of right now for the next week and a half or two weeks. From the early start one of the things that I've picked up on has been in general earning, the numbers themselves, have been pretty good. It's been okay. The vast majority of companies have beaten. That's not actually atypical from a typical earnings cycle, usually somewhere between 60% and 80% of the reports are beats, and we're sort of mirroring that right now. Most of the beats have come via cost cutting as opposed to sort of revenue acceleration or benefits from the top line. I think that's part of some of the sort of quick reactions to the stuff that got announced around Liberation Day, companies moved pretty quickly to limit costs, cut overhead where they could. That being said, earnings beats and stock reactions are different things. One thing that I've definitely picked up on of some of the big bellwethers, the well-owned stocks that have generally been strong performers over the last 18 months, for the most part they have reported in line with those 80% beats but the stocks haven't performed well afterwards.

[00:06:39] Examples of this that I highlight have been Netflix, SAP, UNP which is a railroad, a little bit unique there because they're undergoing their own thing, and then, quickly, yesterday Spotify. Good reports from all of them. Stocks typically traded down and didn't really make up the gains in the next few days. What does that mean? I think it points to one of the things that probably many of us have been talking about, the lack of breadth in the overall market. That's just a simple way of saying everybody owns the same stuff. These are really well-owned stocks. Their evaluation is high. Positioning is very aggressive to the positive side. They report numbers, stocks don't work. Positioning, it's always important. It seems like it's a little bit more important as we kind of etch up on the valuation spectrum of the overall market and breadth is very, very narrow.

[00:07:27] Rory Poole: People probably scrutinize things a little bit more when market's 24 times earnings and, as you said, the concentrated part of the market, if you will, they get more and more specific about what they need to see from an earnings print in order to actually see the valuation of the company.

[00:07:44] Brett Dley: Good is not good enough. It has to be very good. Look, we're going to get a huge test tonight. We've got Meta and Microsoft, two of the most loved companies in the market, we'll see how it goes.

[00:07:55] Rory Poole: Let's talk about the never-ending cycle of tariff talk in the market right now. Obviously, you mentioned the fact that in April we kind of had Liberation Day. We saw the market trough. There's been a bunch of negotiation, jockeying, deals from the U.S. administration since that period of time and we're kind of coming to this August 1st kind of self-imposed date, if you will, this Friday. How are you kind of factoring that into your approach, recognizing the fact that it's probably not necessarily cut and dry.

[00:08:33] Brett Dley: If we're paying attention I think one thing we need to think about is August 1st, it likely means nothing, right? Obviously, the tariffs were announced, they've been walked back, they've been delayed, etc. There's been some tariffs, they are higher than they were in March to a certain extent, but some of the huge numbers that were thrown around, I think it's fairly clear that that's not happening. Overall, like I said, we haven't really seen the real damage that we thought was going to happen from tariffs because a), they haven't been imposed, b), they're delayed and c), they're smaller than we thought. I think it's just too early to tell We've seen the companies, like I said, kind of get through some cost cutting. Even though tariffs are higher we haven't seen major impacts on the top line for the most part, although some of the calls I was on earlier this week, certain companies are feeling it. Just like when interest rates started going up I don't think you see this in the next month, in the next quarter. I think it's a slower bleed. The market seems to think we're out of the woods here. I'm not sure that's the case. I think it's just way too early to make a call.

[00:09:40] Rory Poole: Is it similar, do you think, on the fiscal side of the coin? We've, obviously, got this new agenda as it relates to kind of government spending and taxation in the U.S. You just mentioned the fact that it might be a slower burn, if you will, on the tariff side of things. Can you maybe comment on that? Is that showing up more or less or is it a similar outcome?

