Q:  What is the history of the fund and how has the MainStay International Opportunities Fund evolved since its inception?

We launched the MainStay International Opportunities Fund as an actively managed mutual fund back in October 2007, to provide investors with the opportunity to invest in the international markets in a non-traditional way—utilizing short selling. The fund started out as an institutional separate account. Currently, it has $384 million under management. We have always managed the fund using a quantitative investment process, and over time we have added more fundamental analysis to the process. In the past, our investment approach used to be more technical, more trend following and the process has matured over time, especially after the financial crisis in 2009. Today, we take a much more sophisticated approach to tactical risk management and optimization. We have a team of portfolio managers and analysts with expertise in the long-short space. They add tremendous value to the process, particularly around what we call ‘blind spot management.’ The model we use has been built and refined over the last 14 years. Essentially, we combine relative value and in-depth awareness of global trends, with prudent portfolio construction across our platform, to produce strong returns for our investors.

Q:  Why should U.S. investors invest in international markets?

If you look at the U.S. today, versus other developed markets, other markets have underperformed the U.S. for the last five years at least. That gives us reason to think there may be a rebound in some of these other markets. For example, in this latest economic cycle, Europe has lagged the U.S. and the U.S. has done quite well over the last three or four years, so we believe there’s a chance for Europe to start leading the charge going forward. In terms of Europe, there’s some promise from the European Central Bank, which may lead to a quantitative easing approach similar to what we’ve seen in the U.S. We’ve already seen this being priced-in recently in the German bond market. Correlation benefit or diversification benefit from investing internationally varies depending on how risky markets are. During the financial crisis there weren’t a lot of diversification opportunities and everybody was pretty much 90% correlated. However, I believe as markets have stabilized, the correlation benefits of international investing have improved and there is significant opportunity.

Q:  Which international markets do you include?

We start with the developed markets but exclude the U.S. and Canada as determined by MSCI Inc., the keeper of reference indexes. We can invest up to 10% in emerging markets. We don’t invest in frontier markets in this fund, however, we do manage the MainStay Emerging Markets Opportunities Fund, which is run using a similar strategy and does invest in emerging opportunities. 

Q:  What kind of opportunities are you seeking?

For us the opportunity is about investing long and short. It’s an enormous advantage to have the ability to short in the fund. Right now we’re creating a lot of the alpha on the short side, which is allowing us to provide better returns than other funds in our peer group. As one of only a handful of long-short funds in the international universe, we see a lot of opportunities that other managers are overlooking because they don’t have a mandate to short securities. They can only underweight the stocks they don’t like. We have the opportunity to add significant alpha by shorting in the fund. In the international space, there’s a huge opportunity to short securities both in the large and the small cap space and investors in our fund can benefit from that. Shorting basically makes up half of our effort, so it’s been half of our returns over the last three years.

Q:  How is investing in small cap different from large caps?

Trend following is more important in the small and mid-cap space where valuation is less relevant. Since smaller cap companies are less mature, it’s important to be a little bit more cognizant of the trends since many companies have not reported any earnings. Using a relative value approach is not going to be all that useful. As a result we increase our exposure to trend following and analyst earnings upgrades.

Q:  How is your fund unique?

One of our core beliefs is that shorting is a great way to outperform traditional large cap benchmarks. It’s important to have the shorting experience and we’re one of the only funds in this space that has a shorting capacity. It gives us a competitive advantage against our peers and I think it’s one of the key reasons why we have tended to outperform in the last several years. By allowing ourselves to short, which is a nontraditional approach to investing in international markets, we’re able to both add alpha and reduce risk and I think that is more attractive than your typical long only fund. I believe the long only constraint can makes portfolios inefficient. Another reason the fund is unique is it has one of the highest active shares out there. Roughly 95% of our holdings are active shares so even though we’re highly diversified and have a beta of 1, close to the index, our portfolio looks nothing like the index and that’s one of the reasons why we can outperform and still have similar to market risk. One of the other interesting things is if you look at the risk of the fund, it’s very close to our peer group, so despite the fact that we’re shorting and using leverage, we’re not adding additional risk to the portfolio.

Q:  What core principles drive your investment philosophy?

