McKinley Capital U.S. Small Cap Growth Portfolio

January 31, 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

The Global Financial Crisis (“GFC”) years, 2007-2011, were difficult for many active managers and McKinley Capital Management, LLC (“McKinley Capital”) was no exception. Though the negative investment results were understandable, the firm was not satisfied and undertook a major effort to enhance its processes. The firm’s Quantitative Research Team addressed the alpha model, implementation, portfolio construction and risk management. The goal: mitigate the downside without sacrificing the upside. With four years of performance results to analyze, McKinley Capital is pleased to conclude that its enhancements have been successful: positive performance in recent favorable environments with evidence of downside mitigation. The firm estimates that it has approximately $1 billion of additional capacity in its U.S. Small Cap Growth product.

U.S. Small Cap Performance History

McKinley Capital has successfully managed a U.S. Small Cap Growth strategy since the beginning of 1997 – earning an excess return calculated over the entire 19 year history (see Appendix One). For the first ten years (1997-2006), the U.S. Small Cap Growth Composite showed an annualized return of 7.99%. This performance represents an annualized gross excess return versus the Russell 2000 Growth Index of 3.11%. The main problem in the GFC period was that the firm’s primary investment factors – earnings acceleration (the firm’s definition of growth) and price momentum – were out of favor throughout much of this time interval.

  Chart 1 – Average Pairwise Correlation for the Russell 2000

Chart 1 – Average Pairwise Correlation for the Russell 2000

Chart 2 – Share of IWM ETF Volume as Share of Total Volume in Russell 2000‡‡

Chart 2 – Share of IWM ETF Volume as Share of Total Volume in Russell 2000

A second problem was that, for much of this time period, the average correlation between all pairs of U.S. small cap stock returns was exceptionally high – up to nearly 50%. When average correlation is high, there is less opportunity for a stock-picking firm like McKinley Capital to offset negative factor returns with exceptional stock picks. Chart 1 shows the pairwise correlation for the Russell 2000 stocks from 1990 to 2015. Recently, pairwise correlation has returned to the 20% to 30% range. We observe a drop in the percentage of the iShares Russell 2000 (IWM) ETF volume as a share of total volume in Russell 2000 stocks (see Chart 2), corresponding to the pre-GFC pairwise correlation level. These current conditions, while still elevated, form a more favorable environment for a stock picking firm than existed during the GFC.

Alpha Model Enhancements

Factor aware investment managers will perform better at some times than others. When momentum and earnings acceleration factors are out of favor, McKinley Capital will likely under perform, as is to be expected. McKinley Capital, however, was not satisfied with our performance; especially in 2008 and 2009. Following the GFC, the firm engaged in a major research effort, spanning all of its mandates, in an attempt to enhance the investment process without disturbing its important historic exposures of growth and momentum. The goal of the enhancement research was to look for ways to address our factor definitions to more effectively mitigate downside relative performance events while maintaining exceptional relative performance when our factors are in favor. By the beginning of 2012, McKinley Capital had implemented initial enhancements to our investment process across all of our mandates.

Table 1 – McKinley Capital U.S. Small Cap Growth Composite Performance Data‡‡‡

Jan 2012 – Dec 2015 Annualized Return Excess Return Standard Deviation Up Capture Down Capture Information Ration Sharpe Ratio Tracking Error
U.S. Small Cap Growth Composite (Gross) 19.13% 4.78% 14.66% 104.7% 84.3% 1.16 1.30 4.12%
Russell 2000 Growth 14.36% 14.71% 0.97
Jan 2007 – Dec 2011
U.S. Small Cap Growth Composite (Gross) -1.68% -3.77% 25.18% 91.7% 103.0% -0.59 -0.12 6.44%
Russell 2000 Growth 2.09% 24.64% 0.03

 

Some of the featured enhancements to the alpha model included: 1) enhancements to the forecasted earnings acceleration variable, E’, which substantially improved performance in back-tested and real-time settings; 2) legal insider trading was added to momentum as a penalty function and was the second best performing factor after E’; 3) multiple dynamically weighted look back periods for its momentum calculation; 4) penalty functions incorporating changes in news sentiment; 5) changes in the method of risk adjusting the momentum calculation; 6) the incorporation of volatility as a separate factor; and 7) the addition of return on invested capital to the earnings acceleration measure.