[00:10:03] Brett Dley: I think, again, we're just starting some of the policies. They haven't even been implemented. If I take an academic view and I think about what is happening, I think the fiscal side, it's very, very troubling. I'm not sure when it shows up but I think it does. We had a scenario that was thought where tariffs were going to provide an offset, i.e., Income for the country to help with the deficit. Tariffs are lower or non-existent so that's not happening. Meanwhile, we passed the one big, beautiful bill, which is increasing deficit spending so deficits are going up and there's no way to offset it. What have we seen in the non-equity markets? Well, we've seen interest rates inch up ever since this. We've seen the currency of the U.S. dollar specifically deflate. These are things you would anticipate to happen when there are deficits, especially when there is some incremental tariffs which means likely pricing is going up. The U.S. fiscal situation, I think, is quite concerning.

[00:11:03] When I think about what is the play here, how do we get out of this? You've got deficits that aren't going down, we thought they were going to go down, they're actually probably going up, there's two ways to kind of erase the deficit. One is inflation, seems like maybe that's the way we're headed, and the bond market is definitely pricing that in. The other way, which would be a good thing, is productivity. Those are the two ways to eliminate deficits. You inflate your way out of it or you have a productivity ramp. Unclear where the productivity comes from. I know the idea could be that AI could be this massive productivity enhancer. It very well could be. It's far too early to tell. We're not really seeing it in broad parts of the economy. We're seeing it some parts of economy. I think even if that's the case this is not a one-year, six-month type thing. This shows up slowly over time and then it picks up four or five years from now. If that's the bet we're trying to make I think there's a near term pocket of very, very concerning kind of weakness coming.

[00:12:06] Rory Poole: Of course, all this is being reflected in this meme stock rally that we've experienced — I'm being sarcastic — over the course of the past week or two, but that's interesting. The fact that we had this uptick in speculation, I mean, obviously, some different names that are involved this time around. What do you kind of make of that? I know it's not typically an area where you tend to spend a lot of time or allocation within your funds but it's hitting the tape nowadays, so curious if that's like a symptom of potentially something broader that's occurring within the market.

[00:12:44] Brett Dley: The way I try and think about this is like, look, it's a very shallow history of meme stocks. We had the example in 2021 so I'm trying to think about that as a case study. What was happening in 2021 that caused this meme stock phenomenon? Well, markets were ripping so everyone was feeling good. There was ample liquidity in the system. There was a deficit. That all rhymes with where we are today. The meme stocks in 2021 started kind of doing their thing in January, lasted for a few months. I would say this time around they started sort of March, April and it has kind of slowed down in the last several weeks or so.

[00:13:23] The examples this time, they're different than the ones that were last time. There's Opendoor this time, Krispy Kreme, American Eagle because they hired a movie star for an advertisement. What happened in 2021? Once this all settled down the market was actually fairly strong for the next few months and then inflation started coming towards the end of the year and then we know what happened in 2022. It was terrible. I mean, that case study, we're mirroring that pretty closely here. We could have some continued strong markets here for the next few months and then if inflation rears its ugly head, which I think is going to happen like we just talked about, we could be setting up for a similar sort of scenario in 2026 that we felt like in 2022.

[00:14:07] Rory Poole: Good point. Let's pivot, talk about the fund a little bit. You manage the Fidelity Market Neutral Alternative for Canadian investors. A different mandate, I would say, relative to some of the stuff that we typically talk about on Connects. I think people are used to more like the long-only portfolio. I know there's many folks who listen to this show that are more familiar with liquid alternatives, and in some cases market neutral investing. Maybe you can just take a minute and talk a little bit about kind of the funds MO and what you're trying to accomplish within the product.

[00:14:46] Brett Dley: The way that I like to think about market neutral, and the way I think we should all think about it, is think of it as like a different asset class. What I mean by that is we use equities to construct the fund both long and short but it doesn't behave like the underlying equity markets. What that means is, by definition, market neutral means it has a beta of zero, which is a fancy word for correlation, which means the correlation with the underlying equity class is zero. We keep it there. We manage to that. We make sure that's the case. Whether the stock market is going up a lot or down a lot should have, basically, no bearing on the performance of the fund. Over the course of the last several years that has been true.

