Analysis of Long-Only Versus 130/30 in the MSCI EAFE Space Given Model Enhancements:

April 1, 2014

McKinley Capital Management, LLC (“McKinley Capital”) continues to make improvements to its Non-U.S. Developed and Non-U.S. Developed 130/30 strategies over the last couple of years.

In the MSCI EAFE space, McKinley Capital has worked to smooth the profile across the fractiles of return associated with these two strategies and has added a significant number of enhancements to its models. One of McKinley Capital’s goals was to improve the up/down capture of the risk factors without significantly altering the portfolio level factor footprint. To this end, McKinley Capital reduced the volatility of the earnings growth and acceleration variable (“E”) by adding a Return on Invested Capital (“RoIC”) component (similar in scope and consistency to Return on Asset (“RoA”)) to its quantitative investment process. The firm also enhanced its earnings surprise component by creating a new variable called True Market Surprise (“TMS”) which is combination of actual surprise and guidance. The use of the TMS variable results in less volatility and therefore, less turnover.

McKinley Capital has also made several important enhancements to the Momentum side of its quantitative process. First, the firm separated volatility from the calculation to stay high in the Momentum deciles without detracting from the rank. Second, McKinley Capital altered the look back period to include a more dynamic adjustable method. Third, the firm recalibrated the definition of Momentum from a relative return to an alpha regression with a lag. Finally, McKinley Capital included more robust penalty functions to mitigate Momentum scores that would otherwise lead to candidate stocks with high reversal risk. The result of these four enhancements is a much more powerful version of Price Momentum.

Together, these new component variables and enhancements to the model result in stronger information coefficience. Chart 1 below compares the enhanced model with the old model and shows improvement in T-statistics to the 5% confidence level.

1404 Analysis-01 Chart 1

A review of the decile breakdown of returns from best to worst can help determine if a model can be better implemented in a long-short strategy. Chart 2 below shows the average monthly return by quintile, ranked from best to worst, for the old and enhanced models. The enhanced model is clearly more powerful and monotonic in each quintile. This means that the opportunity for returns by purchasing securities in the top quintile or by shorting securities in the bottom quintile is roughly the same. Even given the higher transaction costs associated with shorting securities, Chart 2 shows ample room for better returns with MQEnhanced versus MQOld.

1404 Analysis-02 Chart2

While increasing returns by enhancing its investment model was part of McKinley Capital’s goal, the firm wanted to do so without increasing and possibly decreasing the risk associated with those same returns. There are several definitions of risk that are relevant to portfolio management, including Standard Deviation (total volatility) and Tracking Error (risk of model relative to benchmark volatility). For this analysis, Tracking Error is used as it demonstrates how McKinley Capital’s return profile acts in comparison to the benchmark. As Chart 3 illustrates below, the enhanced model shows a better volatility profile at the top two quintiles for longs and at the bottom quintile for shorts. The enhanced model could improve the risk return profiles of both the long-only and long-short models.

1404 Analysis-03 Chart3

Lastly, and perhaps most importantly from the perspective of considering long-only versus long-short implementation, is performance.  Chart 4 below shows that although the long-only portfolio could generate positive relative returns (see Top MQEnhanced Quintile relative to the benchmark), a better model may be one that utilizes the long process while simultaneously incorporating a shorting process (see Bottom MQEnhanced Quintile relative to the benchmark).

1404 Analysis-04 Chart 4

The Global Financial Crisis was a difficult period for investment models that contained components of Growth and Momentum factors. McKinley Capital weathered the storm and since that time, has worked with fervor, as discussed in this paper, to improve the up/down capture of its factors. The firm has seen significant improvement since that time. A question is whether McKinley Capital fit the enhanced model to yesterday’s problem, preparing itself for the next similar crisis while missing the upside when it occurs. McKinley Capital is very pleased to report that this risk did not materialize in the strong upside market of 2013 as the firm’s portfolios saw good relative returns with contained volatility. Ex-ante tracking error today is roughly 3% for long-only and 4% for long-short models. Returns for the firm’s actual portfolios from 2007 (inception of long-short portfolio) through February 2013 are shown in Table 1 below.  Table 1 shows improvement in both portfolios versus the benchmark since the enhancements were made, especially in the long-short portfolio.

1404 Analysis-05 Tab1

McKinley Capital knows that it is never possible to capture the returns of a back test.  However, the firm is strongly encouraged by the results shown above. McKinley Capital’s MQEnhanced shows improvement versus MQOld. The returns are more monotonic and at lower levels of relative risk. These enhancements have actually played out in the live portfolios over the last few years. While no amount of back testing can give an exact split between long-only and long-short, the data discussed above demonstrates the strong benefit of a long-short portfolio. At a minimum, a more balanced weight between the two strategies, perhaps even favoring long-short to a degree, seems advantageous. As always, McKinley Capital is available to discuss its research, investment process and/or questions.

DISCLOSURE

McKinley Capital Management, LLC (“McKinley Capital”) is a registered investment adviser under the U.S. Investment Advisers Act of 1940. McKinley Capital is not registered with, approved by, regulated by, or associated with the Financial Conduct Authority (“FCA”) or the Prudential Regulation Authority (“PRA”). Neither the FCA nor the PRA have commented on the firm, the content of any marketing material or any individual suitability assessments.

All information contained herein is believed to be acquired from reliable sources but accuracy cannot be guaranteed. This presentation is for informational purposes only, may contain confidential information and should not be further disseminated without written approval from McKinley Capital’s Compliance Department. It is not intended to represent specific financial services or recommendations for any targeted investment purposes. The data is unaudited and may not correspond to calculated performance for any specific client or investor in referenced disciplines. McKinley Capital, nor its employees, makes any representations or warranties as to the appropriateness or merit of this analysis for individual use. Investors must seek individualized professional financial advice before investing.

