Mallory Horejs: My name is Mallory Horejs, and I'm an alternative investments analyst here at Morningstar. Today with me I have Ricardo Cortez, senior portfolio management specialist at Broadmark Asset Management.
Rick, thanks for joining us today.
Ricardo Cortez: Thanks, Mallory.
Horejs: First, let's start with the discussion of risk. I know Broadmark recently put out article titled "Redefining Portfolio Risk." How does your firm think about investment risk?
Cortez: Well, we define risk as the loss of capital or the loss of principal, and to distinguish that from the past, Modern Portfolio Theory generally looks at volatility as the measure of risk or standard deviation. That's fine in an environment where stock prices in the capital markets are rising, but in periods that we've been in like the last 10 years, the 1960s into the 70s; 1940s and 1930s when the market goes back and forth and back and forth without making much ground over the long term, we think that defining risk as the loss of capital is very important.
Mathematically, if you lose 50% of your money, of course, you've got to double it to get even. That's fine in a rising market environment, where it might be a little bit easier to catch up. However, if the market is flat and you lose 50%, it's very difficult to make that doubling of the money to get back. So, in this type of environment, we think that defining risk as the loss of principal or the loss of capital is important.
One more point, again mathematically, if you limit risk to 10%, and you don't lose 10% at any time, you only have to capture one third of the upside to match the S&P 500 or match the market. So, in a way, it's winning by not losing: Managing the risk on the downside by defining it as loss of capital and then trying to capture a little bit of the upside, but then you don't have to capture a lot of the upside to be able to have equity returns.
Horejs: That's a really good point. I think a lot of investors overlook the fact that there is two ways to beat the market. It's not just the upside, it's also avoiding those large losses on the downside.
Cortez: That's right. I mean over the years, of course, we've gotten used to Modern Portfolio Theory and buying and holding because nobody can predict the markets. But in an environment that's going back and forth, it's very, very important to protect the downside of the portfolio, really as you start out managing risk in the portfolio and then worry about making money after you protect your downside in an environment like this in the last 10 years that probably will last another few years at least.

Horejs: Well given that perspective on risk, could you tell us more about your tactical growth strategy and how that can help investors avoid capital losses?
Cortez: Sure. Our strategy is a long/short strategy. It's a little bit different than others, because we're not generally long and short at the same time. What we're trying to do is, identify those economic conditions which lead to intermediate moves in the market, which we define as three to six months in duration, 7% to 10% either up or down. So we're not short-term; we're not long-term. We're trying to identify those conditions which exist prior to intermediate moves in the market, and we move the portfolio back and forth in exposure. We call it managing our equity exposure. We can be a 100% long in the market. We can be a 100% in cash, and we can take short positions. So we can actually make money in down markets.
There are what we call three pillars of our investment process. The first three are qualitative or fundamental in nature. We look at valuation of the market, we look at monetary policy, and we look at investor sentiment, which is the observation that unfortunately most investors buy more as the market goes up and sell more as the market goes down. Therefore they buy the most at the top and sell the most at the bottom, exactly the opposite of what we should be doing. So we take a contrarian approach to that. So when valuations are low, monetary policy is easing, and sentiment is negative--that is people think the market is going down--that's the time to buy.
However, the problem with using valuations only or fundamentals only is often that they're very early or very late. So we validate the fundamentals with our fourth pillar which is quantitative in nature. That is, it's the flow of funds into and out of the market. We follow volume and breadth, and specifically we're trying to get a handle on institutions putting money into the market and taking money out of the market because since 70% to 80% of the volume on the exchanges and over-the-counter every day is institutional. They're very big players in the market--the big pension funds, the big hedge funds. If you know what they're doing--it's not that they're smarter than anybody else, but they have the money.
So we validate the fundamentals by looking at the flow of funds, and we don't try to catch a falling knife as the market is going down. We wait until the market turns, so that we're able to get in the market. And when we decide to buy, we only buy ETFs and futures contracts of the major market indexes. We buy the most liquid ones like the Dow, the S&P, and the Russell. So we take no stock-specific risk, and we build the portfolio based upon our market indexes. We choose those market indexes based upon relative strength, relative value, flow of funds, et cetera, and that's how we construct the portfolio.
