Our investing philosophy hinges on three key beliefs:
A note on volatility: We don’t believe volatility equates to risk and that few investors care about upside volatility. We care about volatility, as it pertains to the first two tenets of our philosophy. We care that we’ve chosen a portfolio of investments whose risk drivers provide idiosyncratic and diversifying exposures to other investing strategies, and we care that our downside is attended to strategically, not just tactically (we do our best to manage maximum drawdown).
To achieve its Objective and Goals, the Hedged Equity Strategy uses a combination of long and short stocks, options, and ETFs (of all asset classes) to construct a reasonably diversified portfolio with an intentional exposure to market risk. The portfolio has a long bias, maintains a long-term business mindset in its analysis, and is intently focused on managing risk.
The role of long equity positions is to drive returns through dividends, capital gains from purchase prices below intrinsic value, and appreciation from faster-than-expected increases in intrinsic business value. The first source of return rarely gets mispriced, and the second hinges primarily on market conditions, but the third most often results from taking a long-term, business-focused mindset and investing alongside wonderful businesses.
All else equal, we prefer our long book to be stacked with the greatest businesses imaginable because they surprise the world by compounding their value at unexpectedly high rates.
The role of short positions is to achieve positive returns through declines in value above the cost of carry. Additionally, during precipitously falling markets, shorts will cushion the fund’s downside by reducing overall net exposure.
The role of hedges is to achieve a desired net market exposure in a cost and time-efficient manner or to mitigate specific risks in long positions. The role of option positions is to flexibly and efficiently express an investing thesis, eliminate unwanted risk, or achieve a desired net market exposure. The role of ETF positions is generally to access idiosyncratic risk/return exposures and maintain a higher resilience to diverse market conditions.
The Hedged Equity Strategy is an opportunistic hedged equity investment program, but it will remain disciplined in strategically maintaining a hedged net exposure profile. The portfolio also seeks to achieve a modest net long exposure (around 70%) during most market periods. There will be a natural window around that baseline net exposure whereby we believe the goals and objectives can be achieved. During periods of market extremes, the net exposure may differ significantly — but these occurrences should be rare.
Although our target exposure is strategically set, we construct our portfolio from the bottom up. Our ability to find attractive long and short ideas will heavily influence the number of long and short positions as well as the gross market exposure.
We seek reasonable diversification through position size limits, diversification across investment themes, and, most important, through careful analysis of core risk drivers. We also use equity substitutes (options and ETFs) if we believe they offer the opportunity to enhance our risk/reward. The portfolio does not focus on diversification through quantity. Instead, it seeks to hold enough positions so that good ideas contribute meaningfully, but not so few that a single bad outcome, bad luck, or bad timing could severely impair our ability to achieve our goals.
|Number of Longs||18-25||15-35|
|Number of Shorts||5-30||0-45|
The various short strategies utilized in the Hedged Equity Strategy may generate cash. Although permitted to do so at the portfolio manager's discretion, MFWM generally will not create leverage in client accounts by reinvesting the cash proceeds of short sales. As a consequence, clients may see a cash balance in their account after MFWM executes a short sale. The cash balances associated with short sales act as collateral for the short position, and clients will not earn interest on it. Amounts of un-invested cash may be significant. Holding significant amounts of cash may be inconsistent with client investment strategies, and could drag on an account's ability to achieve it investment objective.
Our investment decisions are based on in-depth, bottom-up, fundamental research and a commitment to respecting the Hedged Equity Strategy’s goals and objectives. The dissection of competitive landscapes, company strategies, and secular trends uncovers quality companies poised to benefit — but also companies failing to adapt, with misplaced focus, or with valuations inconsistent with competitive reality. We analyze and estimate the value of businesses and then assess which investing vehicle best expresses our opinions with the optimal reward and risk profile. We then combine these investments in a manner that supports the goals outlined above.
On the long side, we look to invest in defensible, advantageous businesses with continually strengthening positions in industries benefiting from secular tailwinds or improving competitive dynamics. Financial durability and strong management are additional hallmarks of our core long holdings. We seek to purchase longs with a margin of safety relative to our conservative appraisal of intrinsic value.
On the short side, we look to invest in companies with deteriorating businesses in industries suffering from secular headwinds or challenging competitive dynamics. Financial strain and subpar management are additional hallmarks of short holdings. We seek to sell shorts at elevated prices and in the presence of catalysts.
Position sizing will be positively correlated to conviction, diversification attributes, and the ratio of expected returns to the range of outcomes. We will tolerate larger position sizes for longs than for shorts. We view options positions in terms of notional exposure and capital at risk.
|Market Exposure (Hedge)||up to 10%||up to 100%|
|Speculative Ideas||0.5%-2.0%||Up to 0.5%|
Positions are managed according to the Objective and Goals of the Hedged Equity Strategy. Each position is regularly monitored and appraised on its ability to 1) achieve long-term capital appreciation, with a focus on providing positive real returns over the next three years, 2) provide diversification benefits relative to other holdings, and 3) reduce portfolio drawdown. Monitoring is dynamic, and our willingness to act is driven by business quality and contribution to portfolio risk.
The value of investments in the Hedged Equity Strategy may increase or decrease, which will cause the value of the investor's portfolio to increase or decrease. Investors may lose money on their investment and there can be no assurance that the strategy will achieve its investment objective and goals.
The principal risks inherent in this strategy are:
Options Trading and Short Selling Risk
Shorting securities or writing option contracts involve additional risks. With short sales and certain forms of option trades, the risk of loss is hypothetically unlimited as investors who short may be required to purchase shares to cover at any time, and at any price. Options can be used to create leverage, which can increase the risk of total loss, since smaller fluctuations in value will have significant effects on the owner's portfolio. Writing options and shorting stocks also involves the risk of timing, where the counter party assigns the option holder shares or forces the short seller to cover a short, which may not allow the strategy to play out.
The stock of any company may not perform as well as expected, and may lose value, because of factors related to the company, including adverse developments regarding the company's business, poor management decisions, or changes in the company's industry or popularity of its goods and services. In the event a company becomes insolvent, stock holders will generally have lowest priority among owners of that company's obligations as to the distribution of the company's assets. Stocks may also be affected by general market and economic factors, even when their companies' respective business fundamentals are unchanged.
Please see Appendix A to our Investment Advisory Agreement for a discussion of additional risk associated with this strategy.
Each Personal Portfolio is subject to an account minimum, which varies based on the strategies included in the portfolio. Motley Fool Wealth Management retains the right to revise or modify portfolios and strategies if it believes such modifications would be in the best interests of its clients, and we may modify allocations within a client's account subject to the constraints of each client's current risk score and objective. Clients should be aware that their individual account results may not exactly match the performance of the Model Portfolios.