Investments and commentary were based on information available at the time and are subject to change without notice. Any references to specific indexes or securities are for informational purposes only, may or may not have been owned by McKinley Capital in the past, may or may not be owned by McKinley Capital in the future and may or may not be profitable. No single security, discipline, or process is profitable all of the time and there is always the potential for loss. Past performance is not indicative of future returns. All returns are gross of investment management fees, broker commissions, taxes and all other fees, costs and expenses associated with client account trading and custodial services and therefore individual returns may be materially negatively affected. Returns do include the reinvestment of gains, dividends and other income.

Returns are absolute, were generated using McKinley Capital’s proprietary growth investment methodology as described in McKinley Capital’s Form ADV Part 2A, are unaudited, and may not replicate actual returns for any client. McKinley Capital’s investment methodology has not materially changed since its inception but it has undergone various enhancements. No securities mentioned herein may be considered as an offer to purchase or sell a firm product or security. Any comment regarding an individual security is presented at the client’s request, may only be used for client reference, and may not be reflective of composite or individual portfolio ownership. McKinley Capital may not currently hold a specific security. In addition, any positive comments regarding specific securities may no longer be applicable and should not be relied upon for investment purposes. No security is profitable all of the time and there is always the possibility of selling it at a loss. With any investment, there is the potential for loss. Investments are subject to immediate change without notice. Comments and general market related perspectives are for informational purposes only; were based on data available at the time of writing; are subject to change without notice; and may not be relied upon for individual investing purposes. Past performance is no guarantee of future results.

Trade date based performance shown reflects the reinvestment of realized gains, dividends, interest and other earnings calculated using McKinley Capital’s growth investment methodology. Portfolio performance is shown gross and/or net of management fees or asset based broker fees as indicated in the text of the presentation. Clients should realize that net returns would be lower and must be considered when determining absolute returns. Detailed account inclusion/exclusion policies are available upon request. Returns are based on fully discretionary accounts and do not take individual investor tax categories into consideration. No guarantee can be made that the composite performance reflects a statistically accurate representation of the performance of any specific account. Charts, graphs and other visual presentations and text information are derived from internal, proprietary, and/or service vendor technology sources and/or may have been extracted from other firm data bases. As a result, the tabulation of certain reports may not precisely match other published data. Specific results from calculations and formulas may be rounded up. Future investments may be made under different economic conditions, in different securities and using different investment strategies.

Fees are billed monthly or quarterly, which produces a compounding effect on the total rate of return net of management fees. As an example, the quarterly effect of investment management fees on the total value of a client’s portfolio assuming (a) $1,000,000 investment, (b) portfolio return of 5% a year, and (c) 1.00% annual investment advisory fee would be $10,038 in the first year, and cumulative effects of $51,210 over five years and $110,503 over ten years. Actual client fees vary. A fee schedule, available upon request, is described in the firm’s Form ADV part 2A.

Composite returns include only those accounts holding common stocks, preferred stocks, ADRs, ordinary shares, money market instruments and/or cash equivalents – and for non-U.S. and global composites foreign currencies and stocks. For the period prior to April 1, 2001, composites contain both wrap and non-wrap accounts. For this period, net returns for non-wrap accounts were not reduced by wrap sponsor fees, and gross returns for non-wrap accounts were reduced by transactional costs. The performance results prior to March 11, 1991 reflects the investment performance of discretionary brokerage accounts managed by Robert B. Gillam, Chief Investment Officer at FAS Alaska, Inc. (prior to the formation of McKinley Capital) with a growth investment philosophy and methodology similar to that described in McKinley Capital’s brochure.

Global market investing, including developed, emerging and frontier markets, also carries additional risks and/or costs including but not limited to: political, economic, financial market, currency exchange, liquidity, accounting and trading capability risks. Derivatives trading and short selling may materially increase investment risk and potential returns. These risks may include, but are not limited to, margin/mark-to-market cash calls, currency exchange, liquidity, unlimited asset exposure and counter-party risk. Future investments may be made under different economic conditions, in different securities and using different investment strategies. McKinley Capital’s proprietary investment process considers factors such as additional guidelines, restrictions, weightings, allocations, market conditions and other investment characteristics. Thus returns may at times materially differ from the stated benchmark and/or other disciplines and funds provided for comparison.

Charts, graphs and other visual presentations and text information were requested by the client and derived from internal, proprietary and/or service vendor technology sources and/or may have been extracted from other firm data bases. As a result, the tabulation of certain reports may not precisely match other published data. Data may have originated from various sources including but not limited to Bloomberg, MSCI/Barra, Russell Indices, FTSE, APT, ClariFI, Zephyr, and/or other systems and programs. With regards to any material accredited to FTSE International Limited (“FTSE”)©FTSE [2014]: FTSE™ is a trade mark of London Stock Exchange Plc and The Financial Times Limited and is used by FTSE International Limited under license. All rights in the FTSE Indices vest in FTSE and/or its licensors. Neither FTSE nor its licensors accept any liability for any errors or omissions in the FTSE Indices or underlying data. With regards to any materials accredited to MSCI/Barra: Neither MSCI nor any other party involved in or related to compiling, computing or creating the MSCI data makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of such data. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in or related to compiling, computing or creating the data have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. No further distribution or dissemination of the MSCI data is permitted without MSCI’s express written consent. Please refer to the specific service provider’s web site for complete details on all indices. McKinley Capital makes no representation or endorsement concerning the accuracy or propriety of information received from any other third party.

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1 MQ refers to McKinley Capital’s quantitative score for any stock and is the composite of all its factor scores.