How to capitalize on opportunistic shorting

Charles Reinhard, head of portfolio strategy at MainStay Investments, interviews Andrew Ver Planck, chief investment officer of global systematic equity at Cornerstone Capital Management.

Charles Reinhard: Let’s jump right into it. Can you explain the benefits of a long-term strategy that derives its 100% “net” long exposure from being 140% long and 40% short versus one that is 100% long only?

Andrew Ver Planck: The greater “gross” exposure allows an investor to capitalize on the full spectrum of their research output, including the negative views on stocks. Think of it as building blocks. The first building block is the market return of a passive investment in a benchmark, like the S&P 500 Index or Russell 1000 Index. The second building block is the alpha produced by the long-only active management effort, as it strives to beat its benchmark. The third building block is the potential alpha enhancer coming from an additional 40% long-40% short component.

Mr. Reinhard: One of the hallmarks of investing is diversification. How can diversification be enhanced by a robust quantitative process and by shorting?

Mr. Ver Planck: The benefit of a quantitative investment process is being able to systematically evaluate a larger number of stocks than is humanly possible otherwise. This can enable one to take smaller positions and build portfolios that have a diversified set of holdings, while still enjoying a potentially attractive excess return profile. A quantitative approach can help minimize stock-specific and overall risk, while maintaining a high active share in the range of 85%–95%. A high active share can also allow a strategy to blend well in a broader portfolio. As for shorting, long and short ideas tend to add value at different times, adding another layer of diversification.

Mr. Reinhard: What types of characteristics do you look for in long and short candidates?

Mr. Ver Planck: We are seeking relative-value opportunities with a catalyst. In general, our long positions tend to be cheap versus their peers, with improving fundamentals and price momentum. By contrast, our shorts tend to have the opposite characteristics.

Mr. Reinhard: You say your approach to risk management is to win by not losing. This is unique. Can you describe what this means?

Mr. Ver Planck: We take a multi-layered approach to risk management that focuses on core risk constraints, tactical risk constraints and blind spot analysis. The core set of constraints limits our ability to drift from benchmarks such as the Russell 1000 or MSCI EAFE indices. The tactical layer of constraints helps us identify macro trappings and sector-specific risks. Our blind spot analysis is aimed at special situations and events that cannot be readily captured quantitatively: natural disasters, geopolitical provocations, newly announced corporate actions and so forth. The goal of these risk practices is to preserve alpha or focus capital to areas of the market where we believe we have a better opportunity to succeed.

Mr. Reinhard: In an asset allocation framework, what role should this type of an investment strategy play?

Mr. Ver Planck: Given the 100% net-long posture, we believe this should be considered as a core equity position. Given its large active share and diversified sources of alpha, we believe it offers the potential to get more from the core.