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A Shortlist of Alternatives for Your Stock Portfolio

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar. It's Alternatives and Diversifiers Week on, and today I am checking in with our head of alternatives research, Nadia Papagiannis. She is going to talk a little bit about the role that alternatives can play in diversifying your stock portfolio.

Thanks for joining me, Nadia.

Nadia Papagiannis: Thanks for having me, Jason.

Stipp: So, a lot of times investors will think that they will diversify their stock portfolio with commodities and with fixed income, but you are saying, when you look at that stock portion of the portfolio, you also want to make sure you are diversifying that piece. Why is that important?

Papagiannis: The main reason to diversify your stock portfolio is that a lot of risk comes from your stock portion. So, even if you have a 60-40 portfolio, approximately 90% of the risk is coming from your stock portion of your portfolio. So, it’s not really a balanced portfolio.

So, it’s good to diversify amongst asset classes, but it’s also good to diversify among strategies within the asset class, because what that can do is, it can reduce the risk of that asset class while still giving you exposure to that asset class.

Stipp: So, ... if you were going to diversify your stock position, what about if you were going to say, well, I will own some small caps and I will own some mid-caps. Do you think you should go beyond just that market cap and maybe the style, and diversify even further that stock piece?

Papagiannis: We have seen over the last several years that just picking an allocation to a few spots in the Morningstar Style Box doesn’t really work, because everything is highly correlated. Now, equity risk is very highly correlated.

So, what you need in terms of a diversifier is something that reduces your equity risk, and that’s what long/short equity funds do. They serve to manage the risk in the equity market, while at the same time trying to pick stocks. And you can find smaller-cap focused ones, you will find larger-cap focused ones, value and growth focus ones.

Stipp: So, the folks on your team look at these alternative strategies and alternative funds, and you mentioned the long/short category there. I would like to talk to you about some of the categories that you look at to diversify equity. So with the long/short funds, how do those funds work? How are they different than a regular long equity fund? What are they doing differently?

Papagiannis: There are a few varieties of long/short equity funds. Even though there is one long/short equity category, there are a few varieties within it. So one type of long/short equity fund would be just a hedged equity fund, so it goes long stocks, but it uses either futures or options to hedge that equity market risk out.

The next version would be a long/short stock-picker. Your traditional long and short picking stocks. So your short stocks are designed to make money just as your long stocks are designed make money, yet because they are short, that provides a hedge against the equity market risk in a portfolio.

Then the third version is option-type strategies, where they are actually managing the volatility of the stock market by investing in either writing options or buying options, depending on how highly or lowly priced volatility is in the market.

Stipp: So when you are looking at this new crop of funds, what are some hallmarks of success? So a lot of these are relatively new. What are you looking at as a way to say, this fund has some good prospects, and it deserves a closer look?

Papagiannis: We'll start with the stock-pickers, because those are the most common. In terms of the stock-pickers, you want to look at a stock-picker who has short stock-picking acumen. And that means that they are able to pick stocks short as well as they are able to pick stocks long. And that’s a really hard thing to find, actually. It's really difficult to pick stocks short because it's not just: oh, because consumers are overleveraged and they are having a really hard time with their income right now, I think consumer stocks aren’t going to do well for the next five years, so I am going short a consumer stock for five years. You can’t just do that. What happens is, if you short a stock, and it goes against you, it becomes a larger portion of your portfolio, and that becomes very, very risky. And it can go up, a stock can go up, indefinitely, whereas it can only down to zero basically. So that's why shorting stocks is more risky than buying stocks long.

So a stock-picker who's shorting stocks has to have some kind of a time horizon limit. So for example, this is my thesis, but if it doesn't work over this period of time, then I am going to have some kind of sell-cover discipline in order to get rid of this position or reduce it. Then secondly, they have to look at things besides just the fundamentals. They also have to look at the technicals of what's going on in terms of market sentiment, because even though you are long over the long run, you could be very wrong over the short run.

Stipp: So when you are looking at these funds, do you have a few that are on your shortlist, ones that you like the management team, ones that you like that discipline, for example, of the methodology that they use?

Papagiannis: So one that follows that example would be Wasatch, and the ticker for that is FMLSX; it's Wasatch Long/Short. And the manager, Mike Shinnick, uses technicals as well as fundamentals to figure out when to buy and sell stocks, and he also uses options to hedge around the positions.

So then, we have a couple of examples of the other versions of long/short equity that I also was talking about earlier. So, an example of a fund that uses volatility to its advantage--so looking at the price of volatility--is volatility expensive right now or is it cheap right now?--and then making some kind of bet based on that. That would be Schooner Fund, and the ticker for that is SCNAX. What Schooner Fund does, Greg Levinson is the manager, basically he looks at what volatility is doing. He has a basket of stocks that he likes, high-quality, low-beta stocks that he likes, but he is not so much a stock-picker, he just picks stocks that he thinks are going to do all right over the long run. But then, over the short term, what he is doing is he is writing call options when volatility is very expensive, so that means you're reaping a higher premium by writing that call option, and then when volatility is cheap, he is buying puts or put spreads to protect against the downside, and he's achieved very good results with that.

Then another hallmark, which I didn't mention yet, is a macro point of view, and I think that is very important for any kind of strategy at this point in time. Whether it's a fundamental strategy or a quantitative strategy, you need to have a macro point of view, because there's lot of macro things going on in the market, and I don't think that that's going to go away.

So, one fund that we like that has a macro point of view is called Marketfield, and the ticker is MFLDX. And this manager, Michael Aronstein, what he does is, he has a macro point of view, and then he might create a thesis on a sector or a set of sectors, and then he'll either use ETFs or a basket of stocks that will represent his thesis on that sector--for example, he was short homebuilders and emerging markets before the crisis, and then after the crisis he reversed that position and he took long positions in high beta stocks like financials and things like that. So, he has a macro point of view, and he's actually been very good at expressing it.

Stipp: Right now, these are the three funds that you currently have or will have under coverage soon on your research team?

Papagiannis: That's correct.

Stipp: OK. Thanks so much for the ideas around why diversify your stock position, as well as the individual short list of alternatives that are on your radar, and for joining me today.

Papagiannis: Thank you.

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