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Do You Need a Short Equity Position?

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar reporting from the 2010 ETF Conference here in Chicago.

Optimizing risk and return in your portfolio. I'm here with Jason Huntley. He is the founder and portfolio manager of Mars Hill Partners. He is here to tell us a little bit about their fund, it's a long/short fund, a little bit about their philosophy and a little bit about their portfolio positioning today.

Thanks for joining me, Jason.

Jason Huntley: Thanks for having me.

Stipp: The first question for you, you do run an actively managed long/short equity fund. You look across the globe in some of your investments, and I read a little bit about your philosophy.

The first thing I wanted to ask you about is one of the things you mentioned, which I think is a pertinent point for investors, is that risk and return are not always positively correlated.

So you might end up taking on more risk and not really getting compensated for return. That's one of the things that you feel your philosophy addresses. Can you explain a little bit about why that is and how your fund works in that context?

Huntley: So the context of that statement is in comparing a long/short equity portfolio construction versus a long-only portfolio construction. So in the long-only portfolio construction world, which is the majority of how investors access equity markets and so forth, having total exposure to the direction also exposes a portfolio to substantial drawdown risk, a la events like September 2008, when the Lehman crisis comes along and shocks the portfolio, and you might be an excellent stock-picker, have an edge in identifying relative winners that you hold long-only, and you have value-added producing the portfolio over some benchmark, but that doesn't have a natural sort of risk mitigation mechanism built into it, versus long/short portfolio construction naturally has dollars on the short side of the portfolio, so that if you get a market-wide, more systemic shock to somebody's portfolio, you've got a downside buffer mechanism built in that helps smooth returns over time.

So, in the world of absolute return, which is where we dwell and which is really where the strategy is geared toward, again that long/short portfolio construction is what, in our view, what optimizes the risk/return, risk/reward payoff in the portfolio.

Stipp: I think a lot of investors, when they think about protecting on the downside, they think about their asset allocation and allocating some of their funds to bonds, which they would expect would offer some of that protection. How should I think about fund such as yours in the context of a portfolio that would include stocks and bonds?

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Huntley: Well, historically, if you look at long/short equity as an asset class, relative to long-only equity investing or the S&P 500 Index or the MSCI World Index, over time it's actually produced as good if not better returns with less volatility, less downside volatility, which is significant and shallower drawdowns. So from a portfolio performance and optimization standpoint, again it's helping you smooth out your return stream over time and, historically has a little correlation with stocks and bonds and so, incrementally, it's diversifying the portfolio as it's added in there.

For us, I think the most significant impact that our strategy can have on somebody's portfolio is as a replacement to their long-only equity capital as opposed to just being some small sliver of an alternatives allocation for us. Long/short is a portfolio construction methodology that we've opted to use as a superior way of investing in equities period, versus long-only being again sort of the consensus popularity, largest wallet share in somebody's overall portfolio.

Stipp: Part of your strategy is to look globally and you have a macroeconomic view that you invest on. Can you tell us a little bit – if we looked at your portfolio, what would we be inferring about your macroeconomic view right now where you are seeing areas of strength and areas of weakness?

Huntley: So, given the benefits of full transparency with our ETF, if an investor was to go log on to the Advisor Shares' website and look at the GRV homepage, which is where the ETF resides, they download all the positions, and they'd see where all of our capital is at risk right now. The long portfolio is primarily geared toward emerging markets. The macroeconomic thesis there is the consensus that those countries fiscally and financially are more stable, in better shape right now than the overleveraged developed West, if you will, a la U.S., Europe and the U.K., Japan certainly fits that bill.

And that's what you would find on the short side as well. So, being short European, U.S. financials, discretionary, very economically sensitive sectors and industries given that our macro view is continued slowdown, the double-dip versus still in recession is sort of irrelevant to us. The fact is that growth is slowing and that will put downward pressure on corporate earnings. Asset price deflation is a real threat and so forth. So, overall, going out, we don't expect much in the way of returns for equities as an asset class, again, long-only equities, or fixed income: 10-year yields are pushing 2.5% again. Future expected returns are fairly bleak in that asset class.

So searching for, again, more unique return streams that can generate positive returns regardless of the direction of stocks or interest rates, that's the hallmark of an absolute return strategy like ours and that's – again portfolio construction for us is capitalizing on the spreads, the relative value, performance differential between our long portfolio right now being emerging markets and our short portfolio being U.S. and Europe.

Stipp: Last question for you, since we are at the ETF conference. You used ETFs in executing your strategy. What have you learned and what things would you tell other advisors or investors who want to implement ETFs in a strategy in their own portfolio--what sorts of things should they keep in mind? What sorts of things about ETFs specifically should they know?

Huntley: I think the biggest key that we've discovered being longtime investors in ETFs as well as now launching our own ETF, is that there is a misunderstanding about the size and liquidity issue of investors coming into or potentially coming out of an ETF position.

So, obviously, in the world of creation/redemption units there is a liquidity mechanism in there that's different than other buckets, other packages. And so a small ETF--if you are a large investor and you want to make an allocation to a small ETF or something that's new or whatnot, and you're concerned about, this only has $20 million in it and I want to make $20 million allocation because I am $500 million manager and that's how we operate. Those investors do not need to be fearful of that in the ETF space. If they're accessing liquidity and implementing the investments and redemption process properly via the APs and liquidity providers and whatnot, and coordinating the ETF themselves, that's not an issue. So, again, more permission to put capital at work in bigger tranches and bigger size, more efficiently than any other package out there.

Stipp: Jason, thanks so much for joining me today and for your insights.

Huntley: You're welcome. Thank you.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.