[00:15:31] More importantly, because we're able to hedge risks both on the long side and the short side we want to accomplish this with lower volatility. What I mean by that is ... it's a bit counterintuitive. It doesn't mean that I just own low vol stocks. I can own high dispersion, high volatility stocks s along as if I own one of those types of stocks, say on the long side, that on the short side I'm short those types of stocks. It helps kind of neutralize that factor risk, that valuation risk and that volatility.

[00:16:24] When I think about what is this fund, it is a truly uncorrelated asset to underlying equity markets, fixed income, Bitcoin, you name it. It doesn't trade like everything else. That's by definition, that's by design. Volatility has been much lower than the equity markets. We've had a much lower drawdown than the underlying equity markets, in some instances we've even had lower volatility than fixed income.

[00:16:54] Rory Poole: I want to come back to that point that you just made on the difference between what you're doing versus owning low volatility stocks but let's hold that for just a moment and talk a little bit about one of the words that was mentioned, or phrases that was mentioned, on the title slide of this show that we're doing today, pair trading. Just maybe give everybody a little bit of an idea of what pair trading is and what it means to you within the context of what you just explained in terms of looking at companies or types of stocks that have similar characteristics between one another.

[00:17:34] Brett Dley: What I'm doing in this fund is relative value investing. The way I accomplish that is through a series of pair trades. What a pair trade is, in general, is if the fund is given a dollar, we take that dollar,  we buy a dollar worth of securities long and we short a dollar worth of securities against it. The net exposure is zero. The fund is constructed of a group of different pair trades. I usually have around 40 of these trades on. What I'm trying to do is look at similar types of companies with similar stock profiles, whether it's volatility, valuation, growth, value, etc., and just try and identify which one looks cheaper or is growing faster, has a better outlook than the other one. What that means is I am not particularly concerned if have a pair trade on and I think that both stocks are overvalued. That's just fine. As long as I think the stock that I am long is less overvalued than the stock I'm short we will make money. What that means in simple terms is stocks can go up or down, it doesn't matter, as long I get the relative dispersion correct we make money.

[00:18:44] An example of that is in high volatility stocks is a trade I had on which was a company called MongoDB versus a company that I was short called Asana. These were high, high multiple tech stocks. Super volatile, fast growing, sort of 30% growth. They were trading at like 20 times EV-to sales. My call is not, is 20 times EV-to-sales the right multiple for this type of stock? My call is simply, should Mongo trade at a higher valuation than Asana? What happened there was Mongo's a faster growing company, a market leader, their market's growing faster, less competition, better margins, trading at the same valuation as Asana. Asana was, basically, the opposite of that, had lots of competition, lots of privates, bad margins. Both stocks were bad. This was in 2022. The stocks were bad, Nasdaq was bad, stocks were terrible. Mongo was not a good stock, it was down about 20, 30%. However, Asana was a far worse stock and it went down 70, 80%. Even though both stocks were down a lot we captured that spread and we made 40% on that trade.

[00:19:51] Rory Poole: With that being the case then, and just for our audience and the folks that may be a little bit less familiar with this style of investing, I think what you mentioned made a lot of sense in terms of the fact that as long as the stocks have a relatively high degree of correlation among one another, and your long is effectively outperforming your short, then you have the ability to capture return for investors. What's the biggest risk or what are maybe some of the risks that you look at that might be a little bit different compared to that of, let's say, a long-only portfolio manager because they're, obviously, very concerned with is stock A or stock B going to simply go down, or do I not own enough of stock A or stock B relative to that of the market. Is there anything on the risk side of things that you think is a little bit differentiated in terms of what you do compared to maybe some of your colleagues upstairs?

[00:20:45] Brett Dley: I think all of us at Fidelity in general are trying to get the fundamentals right. If we can assume that we're getting the fundamentals right, that sort of is the same concern amongst everybody. You get some right, you get some wrong. When I'm constructing a trade the biggest risk points are, is there a factor mismatch? What I'm trying to do is isolate the difference in fundamentals. One stock has better management team, balance sheet, growing faster. It should do better than a similar stock trading at the same price over time. Is there something I'm missing? Is one stock moving less because of fundamentals and more because of interest rates or commodity prices or inflation? It's those unintended bets that I really try to neutralize for because what I'm trying to focus on is pure stock versus stock, neutralizing valuation risk, market risk, a bunch of other factors. Those are the main differences in the way that I approach risk control versus, perhaps, some of our other managers here.