One final point is that since our emphasis is on risk management, if our models turn down, if we see that institutions are taking money out of the market and our intermediate long-term models turn down indicating substantial selling by institutional investors, then we can move to cash and are in a way forced to move to cash by our risk management system, and it's at that point that we might take short positions. So that's our strategy.
Horejs : And I know looking at the universe of long/short equity funds, last year was a pretty rough year for most of them, the category was down 2.8%, the market was up just over 2%. Your fund was down a little bit more. What about last year's market environment was so tough for long/short equity strategies?
Cortez : It was a very tough market environment; our toughest ever actually, but I point out this. Between January and October of last year, we did quite well. The market as of October 3, which was the day of the bottom, was down 11% for the year, and we were only down 2%. So we were 900 basis points ahead of the market in October. So what happened? The market bottomed, we got in, our fundamentals went bullish, the quantitative models went bullish, and we invested. Then if you remember, it was in November, there was talk of the Greek crisis and default by Greece and possibly the country leaving the eurozone and contagion to banks, and the market dropped 842 points in four days. Our risk management system kicked in and we had to sell or we were forced to cut back on our exposure to the market. And then the Fed stepped in, and everything was fine and the market turned around and went up. So we got caught in that whipsaw.
So, it was a difficult environment, and we find that our most difficult environments are not high volatility because actually if you look at the standard deviation of the stock market in 2011, it was 15.9% for that 12-month a period, which is actually lower than the long-term standard deviation of the market of about 16%.
Horejs : That's interesting. Given how many volatility shocks there were last year, that's surprising.
Cortez : That's right. I believe the number of 3% daily moves was unprecedented in the American financial history. But it was during that period of time; it was not the whole year. So it's those extraneous events and day-to-day changes. Very few models will ever pick up four-day, 900-point advances and declines. Our goal is to just keep our powder dry, keep safe for the next up move or down move and just not to lose money. The first principle to make money is don't lose money.
Horejs: Well, given that perspective then, what's the best kind of environment for a strategy like this? When can investors expect that the fund will really outperform?
Cortez: Well, the stock market in the economic cycle is such that there is usually a year or two of expansion, followed by a transition period of a few years, followed by a contraction. Most of economic American history has followed that cycle, a four- to six-year cycle. We tend to do extremely well when the market is discounting an expansion or discounting a contraction in the economy.
2002, we did very well when the market went down. 2003, we did well when the market went up. Similarly 2008, 2009 were good. It's during those few years of transition periods, where we sometimes outperform the markets, sometimes underperform, but it's there that our most important principle is just keep your power dry and wait for those big moves.
So, the answer to your question when we do very well is when we see the market either having a major move downward or major move upward. You never know when that's going to happen. So our models are designed to identify that, and hopefully in the next year or two, we’ll see one of those types of moves because the last few years have been more transition.
Horejs: Well, given that risk/return profile that we just discussed, how would you suggest investors use this fund? Is it supposed to be an equity complement? Is that supposed to be a core holding in an alternative bucket?
Cortez: It has been used as both. I think it can be used as an equity complement. I know if an investor has $100 in stocks, that is long-only, the risks there are great, and the market went down 50% to 60% in 2008-09. There is no law that I'm aware of that says the market can’t go down 92% or 90% as it did in 1929 to '32; hopefully that won’t happen. But stocks are pretty risky. So I think that if you carve out 20% or 25% or perhaps more of your long-only portfolio and allocate it to a long/short manager, that manager can act as kind of a swing in the portfolio, protecting you on the downside during those poor periods of time. But more people have been using us recently as a core holding.
That is many of us have been taught over the years your core holdings should be stocks and bonds. You get beta, you get low fees if you are in index funds and passive indexes. The problem with that, of course, is that stocks can go down a lot, and bonds now, I mean, we are seeing the lowest bond rates in American history, just about since the depression. As for interest rates, the 10-year today is about 1.5%; if it goes to 3% or 4% or 5% you are looking at significant losses in your bond portfolio.
We've talked that bonds are supposed to be a store of value, which provide a safe and steady stream of income to meet present and future needs, and bonds are, frankly, none of those things today. So we think that perhaps taking this kind of long/short risk-managed approach could be a substitute for your core stock and bond portfolio and diversification, of course, but making it more of a core holding than simply an equity holding.
Horejs: Well, thanks so much for joining us today, Rick. That certainly gives us a lot to think about.
Cortez: Great. Thanks, Mallory.