Improving the Investment Process for Long-Only and 130/30 Non-U.S. Developed Mandates

April 16, 2014

The McKinley Capital Management, LLC (“McKinley Capital”) investment process is designed to create portfolios of securities with earnings acceleration (McKinley Capital’s definition of “growth”), momentum, and liquidity, at a controlled level of risk. The growth and momentum footprint of all McKinley Capital mandates has been maintained throughout the firm’s history. McKinley Capital’s philosophy is to continually challenge, test, and validate its investment process and the firm is constantly reviewing, testing and evaluating possible enhancements. The intent is to improve the definition and calculation of McKinley Capital’s basic factor exposures. An ongoing goal of process enhancements for any McKinley Capital mandate is to improve the up/down capture of the investment process’ factors without significantly altering the portfolio level growth and momentum exposure footprint. Specifically, McKinley Capital seeks improvements to its factor definitions and calculations which will have the effect of mitigating the downside during times when momentum and growth are out-of-favor (such as from March through May of 2009), without sacrificing the upside when the factors are in favor (such as during 4th quarter of 2013).

In the non-U.S. Developed MSCI EAFE space, McKinley Capital manages both long-only and long-short 130/30 portfolios. For that reason, it is important for the Non-U.S. Developed stock ranking model to be monotonic in its performance. In other words, top ranked stocks should, on-balance, outperform the relevant benchmark, while low ranked stocks should, on-balance, underperform the relevant benchmark. McKinley Capital has implemented several enhancements in the last couple of years to its Non-U.S. Developed and Non-U.S. Developed 130/30 mandates as well as its Global, Non-U.S., and U.S. mandates.

The first area of focus relates to the efficacy and volatility characteristics of the earnings acceleration factor. McKinley Capital reduced the volatility of the earnings acceleration rank, or E’ signal, by adding a Return on Invested Capital component to its quantitative investment process. This component is similar in scope and consistency to the previous Return on Asset component but with the improved ability to identify superior financial stocks. The firm also enhanced its earnings surprise indicator by creating a variable called True Market Surprise. True Market Surprise focuses on the price impact and earnings revision impact of an earnings announcement, not just on the actual operating earnings number. This broad focus allows the earnings surprise indicator to reflect important announcements like guidance, management changes, and revenue surprise, which could be lost with a singular focus on the earnings number. McKinley Capital believes that the additions of True Market Surprise and Return on Invested Capital to the E’ quantitative indicator have resulted in better returns, less volatility and lower turnover.

The second group of quantitative process enhancements relates to the risk adjusted momentum factor of the firm’s investment process. McKinley Capital altered the definition of its primary indicator, price momentum, from a concept of absolute six to twelve month stock returns to a beta adjusted (or alpha) return concept. Using measured historic alpha as the definition of price momentum mitigates the tendency of a momentum portfolio to migrate to mostly high beta stocks following a sustained bull market, or to low beta stocks following a sustained bear market. If left unadjusted, such migration implies a continued position in overall market direction – a volatile strategy that risks detracting from McKinley Capital’s bottom-up process. With the adjustment, McKinley Capital continues to discount the impact of very short-term price changes. This model feature was retained after research indicated that momentum is likely a negative indicator in the very short-term. The primary momentum signal also continues to be tempered by return volatility. All other things being equal, low volatility stocks are preferred to high volatility ones.

Within the momentum side of the quantitative process, McKinley Capital has added a secondary indicator which dynamically weights multiple momentum measures with look back periods ranging from a few days to one year. Typically, the six-month to one-year measures receive positive weight while the short term signals receive negative weight. However, these weights can shift in times of rapid leadership and market rotation.

Finally, McKinley Capital has sought ways to increase the contribution to return of the low ranked stocks for use in the short side of the 130/30 mandate. While research continues, some enhancements include dynamic factor weighting and additional indicators to re-rank the least attractive stocks.

In total, based on simulated data, these enhancements to the model definitions are expected to result in higher information coefficients with more significant T-statistics. Chart 1 compares the enhanced model with the old model.

