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By Mallory Horejs, CFA | 06-05-2012 10:00 AM

Looking to Win by Not Losing

Broadmark's Ricardo Cortez says that limiting downside risks and investing during transitional market environments are hallmarks of the firm's long/short strategy.

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.

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