Inspired by Jeff Fischer's hedged equity portfolio-building service

To learn more about our Pro strategy, please watch the brief but insightful introductory video below...

Then simply scroll down to get a more in-depth look at everything from this strategy's goals and objectives... to who this strategy is designed for... to the particular portfolio management process it incorporates.


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Pro SMA: Philosophy and Strategy

Our investing philosophy hinges on three key beliefs:

  1. Diversified strategy: We believe that the Foolish use of untraditional strategies and investments (like shorts, hedges, ETFs, and options) can provide risk mitigation as well as consistent, attractive, and resilient real returns.
  2. Mental matters: We believe that lessening maximum drawdowns (the largest peak-to-trough fall of the portfolio over any period of time) provides behavioral and practical benefits. The human tendency is to disproportionately feel the sting of losses, which can lead to emotion-driven selling. Mathematically, the long-term compounding of returns is easier and more powerful with smaller drawdowns.
  3. Discipline: We believe that disciplined portfolio management and fundamental analysis are key to respecting risk and seeking return.

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 Pro 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 market hedges is to achieve a desired net market exposure in a cost and time-efficient manner. 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.

Portfolio Management Process

Portfolio Construction

The Pro 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.

  Target Minimum/Maximum
Gross Exposure 90%-170% 50%-200%
Net Exposure 50%-75% 0%-100%
Long Exposure 70%-120% 50%-125%
Short Exposure 20%-50% 0%-100%
Number of Longs 20-30 15-45
Number of Shorts 6-15 0-45

Investment Selection

Our investment decisions are based on in-depth, bottom-up, fundamental research and a commitment to respecting the Pro 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. Obviously, the greater the company overall, the less focused we become on valuation.

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

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.

  Longs Shorts
Market Exposure (Hedge) up to 10% up to 100%
Best Ideas 6.0%-7.0% 3.0%-4.0%
Great Ideas 4.0%-6.0% 2.0%-3.0%
Good Ideas 2.0%-4.0% 1.0%-2.0%
Speculative Ideas 0.5%-2.0% 0.5%-1.0%

Position Management

Positions are managed according to the Objective and Goals of the Pro 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.

While we embrace the idea that every decision is unique and situation-dependent, we have guidelines in place that call attention to instances in which a position should be considered for adjustment. We think having a consistent "flagging" framework built into our process will keep us from over-transacting and micromanaging positions.

  1. The first flag is allocation-related; when the actual weighting in the portfolio deviates more than 0.5% from its target allocation, we take note. If the average position size is ~4%, a 0.5% deviation is 25% of the position size, which is sizable enough that we should acknowledge and discuss its appropriateness.
  2. The second flag relates to our risk and return expectations and alerts us with a trim/add flag when certain expected return levels are breached. Importantly, this flag is aligned with our rolling three-year return horizon and desire to manage maximum drawdown, and it is influenced directly by the quality of the company.

Account minimums may apply. All investments involve risk and may lose money. MFWM makes no assurance that investment objectives will be met. Clients should be aware that their individual account results may not exactly match the performance of the Model Portfolios. Past performance is no guarantee of future results.

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.

Portfolio Managers

Bryan Hinmon, CFA Bill Barker, CFA

Investment Objectives

The Pro Strategy seeks to make a diversified portfolio better by improving its risk-adjusted return. In pursuing this objective, we will focus on achieving three goals:

Long-term capital appreciation, with an emphasis on positive real returns over every rolling three-year period

Modest correlation to other asset class returns

Lower maximum drawdowns than other equity allocations

Who Should Invest

Investors who may be interested in this option include those searching for...

Potential for a more attractive return/risk profile.

Reduced maximum drawdowns that offer numerous benefits, including: Behavioral (Easier to stay invested through an entire cycle) and Mathematical (Returns compound over the long term off of a higher trough).

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