Manager Research Newsletter: May 2017

It's Time to Up Your Game in Large-Cap Core:
A Practical Solution to Help Outperform Efficient Markets

If you review any presentation from an 'active' large-cap core investment strategy, you probably come across one or more of the following phrases: that investing in high quality companies, attractive valuations, downside protection, and diversified portfolios doesn't differentiate that manager from any of the other 'active' mutual funds in Morningstar's large blend category. Traditionally, large-cap managers have constructed concentrated portfolios to add alpha and separate themselves from their diversified peers. However, the results over the last five years demonstrate that may not be enough.

As of year-end 2016, within the Morningstar large blend category, strategies with 50 or less holdings averaged the 67th and 64th percentile for the trailing 3-year and 5-year periods, respectively. Diversified managers with 51-300 holdings averaged the 51st and 52nd percentile for the trailing 3-year and 5-year periods, respectively. What does that tell us? Taking on concentration risk hasn't worked very well over the past five years. Nor has owning a diversified, long-only portfolio of large-cap stocks. That leaves two remaining options within large blend: passive indexing or opportunistic investing.

If you're still allocating to active managers in large blend, there's a valid reason to consider long-biased strategies that also invest opportunistically on the short side. Large Blend strategies with at least 50 long holdings and five short positions averaged 42nd and 31st percentile for the trailing 3-year and 5-year periods as of 12/31/16, respectively. MainStay U.S. Equity Opportunities Fund is the best example of what can be achieved through opportunistic shorting, finishing in the 1st percentile of all large blend funds for both the trailing 3- and 5-year periods, as of 12/31/16, respectively.

As we've illustrated above, potential returns may be limited by only utilizing strategies that can be long the underlying securities. A portfolio that utilizes opportunistic shorting has the potential to increase its relative returns and provide diversification without significantly increasing its overall risk exposure. Of course, not all shorting methodologies are created equal. In this article, we explain the concept of opportunistic shorting, how it works, the benefits and risks, and how it can be used as part of an overall investment strategy.

Portfolio managers spend a great deal of time conducting fundamental or systematic analysis to evaluate the prospects of an individual stock. There are three conclusions they can reach:

  1. Buy the stock if their analysis determines it's undervalued and has future earning potential.
  2. Don't buy the stock if they determine the company's future earning potential is neutral or negative.
  3. Sell the stock short if they believe the stock price will fall in the future.

The third possibility is only available to managers who have the ability to incorporate shorting in a portfolio to express their negative view. If this provides another source of alpha, why not use it? Cornerstone Capital Management embraces this third option in an attempt to increase returns by simultaneously purchasing selective buy ideas, combined with opportunistic short selling of high conviction sell ideas.

Opportunistic shorting and benchmarks

Opportunistic shorting typically involves a portfolio of hundreds of securities, some of which will be short positions. The performance of a portfolio that utilizes opportunistic shorting is based on its relative results versus a specified index, or benchmark. Conventional equity indices are constructed based on several criteria, but most have one common denominator: security weights are determined by market capitalization. This construction criterion has important ramifications for opportunistic shorting. We illustrate this point by decomposing the MSCI EAFE Index, although the potential benefits and increased alpha from opportunistic shorting exist in both U.S. and international markets.

Exhibit 1 compares the market-capitalization distribution of the MSCI EAFE Index using two criteria. The red line shows the securities within the Index if they were equally weighted, whereas the blue line shows the same securities if they were market-cap weighted. Stocks are sorted from largest to smallest along the x-axis. The y-axis represents the cumulative market capitalization, as you move from the largest stock to the smallest stock. An equal-weighted index means each stock has an identical weight of 0.11%, and the straight upward slope of the red line illustrates that each incremental stock adds the same 0.11% to the cumulative market capitalization.

The blue line denotes the impact from a capitalization-weighted perspective, whereby the 30 stocks with the largest capitalizations make up approximately 25% of the Index. In fact, 50% of the Index's entire market capitalization is made up of 110 stocks. The remaining 50% of the Index is made up of approximately 800 stocks with smaller capitalizations. This causes the blue line to start off with a steep slope, but it gradually flattens out. In addition to demonstrating the large number of relatively small stocks in the Index, the incremental impact of adding one additional stock becomes smaller and smaller.

