McKinley Capital U.S. Large Cap ESG Strategy

October 7, 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 today’s world of governance and other social and environmental concerns (“ESG”), many investors increasingly seek socially responsible portfolios. In the past, to address ESG concerns, investors or their managers developed lists of stocks to be excluded from purchase. In some cases, excluding groups of stocks for possible purchase resulted in less than optimal portfolios and the possibility of lower returns. Recently, select and innovative equity managers have researched and integrated ESG indicators into their alpha models, with the intent of enhancing return. As one of these managers, McKinley Capital Management, LLC (“McKinley Capital”) has successfully tested a portfolio that incorporates a governance-based, ESG alpha generation factor.

In the current environment of low global interest rates, many investors are increasingly seeking to capture both ESG and higher dividend yield from their equity investments. Long the province of equity-income oriented value managers, select growth managers have created specialized strategies that feature earnings acceleration and a higher than average level of yield. For many years, McKinley Capital has successfully managed an ultra-high yield1 growth equity portfolio featuring U.S. traded investments in select pass-through and other high yield growth securities with accelerating dividends. Recently, the firm has observed demand for a similar strategy, but one that features more traditional U.S. large capitalization (“cap”) growth stocks with attractive dividend yields.

McKinley Capital’s analysis positively reports that a portfolio comprised of ESG and U.S. large cap yield stocks is attainable. The simulated U.S. large cap portfolio features McKinley Capital’s newest, governance-based, ESG alpha generation factor, and above-average dividend yields without sacrificing the prospects for future earnings acceleration, dividend growth, and higher returns.

McKinley Capital U.S. Large Cap ESG and Dividend Strategy

At the request of an institutional investor, McKinley Capital recently researched and modeled a U.S. large cap portfolio that features both McKinley Capital’s newest, governance-based, ESG alpha generation factor, and above-average dividend yield stocks2. These results were then superimposed over the traditional McKinley Capital factors of momentum, earnings acceleration, and return on equity, with controlled volatility, to create the simulated investment portfolio.

For the time period April 2013 to June 2016, the firm simulated monthly rebalanced portfolios as described in the previous paragraph3. The portfolio was constrained to generate a dividend yield equal to or greater than the weighted average dividend yield of the stocks in the Russell 1000 Index. In addition, McKinley Capital purchased any stock in the universe that met its ESG governance criterion, and sold any stock in the portfolio that failed. The governance criterion is based on three decile or more changes in ISS Corporate Governance rank scores.

The simulated results are reported in Table One, with the simulated growth of one hundred dollars charted in Figure One. The simulated annualized return for the portfolio was 14.10%, with an annualized return standard deviation of 10.03%, and a Sharpe Ratio of 1.40. By way of comparison the same data for the Russell 1000 Index was as follows: 11.44% annualized return, 10.99% standard deviation of return, and a Sharpe Ratio of 1.04. The portfolio had an Information Ratio of 0.60 and a 4.42% tracking error. The final portfolio showed a simulated dividend yield of 2.17%. Figure Two shows the Axioma style factor exposures. As might be expected for this McKinley Capital managed product, the simulated portfolio was significantly and positively exposed to return on equity, dividend yield, and medium-term momentum. It was opportunistically exposed to small size and liquidity. Other exposures were less significant.

Figure 1: 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. 10/06/2016.

Table 1 – Simulated Portfolio Risk and Return

April 2013 – June 2016 Annualized Return Standard Deviation Sharpe Ratio Tracking Error Information Ratio
Simulated U.S. Large Cap Dividend Strategy Portfolio
(Gross)
14.10% 10.03% 1.40 4.42% 0.60
Russell 1000 Index 11.44% 10.99% 1.04

Simulated returns calculated by McKinley Capital Management, LLC. Portfolio risk and return statistics calculated using Zephyr StyleADVISOR. 10/03/2016.

Figure 2: Axioma Style Factor Average Exposures

Figure 2: Axioma Style Factor Average Exposures

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

In summary, it appears that the established McKinley Capital investment process works well in the higher yield U.S. large cap environment. The firm has significant long-term successful experience managing U.S. large cap growth portfolios. This experience and process can be actively applied for those clients interested in ESG investing along with exposure to a higher level of yield than is typical for a U.S. large cap growth portfolio.

¹Over the last ten years, the yield of this strategy has averaged over 7% per year.
2 Equal to or exceeding the market capitalization weighted average dividend yield of the stocks in the Russell 1000 broad-based benchmark – 2.17% as of June 30, 2016.
3 The simulation time period was selected to correspond to the time period for which the necessary ISS ESG data was available for U.S. stocks. For the simulation, the selection universe was the stocks in the Russell 1000 Index. The benchmark used was the Russell 1000 Index. The simulation assumed AUM at $100 million. The risk model used for the simulations was the Axioma U.S. Fundamental Equity Risk Model with an objective function of: Maximize (2 x expected return – total risk), and using the regular McKinley Capital Quantitative factor as applied in the U.S. large cap space. The security weight limit was the benchmark weight ± 2% with a 1.5 day dollar volume limit. The threshold holding was 0.35%. Turnover maximum was 20% per month, with a threshold trade of 25 basis points. The simulation assumed transaction costs were based on ITG cost curves with a 1% default. Please see below for important disclosures.

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.

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.

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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.

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