Murphy: What are you telling your clients to do to prepare themselves for that environment?
Del Vecchio: I still advocate the long/short approach. I think our clients who buy HDGE understand the value of the hedges. In my opinion, brokers that are using alternative investments and hedging might not be making as much money on the upside when everyone is giddy, but they are not getting hit as much on the downside, so they are coming out ahead with a smoother equity curve.
Just talking to people in that space who buy our funds, we know that their clients—who are mostly wealthy individuals—are not interested in huge returns; they are interested in preservation of capital and a reasonable return on top of inflation. They are looking for 6 to 7 percent returns, and not the 15 percent everyone else wants. In that scenario, protecting on the downside is as important as it is capturing the gains on the upside.
Murphy: That’s where indexing comes in, right? In your book you also talk a bit about the pitfalls of indexing. Is your gripe really with market-capitalization-weighted strategies that dominate the ETF space?
Del Vecchio: That’s exactly right. There are two issues that I think are a problem with traditional indexes. First, it’s the market-cap-weighted strategies that put so much emphasis on the big companies. If you look at the S&P 500, the top 100 stocks are about two-thirds of the index weight, and obviously Apple is the biggest company. You also have others like Exxon Mobil, Johnson & Johnson, etc. If you could have predicted these companies would be where they are now, you’d have done really well, but you can’t. Market cap isn’t the best strategy, again because you can’t predict who will be on the top and the winners don’t carry over from generation to generation.
The other thing goes back to my first point, and that is that most stocks underperform even in bull markets, so traditional indexes have all the best companies, but they also have all the bad ones too.
In our process, we score the stock based on earnings quality and instead of shorting it, we exclude it from the mix. When we did that, we found that over time it gave us better returns. It’s an index that takes advantage of a short-selling methodology but without actually shorting any stocks. We are trying to exploit the few problems that we see: Market-cap weighting is a flawed strategy, so we look at earnings quality, and we try to exclude some of the losers; that way, you can enhance traditional indexing.
Murphy: So traditional indexing, if you will, has its pitfalls, but fundamental indexing is a viable alternative?
Del Vecchio: I’m still not a big fan of fundamental indexing that includes all the losers. Indexes like the S&P 500 that are dividend-weighted, low volatility-weighted, etc., those are fundamentally weighted indexes that still have problems because they still include the stocks that are dragging down the index. We are trying to change the nature of indexing by excluding companies that we perceive to be losers. If you weight by earnings quality and exclude losers, you can improve your returns in a rules-based process.
Murphy: What’s the main takeaway you want people to get from your book?
Del Vecchio: You need to focus more on losses. Winners take care of themselves, but it’s the losses that can make all the difference. People are afraid to take a loss, but you have to admit that you were wrong and take a small loss so that you live to invest another day.