Why is this so important for opportunistic shorting? As the capitalization-weighted benchmark demonstrated, there can be hundreds of stocks with small weights. As shown in Exhibit 2, a long-only portfolio is limited to a maximum underweight by not owning a security. In contrast, a portfolio utilizing opportunistic short selling has the ability to potentially benefit from shorting stocks they believe will decline in value. For long-only strategies benchmarked to capitalization-weighted indices, there is a substantial lost opportunity set.

Similarly, whereas a long-only portfolio can only underweight the index weight of a company, a passive investment is required to own the index weight and subject investors to full participation of the downside. Now let's compare a strategy utilizing opportunistic shorting (MainStay U.S. Equity Opportunities) to a passive ETF. Over the last three years ending March 31, 2017, MainStay U.S. Equity Opportunities Fund (MYCIX) delivered a similar upside capture (96.97%) versus the passive Vanguard Russell 1000 (VONE) ETF (99.31%). However, the Fund protected on the downside significantly better: 82.08% for MainStay U.S. Equity Opportunities Fund versus 100.48% for the passive ETF. 

Benefits of opportunistic shorting: Raising the efficient frontier

Let’s explore some of the benefits of opportunistic investing, specifically those tied to raising the efficient frontier. Passive investments that mirror a particular index cannot provide returns in excess of the optimal portfolios represented by the efficient frontier. In this case, the excess return and risk, defined as tracking error, is zero. Exhibit 3 demonstrates that enhanced and active portfolios assume greater risk in an attempt to generate excess returns. Although, there are diminishing marginal returns so at some point, an increase in risk does not correspond to an identical increase in expected excess returns.

As shown in Exhibit 3, opportunistic short selling has been simulated to achieve the goal of shifting the efficient frontier higher. At each level of risk, opportunistic shorting may provide higher expected excess returns, although it still is subject to the law of diminishing marginal returns. We believe there are a number of reasons why the efficient frontier curve shifted in the hypothetical simulation when employing opportunistic shorting:

  • Greater flexibility: In our view, the primary reason the curve is elevated is due to the elimination of the long-only constraint. Opportunistic short selling enables a skilled portfolio manager to achieve a more effective implementation of best and worst ideas. Capital is still allocated to "buys," but now a strong negative view on a "sell" idea can also be expressed commensurate with negative conviction.
  • Uncorrelated alpha: The curve also shifted because of two uncorrelated sources of alpha: the long and short positions. Investors have the opportunity to reap additional rewards not only because they have two ways to achieve returns, but also because these performance drivers do not move in tandem. While past performance is no guarantee of future results, these uncorrelated return streams have typically led to less overall portfolio volatility.
  • More effective risk control: Short selling gives a portfolio manager the ability to hedge undesirable exposures. One way for long-only equity managers to generate alpha is to focus on more inefficient areas of the market, such as relatively smaller-capitalization companies. Opportunistic shorting can avoid these market-cap biases, as long and short positions can be managed, so that the net exposure is zero. Said another way, a short position in the sell candidate can be offset by a long position in a security with equivalent capitalization.
  • Increased "active share:" "Active share" measures how truly "active" mutual fund managers are in managing their portfolios. Exhibit 4 compares the active share of an opportunistic shorting strategy versus a portfolio that didn’t utilize short selling. As one would expect, higher levels of active share can be achieved when allowing for opportunistic shorting.


Opportunistic shorting may be a valuable investment strategy that can potentially lead to enhanced risk-adjusted returns in otherwise efficient asset classes, such as large cap. In addition, according to the simulation depicted in Exhibit 3, having the flexibility to utilize opportunistic shorting reduced the negative impact of the long-only constraint, raised the efficient frontier, and allowed for more effective risk management. Given these attributes, we believe opportunistic shorting can be an appropriate strategy to use within an overall diversified large-cap portfolio. Implementation of this strategy allows managers to maintain market-equivalent beta, around 1, to allow for these strategies, utilization in the traditional large cap asset class instead of a liquid alternative classification.

