McKinley Capital Global Small Cap Portfolio Research

October 21, 2016

Robert A. Gillam, CFA Chief Investment Officer McKinley Capital Management, LLC
Gregory S. Samorajski, CFA Director of Investments McKinley Capital Management, LLC

Executive Summary

U.S. and non-U.S. (international) equity strategies have been a regular feature of the institutional investment landscape for many years. U.S. equity portfolios have been frequently categorized into value/growth and large/small capitalization (“cap”) buckets. In the late 1990s, some non-U.S. portfolios and their managers began to be seen as value or growth oriented. Shortly thereafter, a greater number of international managers developed differentiated large cap and small cap expertise. Separately, “global” (U.S. and non-U.S. combined) has gained institutional acceptance as an investment style. Managers created global portfolios by combining their existing U.S. and non-U.S. portfolios (bolted strategies), or by forming stand-alone products. McKinley Capital Management, LLC (“McKinley Capital”) manages U.S. and non-U.S. large cap and small cap growth oriented portfolios. The firm currently addresses global investing using a stand-alone, all-cap approach. McKinley Capital researched the feasibility of successfully managing a small-cap global portfolio using its existing growth and momentum focused investment methodology. This paper presents the promising results of that research.

McKinley Capital Global Small Cap Research

At the request of an institutional customer, McKinley Capital recently researched the feasibility of successfully managing a global small cap portfolio that incorporates the traditional McKinley Capital factors of momentum, earnings acceleration, and return on equity, with controlled volatility. In creating a simulated investment portfolio, the firm incorporates mathematical portfolio construction.

For the time period January 2004 to September 2016, the firm simulated monthly rebalanced global small cap portfolios formed in accordance with its discipline. The simulated results are reported in Table One (below), with the simulated growth of one hundred dollars charted in Figure One (below). The simulated annualized return for the portfolio was 12.24%, with an annualized return standard deviation of 16.60%, and a Sharpe Ratio of 0.66. By way of comparison, the same data for the MSCI ACW Small Cap Growth Index was as follows: 9.12% annualized return, 18.21% standard deviation of return, and a Sharpe Ratio of 0.43. The portfolio had an information ratio of 0.59 and a 5.31% tracking error. Figure Two (below) shows the Axioma style factor exposures. As might be expected for this simulated McKinley Capital product, the simulated portfolio was, by design, positively exposed to the Momentum and Growth style factors. It was opportunistically and negatively exposed to Volatility and Liquidity, and positively exposed to Value. Other exposures were less significant.

Figure One: Simulated Growth of $100

Figure 1: Simulated Growth of $100

Simulated Returns calculated by McKinley Capital Management, LLC. Growth of $100 chart created using Zephyr StyleADVISOR. 10/19/2016.

Figure Two: Axioma Style Factor Average Exposures

figure-two-axioma-style-factor-average-exposures

Simulated holdings modeled by McKinley Capital Management, LLC. Style exposures calculated by Axioma. 10/03/2016.

Table 1: Simulated Portfolio Risk and Return

January 2004 – September 2016 Annualized Return Standard Deviation Sharpe Ratio Tracking Error Information Ratio
McKinley Capital Global Small
Cap Simulation (Gross)
12.24% 16.60% 0.66 5.31% 0.59
MSCI ACWI Small Cap Growth 9.12% 18.21% 0.43

Simulated returns calculated by McKinley Capital Management, LLC. Portfolio risk and return statistics calculated using Zephyr StyleADVISOR. 10/19/2016.

Figure Three: Simulated Bolted Growth of $100

figure-three-simulated-bolted-growth-of-100

Simulated bolted returns calculated by McKinley Capital Management, LLC. Growth of $100 chart created using Zephyr StyleADVISOR. 10/19/2016.

Table Two: Simulated Bolted Portfolio Risk and Return

October 2013 – September 2016 Annualized Return Standard Deviation Sharpe Ratio Tracking Error Information Ratio
McKinley Capital Bolted Global
Small Cap Simulation (Gross)
6.73% 12.41% 0.53 3.36% 0.18
McKinley Capital Global Small
Cap Simulation (Gross)
7.86% 12.40% 0.63 4.56% 0.38
MSCI ACWI Small Cap Growth 6.11% 12.29% 0.49

Simulated bolted returns calculated by McKinley Capital Management, LLC. Portfolio risk and return statistics calculated using Zephyr StyleADVISOR. 10/19/2016.

McKinley Capital began managing its non-U.S. small cap portfolio in October 2013 and its U.S. Small Cap Growth portfolio in January 1997. It is possible to observe the simulated stand-alone results from October 2013 to September 2016 together with simulated bolted results of live portfolios. To create a simulated bolted return series, the firm calculated the monthly weighted average of its U.S. and non-U.S. small cap portfolio returns. The weights, recalculated monthly, are the weights of the U.S. and non-U.S. components of the MSCI ACW Small Cap Growth Index.

The simulated results are reported in Table Two and Figure Three. As reported in Table Two, the simulated annualized return for the simulated bolted portfolio was 6.73%, with an annualized return standard deviation of 12.41%, and a Sharpe Ratio of 0.53. When compared to the MSCI ACW Small Cap Growth Index, the simulated bolted portfolio had a 0.18 information ratio and a 3.36% tracking error. For information only, the same data for the simulated stand-alone portfolio was as follows: 7.86% annualized return, 12.40% standard deviation of return, a Sharpe Ratio of 0.63, an information ratio of 0.38, and a tracking error of 4.56%. The data for the MSCI ACW Small Cap Growth Index was: 6.11% annualized return, 12.29% standard deviation of return, and a Sharpe Ratio of 0.49. Because of the different construction methodologies, the simulated stand-alone and bolted results are not directly comparable. The point of this side by side presentation is simply to show that either strategy has the potential to be used as a basis for the construction of a global small cap growth portfolio.

Summary

In summary, it appears that the established McKinley Capital investment process has the potential to work well in the global small cap environment. Success may be possible either using a stand-alone or bolted approach. The firm has significant experience managing U.S. and non-U.S. small cap equity portfolios. Prospectively, this firm’s experience and its process can be actively applied for those clients interested in a global small cap investing style.

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”), the Prudential Regulation Authority (“PRA”), the Securities & Futures Commission of Hong Kong or the China Securities Regulatory Commission. Additionally, none of the authorities or commissions listed in the previous sentence has commented on the firm, the content of any marketing material or any individual suitability assessments.

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.

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¹The time frame was selected to correspond to the ready availability of MSCI ACW Small Cap Growth Index information. For the simulation, the selection universe was the stocks in MSCI ACW Small Cap Index. The benchmark used was the MSCI ACW Small Cap Growth Index. Assumed initial AUM was $100 million. The risk model used for the simulations was the Axioma WW21AxiomaMH risk model with an objective function of: Maximize (2 x expected return – total risk) with a 5% a priori tracking error constraint. Proprietary McKinley Quantitative factors were used to define expected return. The security weight limit was benchmark weight +/- 2% with a 1.5 day dollar volume limit. The maximum holding in emerging market stocks was 10%. The threshold holding was 0.35%. Turnover maximum was 8% per month, with a threshold trade of 25 basis points. Assumed transactions costs were 2% per side.