[00:21:45] Rory Poole: You kind of got into it and that point that I mentioned in terms of going back to the idea of low volatility stocks and how this fund is uncorrelated and it is lower risk in nature compared to that of most other strategies I would say that focus on equity within the market. Again, I think that there are a number of ways as to which equity investors can achieve low volatility. You can purchase a factor-based, low-volatility ETF. You can go out there and pick stocks within, I don't know, the more defensive sectors, the utilities, the communication services of the world. Then you have what you do, which is kind of in a simple sense, as you mentioned, looking at two companies that are maybe fairly similar in nature, or at least they behave fairly similar over time, but kind of like owning a dollar and then effectively shorting a dollar. Would you kind of say that that's the biggest difference or that's what allows you to create that kind of risk profile that your funds exhibited over time?

[00:23:03] Brett Dley: Yeah. I think being able to short provides a totally new tool that allows us to kind of limit exposures, hedge different types of risks and really isolate the returns based on the differences in the fundamentals of the different stocks. One of the things that's unique with a market neutral strategy to achieve low vol versus kind of like the low vol strategies that you highlighted, with the low vol strategies there would be like a factor bet. If you own high quality defensive stocks, that's great, but if those stocks come under pressure for whatever reasons, typically happens at a market bottom when the market's recovering, those stocks will typically underperform, likely even go down because the multiples are elevated but the growth rates are lower versus the rest of the market. That's a risk. Even though they're low vol you can lose a lot of money doing that. We try and neutralize those risks to the best of our ability. It's just a different way to come up with a lower volatility strategy.

[00:24:02] Rory Poole: Let's wrap all of this up, if you will, in terms of the macro that we talked about, in terms the overview of the fund and what we just touched on in terms a differentiated approach to create that lower volatility profile, and maybe talk about some of the areas where you tend to have a little bit more exposure and probably are your areas of core competency from a sector standpoint, and talk a little about what you're seeing within these spaces. Obviously, if you have the ability to provide folks with any examples I think that's always appreciated. You've always been someone that is drawn a little bit more towards what we typically refer to as stock picking sectors. You can correct me if I'm wrong but the way that I interpret that is that there's not as much of a group call or there's potential for larger dispersion of returns within that group, cohort or sector relative to something like, for instance, the Canadian banks where it's a little bit tighter over time given the nature of the competitive environment. Maybe we can start with tech, in particular. What kind of themes are you seeing within tech? Is there anything notable in terms of how you're positioning yourself?

[00:25:19] Brett Dley: Tech is a very high dispersion sector. Like, basically, every other portfolio manager in our Canadian office before I was a portfolio manager, I was an analyst. I covered numerous different sectors. The last sector I covered was North American tech and hardware and software, of course. A couple different types of trades that I've had on over the last kind of year or so within the tech sector have been, one has been within software. We think of software as many things but there's kind of, in general terms there's two different types of software companies. There's what's called vertical market software and then there's what called horizontal market software. Vertical market is like a very specific niche type product that serves a very specific niche type customer. An example of that is a Canadian company, Constellation Software, they roll up all these different types of vertical market softwares. They own stuff that is software that is purely for bus drivers that helps with routing and scheduling, or software that helps with golf courses, it helps schedule your tee time, etc. It's very, very unique. What that typically allows is there's very few competitors because the market itself is not that big. Usually the market is gravitated towards one leader. That one leader's software, basically, becomes core to their customers' ability to run their business.

[00:26:46] What does that mean? It usually means lots of pricing power. I tend to gravitate towards vertical market software in times when there's uncertainty. One of the companies I own is a company that provides, basically, the core software system for an insurance company. They help write your premiums, monitor your premiums, collect your premiums, etc., etc., etc. Insurance, P&C, as a market right now has been doing really, really great. They've gotten very, very strong pricing in North America over the last two years. That means their customers are doing well, they have money to spend and invest in tech and this company is the market leader. They're taking share, they're growing quickly, they've an ability to raise price and once they're in it's really, really hard to take them out.