MainStay U.S. Equity Opportunities Fund / MainStay International Opportunities Fund

These Funds seek long-term growth of capital with double alpha potential, broad diversification, and experienced risk managers. The investment team uses opportunistic shorting to take advantage of buy and sell ideas, providing two differentiated sources of return. With a focus on U.S. equity securities, or developed international equity securities, the Funds are diversified across countries, sectors, and industries. The lead portfolio manager is skilled in shorting and has a background managing long/short hedge funds, making him well-suited to manage these types of strategies.

For more information about opportunistic shorting with Cornerstone Capital Management:

Contact the Research Platform Group

Before considering any investment, you should understand that you could lose money.

The Morningstar RatingTM for funds, or "star rating", is calculated for managed products (including mutual funds, variable annuity and variable life subaccounts, exchange-traded funds, closed-end funds, and separate accounts) with at least a three-year history. Exchange-traded funds and open-ended mutual funds are considered a single population for comparative purposes. It is calculated based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a managed product's monthly excess performance, placing more emphasis on downward variations and rewarding consistent performance. The top 10% of products in each product category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star. The Overall Morningstar Rating for a managed product is derived from a weighted average of the performance figures associated with its three-, five-, and 10-year (if applicable) Morningstar Rating metrics. The weights are: 100% three-year rating for 36-59 months of total returns, 60% five-year rating/40% three-year rating for 60-119 months of total returns, and 50% 10-year rating/30% five-year rating/20% three-year rating for 120 or more months of total returns. While the 10-year overall star rating formula seems to give the most weight to the 10-year period, the most recent three-year period actually has the greatest impact because it is included in all three rating periods.

Short positions pose a risk because they lose value as a security's price increases; therefore, the loss on a short sale is theoretically unlimited. As a result, these funds may not be suitable for all investors. The use of leverage may increase the Fund's exposure to long equity positions and make any change in the Fund's NAV greater than it would be without the use of leverage. This could result in increased volatility of returns.

Growth-oriented common stocks and other equity type securities (such as preferred stocks, convertible preferred stocks and convertible bonds) may involve larger price swings and greater potential for loss than other types of investments. The principal risk of investing in value stocks is that the price of the security may not approach its anticipated value. Investing in smaller companies involves special risks, including higher volatility and lower liquidity. Investing in mid-cap stocks may carry more risk than investing in stocks of larger, more well-established companies.

The Fund may invest in derivatives, which may increase the volatility of the Fund's NAV and may result in a loss to the Fund. Investment in REITs carries with it many of the risks associated with direct ownership of real estate, including decline in property values, extended vacancies, increases in property taxes, and changes in interest rates. The Fund may experience a portfolio turnover rate of over 100% and may generate short-term capital gains which are taxable.

Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks. These risks may be greater for emerging markets. Investing in smaller companies involves special risks, including higher volatility and lower liquidity. Investing in mid-cap stocks may carry more risk than investing in stocks of larger, more well-established companies. The Fund may invest in derivatives, which may increase the volatility of the Fund's NAV and may result in a loss to the Fund. The Fund may experience a portfolio turnover rate of over 100% and may generate short-term capital gains which are taxable.

Tracking error is the divergence between the price behavior of a position or a portfolio and the price behavior of a benchmark.

For more information about MainStay Funds®, call 800-MAINSTAY (624-6782) for a prospectus or summary prospectus. Investors are asked to consider the investment objectives, risks, and charges and expenses of the investment carefully before investing. The prospectus or summary prospectus contains this and other information about the investment company. Please read the prospectus or summary prospectus carefully before investing.

New York Life Investment Management LLC engages the services of federally registered advisors. MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. Securities distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, New Jersey 07302, a wholly owned subsidiary of New York Life Insurance Company. NYLIFE Distributors LLC is a Member FINRA/SIPC.