McKinley Capital Non-U.S. Developed 130/30 Strategy

April 25, 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

In January of 2007, McKinley Capital Management, LLC (“McKinley Capital”) launched its Non-U.S. Developed 130/30 strategy; incorporating an investment process comparable to its long-only Non-U.S. Developed strategy. A leading investment consultant published a blog in March of 2016 analyzing 130/30 strategies at the aggregate level. In this paper, we use the analysis methods proposed to demonstrate the superior 130/30 returns achieved by McKinley Capital.

Introducing 130/30 Investing and the McKinley Capital Non-U.S. Developed 130/30 Strategy

McKinley Capital launched a Non-U.S. Developed 130/30 strategy in January of 2007. A key feature of 130/30 strategies — including the McKinley Capital strategy — is a limited amount of short selling. Net exposure usually remains close to 100%. This is accomplished by purchasing additional securities (from the proceeds of the short sales) to offset the negative market exposure of the short positions. As the name of the strategy suggests, gross exposure as a percent of account equity is usually close to 160%; comprised of 130% long and 30% short. Some firms that manage a 130/30 strategy also manage a comparable long-only strategy. Since May 2004, McKinley Capital has managed a long-only Non-U.S. Developed strategy. McKinley Capital’s belief is that 130/30 strategies are most effectively implemented using systematic strategies — due to the risk control benefits of mathematically coordinating long and short positions. The firm uses its quantitative expertise with a fundamental overlay to manage its 130/30 portfolio.

While popular before the Global Financial Crisis (“GFC”), it appears that the 130/30 investing style lost favor during and after the GFC. It might be that 130/30 investing was thought by some to be a hedge strategy — like long/short equity hedge fund investing — because of the short positions. When 130/30 failed to protect the market downside, those investors might have been disappointed. However, the idea that 130/30 investing is a market hedge strategy is a misconception. 130/30 is a beta one strategy. Shorts are balanced with additional longs. The purpose of the strategy is not to protect against market declines, but to provide exceptional active managers with the tools needed to earn additional excess returns. McKinley Capital remains a strong advocate of 130/30 investing and continues in its commitment to provide the 130/30 alternative within the non-U.S. developed space. The firm asserts that investors, who believe an active manager can deliver excess returns, should consider 130/30 alternatives when offered by those firms. McKinley Capital does acknowledge that the GFC years were difficult ones for many active managers. The firm has implemented a variety of enhancements in its 130/30 and long-only strategies to limit the downside in the future when, as will inevitably occur, its factors temporarily go out of favor.

A 130/30 Industry Consultant Study

In March 2016, a leading investment consultant published a report on 130/30 investing; analyzing the historic performance characteristics of U.S. based strategies over three and five years ending on September 30, 2015.1 In its report, they expressed its opinion that investor interest in 130/30 investing is beginning to re-emerge and found that firms managing 130/30 strategies were typically able to provide extra excess returns versus their comparable long-only versions.

Due to the extra opportunity to achieve alpha (160% vs. 100% gross stock exposure), tracking error tends to be higher for a 130/30 strategy than for the comparable long-only strategy. When comparing information ratios calculated over five years, the consultant found that 130/30 strategy information ratios were, in the median, only about 1.02 times the size of the median long-only strategy. They went on to point out that, on a pure excess return basis, comparisons should consider the extra 130/30 alpha exposure (160% vs. 100%). They suggested multiplying the long-only excess return by 1.6 prior to comparison with the 130/30 strategy. On that basis, the consultant concluded that, over five years, 130/30 strategies, in the median, added only about 30 basis points of additional excess return. Higher costs and fees for 130/30 implementation might reduce the spread even more. While individual advisor results were not reported, the consultant indicated there was a wide performance spread between managers. They concluded that 130/30 is worth considering, but that manager selection is important.

Analyzing the McKinley Capital Non-U.S. Developed 130/30 Strategy

How does the performance of the McKinley Capital Non-U.S. Developed 130/30 portfolio compare with its long-only version, and with the MSCI EAFE Index? The appendix shows the returns from inception through March 2016 for both McKinley Capital Non-U.S. Developed strategies. To compare against the consultant calculated industry-wide results, the rest of this section will analyze performance for the five year time period from October 2010 to September 2015 (to match the consultant study); and with a April 2011 to March 2016 update. Summary results are shown in Table 1. Figure 1 (see page 3) compares the growth of $1 invested in the strategies.

Both actively managed McKinley Capital portfolios did well over the five year time period. The annualized gross returns were 10.06% for 130/30, 6.19% for long-only, and 4.45% for the MSCI EAFE Index. These annualized gross returns equate to annualized gross excess returns of 5.61% for 130/30 and 1.74% for long-only; both vs. their EAFE benchmark. Standard deviations of return were 15.35%, 14.85%, and 15.21% respectively. The 130/30 strategy volatility was not materially higher than either the benchmark index or the long-only strategy; resulting in a 130/30 strategy Sharpe ratio of 0.65 compared to the long-only portfolio at 0.41, and the EAFE benchmark at 0.17. As expected, tracking error was somewhat higher for 130/30 than for long only; 5.20% versus 4.34%. Even with a slightly higher tracking error, the 130/30 strategy demonstrated an exceptional 1.08 information ratio, compared to 0.40 for long-only. The firm earned excess returns on both the long and short positions.

