Ask the Manager: Wayne Penello on Why Actively Managing Equity Risk Is Essential

In this edition of our Q&A series, we explore one of the most important challenges facing today’s equity investors: how to manage risk without sacrificing long-term returns. While diversification has long been considered the foundation of portfolio construction, it offers limited protection against the systemic shocks that increasingly drive market volatility. To better understand the limits of traditional approaches—and how long/short strategies delivered through ETFs may offer a modern alternative—we sat down with Wayne Penello, founder and CIO of NextGen EMP and co-creator of the EMPB ETF. With more than four decades of experience in risk management, Penello shares his perspective on why actively managing equity risk is becoming essential for investors navigating today’s markets.

What types of risk am I exposed to in my equity portfolio?

Equity investors face three primary forms of risk:

• Idiosyncratic risk: Company-specific events
• Systematic risk: Industry or sector-level pressures
• Systemic risk: Broad market or global uncertainty

Nobel Prize–winning economist Harry Markowitz, founder of Modern Portfolio Theory, famously noted that “diversification is the only free lunch in finance.” His work demonstrated that diversification can reduce risk without reducing expected returns.

Where does diversification fall short?

Diversification works extremely well at lowering idiosyncratic and sector-level risk.
However, it does not meaningfully reduce systemic risk—the broad market forces that cause correlations to rise across nearly all sectors during periods of stress.

To address systemic risk, many investors limit their equity exposure and shift into lower-risk, lower-return assets. While effective at reducing volatility, this approach also reduces long-term returns.

A more effective alternative is to actively manage risk, allowing a higher share of investment capital to remain positioned for equity-level returns.

Can option strategies fill the gap and protect against market risk?

Yes—but always at a cost.

Investors can:

• Buy options for direct protection (paying constant premiums), or
• Use option-based long/short structures that reduce extreme downside risk but also cap the upside.

Buying protection creates a persistent drag on returns.
Capping gains can be even more damaging over time.

Investment legend Charles Ellis, former chair of Yale’s Investment Committee, illustrated this tradeoff: over a 10-year period, missing the best 90 trading days would turn a $1 investment that could have grown to $5.59 into a $0.22 loss. Strategies that truncate gains risk undermining long-term performance.

How can I manage market risk without sacrificing long-term returns?

Introduce short positions to offset market exposure.

U.S. industry sectors are correlated to varying degrees, but they tend to move together during major macro events—rate shocks, inflation surprises, recessions, geopolitical stress, or market-wide crises such as COVID-19.
In these moments, disciplined short exposure can dampen drawdowns and control volatility.

Aren’t short positions themselves risky?

A single short position can be risky due to asymmetric payoff.
But in a diversified, risk-managed framework, short positions reduce overall portfolio risk.

This insight dates back to A.W. Jones, who developed the first long/short equity strategy in the 1940s. His approach—pairing long positions in strong companies with short positions in weaker ones—remains the foundation of modern risk-controlled investing.

Why aren’t long/short strategies more widely used by individual investors?

Institutional investors—foundations, endowments, pensions—have long relied on long/short approaches because they are effective and tax-efficient for them.

Individual investors often lack the time, tools, or expertise to manage a long/short portfolio themselves, which historically limited adoption.

Have ETFs changed the landscape for long/short strategies?

Yes.

ETFs using long/short strategies now give all investors access to institutional-quality risk management in a tax-efficient vehicle.
When an ETF adjusts its portfolio, it can use Section 351 exchanges, allowing in-kind transactions that avoid realizing capital gains. The investor’s tax liability is typically based only on their own buy and sell dates.

This structure opens the door for investors and advisors to efficiently incorporate long/short risk management.

What is EMPB’s investment strategy?

EMPB

combines a highly diversified long portfolio—representing sectors expected to lead the market—with a targeted set of short positions in sectors expected to lag.

The goal is simple:
Actively manage risk while delivering consistent, equity-like returns.

By emphasizing both the quality of long positions and the strategic role of shorts, EMPB aims to reduce drawdowns, control volatility, and improve risk-adjusted performance.

What role should long/short risk management play for equity investors?

Investment success becomes more consistent when risk is managed with discipline.
A portfolio that loses less during downturns advances from a higher base when markets recover. That means:

• Less ground to make up
• More capital working during the rebound
• Higher compounded long-term returns

This also reduces the emotional stress investors often feel during volatile markets.