Asset Allocation ETF Portfolio

October 1, 2014

There is a growing industry-wide interest in funds that allocate between major asset classes using ETFs as the primary investment vehicles. Classes often include U.S. Equity, International Equity, Fixed Income, and Real Assets. Momentum and volatility models are among those used to determine allocation percentages.

McKinley Capital is a pioneer in the application of innovative and sophisticated momentum strategies. The McKinley Capital approach to momentum investing differs from generic industry models in its use of risk adjustment techniques, penalty functions, and dynamic momentum term-structure rotation. Generic momentum models, while historically effective long-term, have been plagued with occasional large losses (referred to as negative skew). These losses have generally occurred at major market inflection points. As an example, the early 2009 time period was difficult for equity strategies due to the v-shaped transition from a serious down market to a rapid but non-earnings related rally. Proprietary risk adjustment and other techniques can be used to mitigate this risk without sacrificing the upside. For example, McKinley Capital can forecast times when a momentum investment strategy is likely to be less effective. During these periods, the firm can focus less on momentum and more on other aspects of its investment process.

Can McKinley Capital use its proprietary process to successfully manage a broad-based asset allocation fund? To answer this question, the firm created a benchmark as the composite of the MSCI ACW Index and the Barclay’s 7 to 10 Year Treasury Index in a 60% to 40% ratio. Quarterly returns were computed from January 2002 to June 2014. As reported in the Table below, the annualized benchmark return was 7.88%, with a standard deviation of 9.89%, a Sharpe ratio of 0.646 and, by definition, a zero information ratio. For comparison, the annualized S&P 500 return over the same time period was 6.49%, with a standard deviation of 14.94% and a Sharpe ratio of 0.334.

TABLE: ASSET ALLOCATION STRATEGY RETURNS FROM JANUARY 2002 TO JUNE 2014

1410 Asset-01 Tab
McKinley Capital constructed and tested three alternative active strategies. The first strategy, labeled “Alpha 12”, assigned asset class policy weights of 35% to U.S. Equity, 30% to International Equity, 30% to U.S. Fixed Income and 5% to Real Assets. 22 ETFs or their corresponding indexes were considered and divided into the four classes1. There was no allocation to cash. An individual ETF policy weight was computed by dividing the corresponding class policy weight by the number of ETFs in the class. Each of the 22 ETFs was ranked from one to 22 using McKinley Capital’s proprietary momentum indicator. Active weight (difference from policy weight) was assigned to each ETF based on its momentum rank. Bands were established for class weights. In testing this strategy, the firm assumed a conservative 50 basis point transaction cost per side. The portfolio was rebalanced quarterly and averaged 13% quarterly turnover. The results are reported in the Table above. The annualized strategy return was 9.49%, with a standard deviation of 12.18%, a Sharpe ratio of 0.657 and an information ratio of 0.43. The Chart below shows the class weights over time.

CHART: CLASS WEIGHT SUMMARY – ALPHA 12 STRATEGY

1410 Asset-02 Chart

1 U.S. Equity – Consumer Discretionary (XLV), Consumer Staples (XLP), Energy (XLE), Financials (XLF), Healthcare (XLV), Industrials (XLI), Materials (XLB), Technology (XLK), Utilities (XLU). U.S. Fixed Income – Intermediate Treasuries (IEF), TIPS (TIP), Investment Grade (LQD), High Yield (HYG), Mortgages (MBB). International Equity – Europe (VGK), Canada (EWC), Japan (EWJ), Pacific Ex-Japan (EPP), Emerging Market (EEM). Real Assets – Gold (DGL), Real Estate (IYR).

The second strategy, labeled “Modified Alpha 12”, was constructed in the exact same way with the exception of the ranking model. Instead of ranking only by momentum, the ETF ranking algorithm included a short term momentum reversal component and a volatility component. The annualized strategy return was 8.77%, with a standard deviation of 10.37%, a Sharpe ratio of 0.702 and an information ratio of 0.37.

In the third strategy, labeled “Optimized Alpha 12”, the ETFs were ranked only by momentum. Instead of algorithmic weighting, weights were determined using a proprietary mathematical optimization system. Each of the 22 ETF weights was constrained to the range of 1% to 12% and bands were used for each class. The annualized strategy return was 9.51%, with a standard deviation of 8.53%, a Sharpe ratio of 0.941 and an information ratio of 0.59.

It appears that investment models employed by McKinley Capital have the potential to perform in the context of a broad-based, asset allocation fund. As always, your McKinley Capital account representative is available to discuss its research and investment process and to answer your questions.

 

DISCLOSURE

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The material provided herein has been prepared for a one-on-one institutional client presentation, may contain confidential and/or proprietary information, and should not be further disseminated without written approval from McKinley Capital’s Compliance Department. This report contains back tested and/or model information; any performance is hypothetical and may not be relied upon for investment purposes. Back tested performance was derived from the retroactive application of a model with the benefit of hindsight and does not represent an actual account. Models may not relate or only partially relate to services currently offered by McKinley Capital and model results may materially differ from the investment results of McKinley Capital’s clients. Unless otherwise indicated in the presentation, no fees or expenses of any kind have been deducted. Trading activity, asset allocation, and portfolio decisions are based on the management style that McKinley Capital may have followed had it been actively managing a discretionary account for that period. Unless otherwise indicated in the presentation, returns are calculated using the internal rate of return; do not adjust for external cash flows; do not include brokerage commissions; ignore cash interest during adverse states and when deleveraged, are based on fully discretionary accounts; reflect the reinvestment of dividends and interest; are gross of all investment management and all other costs, expenses and commissions associated with client account trading and custodial services fees; and do not take individual investor tax categories into consideration. Returns do include the reinvestment of hypothetical gains, dividends and other income. The currency used to calculate hypothetical performance is the USD, and no specific benchmark is used unless otherwise noted in the presentation. Individual and actual returns may vary and additional fees or charges will negatively impact an investor’s absolute returns. Clients should realize that net returns would be lower and must be considered when determining absolute returns.

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. Returns reported for the periods prior to January 1, 2001 were initially calculated using McKinley Capital’s quarterly reporting methodology. Monthly returns for the period were retroactively calculated and are considered supplemental information. Returns from January 1, 2001 to current date utilize a monthly reporting methodology. 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.

For GIPS® compliant presentations, all information is supplemental to the GIPS® compliant composites and a copy of the applicable GIPS® composite(s) is included with the presentation. Composite returns and individual client returns may materially differ from the stated benchmark(s). Deviations may include, but are not limited to, factors such as the purchase of higher risk securities, over/under weighting specific sectors and countries, limitations in market capitalization, company revenue sources, McKinley Capital’s investment process and/or client restrictions. 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. Foreign accounting principles may also differ from standard U.S. GAAP standards.

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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.

Data may have originated from various sources including, but not limited to, Bloomberg, ClariFi, MSCI/Barra, Russell Indices, FTSE, TQA, APT, Zephyr and/or other systems and programs. With regards to any material, if any, 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, if any, 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 third party. All information is believed to be correct but accuracy cannot be guaranteed. Clients should rely on their custodial statements for the official investment activity records. Clients should contact their custodian with any questions regarding monthly/quarterly receipt of those statements.

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