At the core we believe that markets are inefficient and that if you manage a quantitative strategy in a disciplined fashion and look at thousands of securities, you can find securities that are mispriced. The way we try to determine whether securities are mispriced is using a peer group relative value approach. So we’ll look at a stock and look at how it’s priced relative to some peer group that we determine algorithmically. Then we’ll use a catalyst to try to tell us whether or not it’s time to buy it, or it’s time sell it, or whether it’s time to just leave it alone. Our catalysts tend to be driven by analyst estimate revisions, so at a high level we try to buy stocks that are cheap relative to their peers and that analysts like - and we tend to short securities that are expensive that analysts dislike.

Q:  How are you different from long-short funds?

I think when people hear “long-short fund” they typically expect a fund with relatively modest volatility, that’s less than the market. Our strategy runs with a full market exposure, so we have a beta of one and our volatility is very similar to that of the MSCI EAFE Index, our benchmark. That said, we are aiming to have an upside capture greater than the market.

Q:  Can you share examples of some of your stock finds?

One stock that we’ve found attractive on the long side and I think is something fairly unusual for a quantitative process to pick up is a Danish wind farm manufacturer. We used to short the stock and we made a lot of money doing that. Now we’ve identified it as an opportunity on the long side and it’s been one of our top performing companies. It’s hard to imagine that a model based on relative value would identify a wind farm manufacturer, because stock from a company like that is not usually cheap. But it did. Initially, the company was expected to go bankrupt because the subsidies got pulled away but they were able to restructure quickly enough and get enough new orders. Now they’re a profitable company and look quite attractive. The stock is up about 50% from where we bought it. We have also invested in a Spanish wind turbine maker.

Q:  Will you share one more example, on the short side?

We looked at a Japan based agency for social media and smart phones - an internet company. Small cap Japanese stocks got bid up a lot the last year to unsustainable high levels. This company’s earnings really didn’t move much and now they’re starting to fall quite a bit. This was just a very high beta stock that sold off a lot. The stock is down about 46% for the year so far. Now the company is lowering its outlook. In Japan we’re starting to see some attractive shorts. Much of what happens in Japan will be determined by the government - whether or not they do more economic stimulus or more quantitative easing.

Q:  Are there any group of companies or sectors you stay away from?

Right now, we’re staying away from utility stocks. Generally you’ll see that we’ll probably be underweight that sector, if it tends to lag the market or is relatively expensive. We’re also wary of state owned companies. A government that has a large stake in a company even though it’s publicly traded can often be a hindrance to the company’s growth. We find these stocks can be a bit of a wild card. For instance, perhaps the government has plans to change regulation which could end up reducing prices or increasing prices.

Q:  Delving more into your research process, do you combine your fundamental and technical research?

Yes, we do and the fundamental piece is something that we’ve added over time. When it comes to portfolio management and trading, we’ve added something that we call “blind spot management,” which I mentioned previously. When we’re rebalancing the portfolio, we’re looking at the stocks that have underperformed substantially over the last thirty days. We may identify a cheap stock that’s gotten significantly cheaper and we want to make sure that the reasons the stock has fallen in the last month are incorporated into our model. That’s the essence of it. For example, the CEO could have resigned, or there could be rumors of fraud or an investigation. Those would be reasons why we’d remove those securities from the trade and use our investment process to pick a replacement. We also do this on the short side. While we don’t take a macro approach, we do like to review macro-economic trends and variables and economic forecasts. We look at how they will impact different components of our model and how they might drive performance in different sectors or different regions. We’re trying to make sure that we’re not fighting those trends.

Q:  How is your research team organized?

Our team is comprised of both portfolio managers and quantitative analysts. The portfolio managers are also responsible for conducting research, so everybody participates in that. I’m the lead portfolio manager so all investment decisions come through me, but we discuss ideas at the team level to arrive at a consensus. Usually with quantitative data, the decision making process is much clearer than with the fundamental story - so we don’t spend too much time debating things. To the extent that we’re looking at something tactical that might be forward looking, such as what the ECB is going to do, there’s a lot more debate because there are a lot more unknowns. When it comes to doing research and building models, we can create different factors and back-test them over ten to twenty years. We can do that for hundreds of factors and thousands of securities, with very little effort.

Q:  Do you have a sector based analysts?

Two of our portfolio managers are solely domestically focused – but I’m grooming them to be more globally focused. The rest of our team is global. We have other strategies that use the same process – the MainStay US Equity Opportunities Fund and the MainStay Emerging Markets Opportunities Fund – so it makes a lot of sense for us to be globally focused rather than be sector or regionally focused.

Q:  What role does diversification play and generally how many names do you have in your fund?