The consultant recommends calculating a ratio of information ratios. For the two McKinley Capital products, the ratio is remarkable at 2.70 (1.08/0.40). This compares to the consultant computed industry median of 1.02. Significantly, this result is observed even in a strong performance period for the long-only strategy. What happens if we gross up the long-only excess returns by 1.6 times, prior to comparison.

Analyzing the McKinley Capital Non-U.S. Developed 130/30 Strategy

How does the performance of the McKinley Capital Non-U.S. Developed 130/30 portfolio compare with its long-only version, and with the MSCI EAFE Index? The appendix shows the returns from inception through March 2016 for both McKinley Capital Non-U.S. Developed strategies. To compare against the Aon industry-wide results, the rest of this section will analyze performance for the five year time period from October 2010 to September 2015 (to match the Aon study); and with a April 2011 to March 2016 update. Summary results are shown in Table 1. Figure 1 (see page 3) compares the growth of $1 invested in the strategies.

Table 1 – McKinley Capital Composite Performance Data

Oct 2010 – Sept 2015
(Aon Study Time Frame)
Annualized Return Excess Return Standard Deviation Information Ration Sharpe Ratio Tracking Error
Non-U.S. Developed (130/30) Growth Composite (Gross) 10.06% 5.61% 15.35% 1.08 0.65 5.20%
Non-U.S. Developed Growth Composite (Gross) 6.19% 1.74% 14.85% 0.40 0.41 4.34%
MSCI EAFE Index 4.45% 15.21% 0.17
Apr 2011 – Mar 2016
Non-U.S. Developed (130/30) Growth Composite (Gross) 7.29% 4.53% 15.57% 0.83 0.47 5.43%
Non-U.S. Developed Growth Composite (Gross) 3.73% 0.97% 15.04% 0.22 0.24 4.51%
MSCI EAFE Index 2.76% 15.52% 0.17

Both actively managed McKinley Capital portfolios did well over the five year time period. The annualized gross returns were 10.06% for 130/30, 6.19% for long-only, and 4.45% for the MSCI EAFE Index. These annualized gross returns equate to annualized gross excess returns of 5.61% for 130/30 and 1.74% for long-only; both vs. their EAFE benchmark. Standard deviations of return were 15.35%, 14.85%, and 15.21% respectively. The 130/30 strategy volatility was not materially higher than either the benchmark index or the long-only strategy; resulting in a 130/30 strategy Sharpe ratio of 0.65 compared to the long-only portfolio at 0.41, and the EAFE benchmark at 0.17. As expected, tracking error was somewhat higher for 130/30 than for long only; 5.20% versus 4.34%. Even with a slightly higher tracking error, the 130/30 strategy demonstrated an exceptional 1.08 information ratio, compared to 0.40 for long-only. The firm earned excess returns on both the long and short positions.

The consultant recommends calculating a ratio of information ratios. For the two McKinley Capital products, the ratio is remarkable at 2.70 (1.08/0.40). This compares to the consultant computed industry median of 1.02. Significantly, this result is observed even in a strong performance period for the long-only strategy. What happens if we gross up the long-only excess returns by 1.6 times, prior to comparison. For the long-only strategy, the “adjusted” gross annualized excess return increases from 1.74% to 2.78%. With gross excess returns at 5.61%, the 130/30 strategy outperforms the grossed up long-only returns by 2.83% on a gross annualized basis. This difference significantly exceeds the 30 basis point difference reported by the consultant as the industry median. While the consultant did not report the performance spread of managers, we believe our performance would place our firm high up any list.2

The data presented herein demonstrates the success McKinley Capital has achieved with its Non-U.S. Developed 130/30 strategy. Firm clients who are able to short stocks, or invest in vehicles that do, might consider this strategy as a way to leverage the alpha generation capability of McKinley Capital.

Figure 1: Growth of $1 Invested for 5 Years

Figure 1: Growth of $1 Invested for 5 Years

Aon Hewitt Investment Consulting, Inc., an Aon Company, “130/30 Investing,” In Aon Hewitt Retirement and Investment Blog, March 10, 2016. Accessed April 7, 2016 from web address: https://retirementandinvestmentblog.aon.com/BlogHome/Blog/March-2016/130-30-Renaissance.aspx

2 It is true that the consultant study only considered U.S. mandates, and that the firm’s product universe is non-U.S. developed. According to the study, it might be the case that top performing global equity managers outperformed U.S. only managers.

Disclosure

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