Asset Allocation Strategies

March 16, 2015

McKinley Capital Management, LLC (“McKinley Capital”) has observed a growing interest in funds that allocate on a dynamic basis between major asset classes including equities, fixed income, real assets, commodities, and cash. The firm believes the combined use of momentum and volatility models is the best method to implement asset allocation decisions.

McKinley Capital is a pioneer in the application of innovative and sophisticated momentum strategies. The firm’s 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 substantial 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.

Can McKinley Capital use its proprietary process to successfully manage a broad-based asset allocation fund? To answer this question, the firm started with a benchmark: a 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 Table 1 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.

1504 Asset -01 Tab1

McKinley Capital constructed and tested three alternative active strategies. The first strategy, labeled “Alpha 12”, assigned asset class policy weights of 30% to U.S. Equity, 30% to International Equity, 35% to U.S. Fixed Income and 5% to Real Assets. Twenty-two 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 1 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 Table 1 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. Chart 1 below shows the class weights over time.

1504 Asset -02 Chart2

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”, 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. Based on these results, McKinley Capital is now managing a portfolio utilizing the Optimized Alpha 12 strategy.

The firm conducted a second study using an expanded list of 87 asset classes where futures are used to gain exposure. Using a similar composite benchmark for comparison, the simulation revealed improved performance from the broader list (Table 2). Annualized gross return over the trailing 12 year period was 12.97% compared to the 7.75% return of the benchmark. Volatility was reduced with a demonstrated standard deviation of returns of 7.31% vs. 9.20% for the composite benchmark.

1504 Asset -03 Tab2

The dynamic nature of the asset allocation decisions can be seen in Chart 2 where the use of cash was particularly apparent in the downturn of 2008 and early 2009

1504 Asset -04 Chart2Chart 3 indicates the average exposure over the entire time period and Table 3 indicates the intended exposures as of December 31, 2014.

1504 Asset -05 Chart3In conclusion, what are some of the practical differences between a portfolio of ETF holdings and a portfolio of future contracts?

1. Futures involve the use of leverage, which some investors choose to avoid. 2. The ETFs used in this construction are liquid and deep. 3. The futures portfolio has many more asset classes to choose from, with the corresponding potential benefit of enhanced return and reduced volatility.

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 the firm’s research and investment process and answer your questions.


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.

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. 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 do 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 is not reflective of composite or individual portfolio ownership. McKinley Capital may or may not have held or 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.

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.

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. 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. Clients should contact the McKinley Capital institutional marketing manager for additional details on such returns.

Decisions and information provided were based on available research at the time and data contains hypothetical results. Back tested and model results do not represent actual trading and may not reflect the impact material economic and market factors might have had on McKinley Capital’s decision-making if it were managing an actual account. Material economic and market factors may have changed and certain investment restrictions may have affected performance. Back tested and model results are not GIPS compliant. Trading strategies that have been retroactively applied may not have been available during the periods presented.

Charts, graphs and other visual presentations and text information were 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, ClariFI, MSCI/Barra, Russell Indices, FTSE and/or other systems and programs. With regards to any material, if any, accredited to FTSE International Limited (“FTSE”) ©FTSE [2015]: 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. 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. 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.

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. To receive a copy of the firm’s ADV or a description of all McKinley Capital’s composites, please contact McKinley Capital at 3301 C Street, Suite 500, Anchorage AK 99503 or 1.907.563.4488. 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.