Diversification plays a huge role in our fund and that’s one of our guiding principles. As a quantitative manager you tend not to have a high level of conviction in an individual security. You have conviction in baskets of securities so maybe twenty or fifty or a hundred securities. So, what we like to do is spread out our bets. We will invest perhaps sixty basis points in, say, fifty or a hundred positions. On the short side we tend to be a little bit more diversified so maybe we’ll short forty basis points at a time and a lot of names. If you look at our entire portfolio I think we have roughly six hundred positions in it at the moment - four hundred of those are longs and two hundred of those are shorts. One of the reasons why we have a lot of positions is that we like to do a lot of investing in small cap names where the market is less efficient. In the small cap space we might be up to 40% short and 40% long so we’re getting the alpha or excess return on those less efficient names but we’re not getting any of the beta or volatility – since our short exposure is roughly equal to our long exposure. That allows us to import some of the inefficiencies from small cap international space onto a large cap benchmark. This is another point of differentiation for our fund.

Q:  What is your benchmark? And, do you hedge?

We’re benchmark centric. Our benchmark is MSCI EAFE Index. We follow the index in U.S. dollars. Sometimes we will hedge currencies but it’s fairly rare in this fund. We have a small hedge on a foreign currency right now but it’s relatively insignificant. If we saw that their central bank was going to be more aggressive with their quantitative easing, we would probably increase that hedge. I would describe it as being minimally hedged at the moment.

Q:  What is your systematic investment process?

The first part of the investment process is very much systematic or programmatic, so every morning our models will run, they’ll score relative value factors, sentiment, catalyst, and trend following factors, on ten thousand securities. Then we use our optimizer to maximize our exposure to the stocks that our model recommends, and also short the stocks that our model thinks will underperform. When we rebalance we have maybe three hundred to five hundred trades that we’re looking at and will execute almost all those trades. This is where the fundamental analysis begins. The team reviews the stocks that may have potential blind spots – so for example a stock looks cheap and has underperformed recently. We’ll be looking to make sure that nothing structurally has happened to the company, for example. On the short side we’ll investigate stocks that have outperformed significantly over the last month and make sure that our model incorporates what’s happening there.

Q:  What drives your sell discipline?

There are about three drivers here. Every time we rebalance our portfolio we trim our winners in an effort to harvest gains and maintain risk levels at the single stock level. Second, we’ll obviously sell a security is if our model changes its opinion. So if our model liked the stock and now it dislikes it or turns neutral, we’ll sell and replace it with something better. Third, if a company is facing an extreme or unforeseen event, we would not wait to rebalance at the end of the month.

Q:  How do you incorporate learning in your model? What kind of changes have you made to the model, if any?

Our biggest change was in response to the Great Recession in 2007-2009. We used to have more trend-following in our model and that’s something we have reduced significantly in the large cap space. We’d rather give up a little bit of return to protect on the down-side because we believe it helps create more stable returns, especially in the large cap space. One of the things that’s important about the way we’ve built our model is it’s not heavily based on statistics. It’s a lot more fundamental and intuitively driven, where we’ll choose what weights we want to use rather than have them be purely driven by statistics and by history. With a statistically based model, you’re explicitly expecting history to repeat itself. We’re always thinking about how to refine the model. We like to incorporate what we’ve learned from past experience. We’ve recently added some new team members to our quantitative team and if they have some interesting new insights, we may try to include those. We’re very much open to those changes. Our global model is always a work in progress. We’ve made a few subtle enhancements in the last few years.

Q:  How do you define risk and what do you do to manage it?

We look at our expected tracking error which is provided by our risk model. We like to keep our active risk in the 3% to 5% range, however, there are also other important risks and those are individual stock risks. We try to manage stock risk by having lots of small positions and by monitoring short positions that have a lot of volatility. In short positions you can lose much more than your initial short or your initial investment. That’s particularly true if you’re shorting small cap names. So we’ve placed a lot of attention on monitoring the performance of our shorts. We have watch lists that we monitor with different types of stop loss limits. In addition to measuring typical risks like country, sector, beta and size, we have to be very concerned about whether our model will outperform or underperform in the current or upcoming market cycle. One of the ways we manage model risk is by understanding what macro factors are driving our model performance. So an example might be if you’re entering a financial crisis (if you think about Europe maybe three years ago), you didn’t want to be a value investor because value stocks just kept getting cheaper and cheaper. Once a backstop was provided by the European government, it was time to return to value investing. That allowed our fund to outperform entering the European financial crisis and since the crisis. That’s something we definitely learned from the U.S. financial crisis of 2009 - how to manage that type of episode.