Enhancement Results

McKinley Capital is pleased to report that the implemented enhancements performed as expected. The firm analyzed its U.S. Small Cap Growth mandate returns from the beginning of 2012 until the end of 2015 compared to its returns from the beginning of 2007 to the end of 2011. The results are reported in Table 1. The annualized return of the portfolio in the later period was 19.13% compared to -1.68% during the GFC years. More importantly, compared to the Russell 2000 Growth Index, the strategy’s benchmark, the annualized gross excess return improved to 4.78% from -3.77%. Portfolio return volatility declined from 25.18% to 14.66%. While the benchmark’s volatility also declined, the portfolio volatility improved from just over benchmark to just under benchmark. In the GFC years, the up capture and down capture ratios were 91.7% and 103% respectively. These ratios improved significantly to 104.7% and 84.3%, measured from 2012 to 2015.

Table 2 – McKinley Capital U.S. Small Cap Growth Contributors to Active Return by Style vs. the Russell 2000 Index (2012 – 2015)‡‡‡

Factor Average Weighted Exposure Annualized Contribution
Medium-Term Momentum 0.78% 3.64%
Return on Equity 0.60% 1.5%
Growth 0.31% 0.54%

Factor Exposures

The model enhancements did not change McKinley Capital’s basic factor exposures. Table 2 reflects the weighted average exposure to the important McKinley Capital related style factors from 2012 to 2015. The U.S. Small Cap Growth strategy had positive and significant exposure to the medium-term momentum, return-on-equity and growth style factors. Beginning in 2012, these factors were frequently in favor. Exposure to each generated a positive contribution to return, with medium-term momentum being the largest. The “specific” active return versus the Russell 2000 Growth Index was 2.32% annualized, suggesting strong stock specific selection. The environment in these recent years was favorable for the McKinley Capital investment process. Positive performance demonstrates that the model enhancements did not diminish upside potential. There has not been an extended time in the last four years when the McKinley Capital factors have been strongly out of favor in the U.S. small market capitalization universe. There have been times when the McKinley Capital factors have been less effective. For example, in 2012, when ranked by momentum, the returns of the top three deciles of U.S. small cap stocks underperformed the bottom three deciles. This is also true of return on assets – a factor forerunner to return on invested capital. Still, in 2012, the McKinley Capital U.S. Small Cap Growth strategy generated significant positive excess returns. While these results cannot always be expected, this kind of performance provides some support that the enhanced model works to mitigate the downside.

Other Enhancements

Besides enhancing its alpha model, the firm invested in its portfolio construction and risk control systems. For example, the Axioma mathematical model was added to the APT system as a portfolio construction tool. The purpose of using a mathematical model like Axioma or APT is to create portfolios which achieve significant excess return with the lowest possible risk. The documented reduction in portfolio tracking error and volatility indicates the investments returned positive results.

The third area of research was the order entry and trade execution systems. A manager with a focus on price momentum and earnings acceleration often seeks to purchase stocks which are performing, and to sell declining stocks. Every effort must be made to increase implementation efficiency; especially in less liquid markets like U.S. small market capitalization. McKinley Capital has worked to optimize its order timing process – the time between model computation, portfolio manager review and decision, order entry and actual trade execution. Also the firm implemented improved trade timing signals. With these improvements, the firm shaved approximately 40 basis points from its average transaction cost – due to lower market impact – from 2011 to 2015.

McKinley Capital created a scientific advisory board to consult on issues of process enhancement. The board includes scientists such as Dr. Harry Markowitz, Dr. Ian Domowitz and Dr. Jose Menchero.4 It conducts regular research panels and provides consulting to McKinley Capital research staff tasked with maintaining and enhancing the McKinley Capital investment models. The firm fully expects that its relationship with these scientific experts will continue to provide valuable support and input into our ongoing research efforts.

As always, your McKinley Capital account representative would be pleased to discuss these ideas and a possible investment with you.

Data source: FactSet, January 29, 2016.
1 It should be noted that of the five years, 2007 was one of positive relative performance for McKinley Capital (+9.94% gross vs. the Russell 2000 Growth Index). We understand that 2007 might have been a difficult year for some quantitatively oriented managers. This year illustrates that the McKinley Capital approach – combining price momentum and growth factors – at times complements the performance of managers exposed to other quantitative factors.
‡‡ Source: Credit Suisse US Equity Strategy team, Bloomberg.
‡‡‡ Supplemental Information. See page 6 for the U.S. Small Cap Growth Performance Disclosure Presentation.
2 Carr Bettis, Ph.D., John B. Guerard, Ph.D., and Daniel McAuley, CFA, “Is US Insider Trading Still Relevant? A Quantitative Portfolio Approach,” Journal of Investment Management 13 (2015), pages 33-56.
3 See the McKinley Capital Enhancement Summary 2015 publication for a full list of enhancement descriptions.
4 See Appendix Two for a complete list of scientific advisory board members.

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, authorized, or regulated by 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. 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.
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.

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, Axioma, 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 [2016]: 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: 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.

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.