Given the number of tactical and absolute-return mutual funds hitting the market, it appears that some fund complexes are now giving their portfolio managers more leeway. The 17 individual traders who run ProfitScore Capital Management's multi-manager long/short unified hedge account accomplish this by actively trading mutual funds within their individual specialty. They primarily buy funds from Rydex, ProFunds and Direxion, including funds that permit intraday trades. Money Management Executive recently spoke with John McClure, CEO of ProfitScore, about this unusual approach.
MME: Your Harmony Plus portfolio delivered 1.8% last year, and your Expedition portfolio was up 3.75%, with five-year track records of nearly 12% and 14%, respectively. Given the pullback of the market in 2008, how did you achieve this growth?
McClure: Asset correlation goes to one in severely declining markets. Everything drops like a safe, and it is not unique to the 2008 bear market. The only things that don't drop are short positions and cash positions.
The difference between us and a traditional asset manager is that we look at a short position as an asset class. We trade all of the asset classes like a traditional portfolio manager: government bonds, high-yield bonds, the dollar, equity sectors, precious metals, oil and gas, international indices, and U.S. indices. I have one asset manager who delivered 42% last year, taking long-only positions that he placed very strategically, sitting on the sidelines when the risks were high. So we are a risk management company at heart. I have a whole team full of traders who are just scared to death of the market all of the time.
MME: Why not trade exchange-traded funds?
McClure: There are 52 different indices both domestically and internationally that we can get our long and short positions in using a mutual fund product.
MME: What are the key factors your traders look at each day to make their trading decisions?
McClure: It varies across the asset class that they are trading, but all of my traders have different edges that are unique to the trader on the team, because if they weren't unique, it wouldn't make sense to have more than one trader in an asset class.
I don't have just one bond trader, or one gold trader or one U.S. equity or international equity trader, but I have several so that I can mitigate the manager-specific risk with every asset class that we trade. We mitigate risk at a lot of different levels.
Take that trader who returned 42% last year. He has figured out an edge that works really well. He has a history of doing that in all markets. I have another gentleman who was up 60% last year placing short trades but who was invested only one third of the time.
You blend these kinds of proprietary talents together-people capable of predicting the movement of their asset class specialty one day at a time-and you get a really rewarding return stream.
We don't forecast long-term trends. We make decisions every day. Now, it might end up being the same decision every day, but it is made day in and day out.
The absolute core tenet of modern portfolio theory is correlation. It is everything to modern portfolio theory. We agree with modern portfolio theory. Its implementation is what is incorrect, because the more non-correlated assets you have, the better modern portfolio theory works.
Embracing the non-correlated segments of the market and coupling that with shorting is what makes us so successful. That improves the correlation of the holdings in our portfolio and enables us to deliver more consistent returns in all market environments.
MME: Does this correlation ever compromise returns?
McClure: Mathematically, if you lose 50% of a $100 investment and it goes to $50, it requires a 100% gain to get you back to break even, and the math works exponentially against you, so a 60% decrease requires take even bigger increase to get you back to break even.
So, managing a loss is twice as important as outperforming a market. And if you only capture 70% of a market's upside, then you only capture 30% of its downside, and that would put you in the top quartile of all money managers on the planet. So if you actually make money in a down market and capture 70% of a market on its upside, you will be one of the top 1% to 5% of all money managers on the planet.
How you knock the cover off the ball over a market cycle is not giving it back because giving it back is twice as painful as making it in the up market.
MME: Do you ever take into account top-down, macroeconomic factors?
McClure: Ninety-nine percent of economists are wrong, so you would be much better served to counter-trend economists.
MME: How did you develop this unusual strategy?
McClure: I used to work at a banking software company. We did some credit scoring work for commercial credits, and the one thing that I learned is that the only thing more emotional than making or losing money in the markets is making or losing lots of money in the stock market. I tended to quantify my decision process and wrote some algorithms to do so.
After launching a hedge fund in 2004, I realized that if you can quantify the investment process and bring some statistics to it, it helps you make better decisions. I thought, if I am mitigating market risk, sector risk, industry risk and company-specific risk, then what is the biggest risk my customers face? It's manager-specific, or model-specific risk. The funds-of-funds industry pinpointed this a long time ago, realizing that absolute-return strategies are great, but you need multiple managers to eliminate the clear and present danger in a limited partner structure where there is no transparency.
Not only that, but we don't have a duplication of fees, and we have our own trading platform on which we net and cross positions through our proprietary sleeve trading technology. And we reduce volatility by investing less cash when the market is moving 1% or more in a day.
MME: How is your investment approach working in this difficult environment?
McClure: The fact of the matter is, even if you have a $1 million portfolio, you are probably underfunded for your retirement. Most people need equity returns but can only stand fixed-income risk. The only way to achieve that objective is through absolute returns.
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