CHART 1: Improvement in Simulated Prediction Quality MQOld to MQEnhanced, 2005-20131

1405 Non-US -01 Chart1

A review of the MQ quintile breakdown of simulated returns sheds light on whether McKinley Capital can achieve its goal of a monotonic stock ranking system – one that is useful in managing a long-short 130/30 strategy. Chart 2 shows the average monthly simulated return, by MQ quintile, of the old and enhanced models. While both models show monotonic simulated outcomes, the enhanced model was superior. What is especially encouraging for the 130/30 mandate is that the opportunity for returns earned by short selling securities in the lowest quintile appears equal to or better than the opportunity for returns available from buying securities from the top quintile. Even with the extra costs associated with short-selling, the enhanced model appears to offer attractive short-side opportunities.

CHART 2: Average Monthly Simulated Excess Return by MQ Quintile vs. MSCI EAFE Total Return Index, 2005-2013

1405 Non-US -02 Chart2

While increasing returns by enhancing its investment model was McKinley Capital’s primary goal, the firm wanted to do so without increasing the risk associated with those superior returns. Chart 3 shows the simulated annualized tracking error of each MQ quintile versus the MSCI EAFE Total Return Index for both the old and enhanced models from 2005 to 2013. The simulation provides evidence that the enhanced model can provide better risk characteristics, as measured by tracking error, in both the top quintile and bottom quintile of stocks ranked by MQ. These quintiles are of interest for both long-only and long-short 130/30 portfolios.

CHART 3: Simulated Annualized Tracking Error by MQ Quintile vs. MSCI EAFE Total Return Index, 2005-2013

1405 Non-US -03 Chart3

Chart 4 portrays the simulated growth of a dollar by quintile. Over time, the top quintile of stocks, when ranked by the enhanced MQ score, outperformed the EAFE Total Return Benchmark. Just as important, the bottom quintile of enhanced MQ ranked stocks underperformed the same benchmark over the same period. This simulated data demonstrates why McKinley Capital believes that a long-only Non-U.S. Developed portfolio can provide excess returns over time and why McKinley Capital believes that a 130/30 long–short portfolio can perform even better.

CHART 4: MQEnhanced, Simulated Total Return Growth of a Dollar by Quintile, 2005 – 2013

1405 Non-US -04 Chart4

The global financial crisis was a difficult period for managers that used investment models based on growth and momentum factors. McKinley Capital weathered the storm and, since that time, has worked to improve the up/down capture of its investment model and process. The firm has seen significant performance improvement since 2009. An investor might ask whether McKinley Capital’s model enhancements were selected to solve yesterday’s problems and thus miss potential upside when it occurs. McKinley Capital is pleased to report that this risk did not materialize in the strong growth and momentum market of 2013. During that market, the firm’s portfolios experienced excellent absolute and relative returns with a controlled level of volatility. The current ex-ante tracking error estimate is roughly 3% for the long-only and 4% for the long-short 130/30 portfolios. Returns for the firm’s actual portfolios from 2007 (inception of the long-short 130/30 portfolio) through February 2014 are shown in Table 1. This data shows the performance improvement in both portfolios since 2009 and especially in the past year.

TABLE 1: ACTUAL RETURNS SINCE 2007
Performance for the period ended February 28, 2014

1405 Non-US -05 Tab1

McKinley Capital knows that it is never possible, in real time, to match the returns of a back test (especially with a zero transaction cost assumption).  However, the firm is encouraged by the results shown above. Simulated data provides evidence that the enhanced model offers a monotonic stock ranking system which generates positive excess returns with a controlled level of relative risk. Since its inception, the enhanced model has worked well. Finally, both the simulated and actual returns provide evidence that a long-short 130/30 portfolio can work better than a long-only portfolio in the NonU.S. Developed space. As always, your McKinley Capital account representative is available to discuss the firm’s research and investment process and to answer your questions.

ACTUAL RETURNS 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 feewould 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.

To receive a copy of the firm’s ADV, a complete list and description of McKinley Capital’s composites and/or a presentation that adheres to the GIPS® standards, please contact McKinley Capital at 1.907.563.4488 or visit the firm’s website, www.mckinleycapital.com.

 

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