[00:27:29] Horizontal software is different. It tries to provide lots of different things to lots of different people. That's more of a macro call. You have issues where budgets can come under pressure, you can cut some things at the margin. One example post Donald Trump and Elon Musk was DOGE. DOGE, federal spending, they used a lot of money to spend on software. They've cut that right to the bone. That's showing up in weakness in all these horizontal software companies. Again, they're both software companies, they're both recurring revenue, good business models, all the reasons we like software. One is much more durable and has more pricing power than the other one.

[00:28:04] Rory Poole: What about something on more the cyclical side of things, so industrials.

[00:28:09] Brett Dley:  I'm pretty positive on cyclical industrials. What the hard thing to do right now is finding stocks where you think that the earnings over the next 18 months can be revised higher and the multiple can be a revised higher, cheap stocks with good fundamentals. That's, obviously, the dream with the market where it is, it's very difficult to find, though I am finding it in industrials. I have gravitated post sort of Liberation Day towards early cycle cyclicals where they have kind of underperformed, derated, and now we're seeing signs where earnings maybe have bottomed. One of the companies I own is a trucking company. The stock is at an all-time low multiple. We're going to have earnings inflecting positively and when that happens the multiple goes up, should be a great stock.

[00:29:04] Rory Poole: Last but not least in terms of what we're going to cover today is on the consumer side of things. I know that's pretty broad but anything notable there.

[00:29:13] Brett Dley: Consumers, I think it's a lot trickier. While there are companies that are outperforming and underperforming, with the tariff news they all traded it as a big basket. Tariff losers got smoked, then they kind of rallied back pretty, pretty hard. There are big valuation differences and areas where ... one of the companies that I look at is one we're all familiar with, it's Starbucks. Their fundamentals have been pretty weak. They've lost share in the U.S., they took too much pricing, traffic's down, and China's been tough. There's a bull case that new management is going to come and fix it. Maybe that's true and earnings will go up. But the stock is, basically, at $100, they're going to earn sub 3. The dream is maybe they can earn 4 or 5. It's already at 25 times a bull case earnings estimate. There's other companies where it's the same situation but they're trading at 13 times. Maybe both companies can do well, they can probably both go up, but one has a lot more room to run than the other.

[00:30:18] Rory Poole: It's crazy that 24 times is like a market multiple rate, at least on a forward-looking basis. We'll leave that conversation for another day. Maybe just to kind of end things off to our folks that have joined today, Brett, in running the Fidelity Market Neutral Alternative Fund, as we discussed, it's a very differentiated product, something that's potentially fantastic for investors in terms of adding a form of diversification in a period of uncertainty, in a period of what is relatively expensive equity markets. For the back half of 2025 my kind of call to action for folks today would be that if you get to talk to your sales representative at Fidelity about either the Market Neutral Alternative Fund, or really any of our alternative offerings, I would certainly encourage you to do so. Before we wrap just a few comments from me. Tomorrow we will have the former TD Bank chief economist, Don Drummond, who will join us on the show. He'll break down both the Bank of Canada and Federal Reserve rate decisions that are coming in today. He'll also share what it all means for inflation, investors and the markets as a whole.

[00:31:37] On Friday we'll have a replay with Chris Kuiper. Chris is Director of Research at Fidelity Digital Assets. He shares his latest trends, or will share his latest trends, from the digital asset landscape, including Bitcoin's institutional and government adoption.

[00:31:55] Monday is, obviously, a civic holiday for us here in Canada so we will be off the air that day and hope you enjoy that day off.

[00:32:03] We'll be back on Tuesday with portfolio manager, Adam Kramer. He'll share his thoughts on both U.S. and global markets, as well as where he is currently finding opportunities for his funds focusing on value and income. Both tomorrow and Tuesday's shows will be offered with live French and audio interpretation. For today, thanks so much for joining us. I'm Rory Poole.