The Impact of Factor Exposures on the McKinley Capital Equity Income Portfolios

June 6, 2014

In managing its equity income portfolios, McKinley Capital Management, LLC (“McKinley Capital”) seeks U.S. traded stocks of companies that pay above average dividends and that the firm believes are likely to increase dividend amounts in the future. This portfolio strategy, if successful, is expected to generate considerable levels of current income along with some capital appreciation. Over the past thirteen years1 (3/31/2001 to 3/31/2014), the annualized gross return of the U.S. Equity Income Wrap composite was 11.26% (10.54% net). Of that amount, the annualized dividend amount was 7.71%, with the balance due to capital appreciation. For comparison, over the same time frame, the S&P 500 index had an annualized return of 5.81%.

The McKinley Capital equity income portfolios are moderately defensive in nature. For the same thirteen years, the U.S. Equity Income Wrap composite return standard deviation was 12.28% compared to 15.25% for the S&P 500. The up capture versus the down capture comparison was 79.42% compared to 54.29% using S&P 500 returns as the calculation base over the same time period.

The performance of these portfolios can be explained through the use of factor exposures. Table 1 below shows important Barra factor exposures and contribution to active return for each of the six years from 2008 to 20132.

As intended, the most significant Barra defined exposure is yield, with a 2.29 annual average. Exposure to yield assists in explaining the defensive character of the portfolios. In four of the five positive market years from 2009 to 2013 the contribution to active return of the yield exposure was negative. In the down year of 2008, yield exposure provided a large positive contribution to active return. The exception was the strong up-market year of 2010, in which the search for income in this era of low interest rates led to increased purchases of high yielding equities.

The other intended Barra defined exposure is momentum, with a 0.26 annual average. As is the case for all McKinley Capital managed portfolios, the preference is for stocks that have already been outperforming prior to purchase. The contribution to active return for the momentum exposure has varied, but was significantly negative in 2009 when momentum, as a factor, was greatly out of favor.

In seeking U.S. traded equities with exceptional and growing dividends, McKinley Capital often identifies for purchase certain kinds of stocks in selected industries. The holdings often concentrate in Master Limited Partnerships (“MLPs”), Business Development Companies (“BDCs”), Real Estate Investment Trusts (“REITs”), and high yield U.S. common stocks and ADRs. This focus often leads to a concentrated exposure to energy and oil, real estate, brokerage, utility, tobacco, and telecommunications industries. In general, these kinds of stocks are smaller, less liquid, and more leveraged than the largest S&P 500 securities. While not strictly intended, McKinley Capital understands these industry and factor exposures are a by-product of selecting securities with the highest yield, and observes that these kinds of exposures often lead to positive active returns.

For example, the equity income portfolios are exposed to smaller stocks, with a Barra size factor exposure averaging -1.25 over the last six years. This small size exposure has added an average of 3.18% per year to the active return of the composite. The exposure to leverage averaged 0.72 annually and added an average of 0.30% per year to the active return.

The exposure to liquidity averaged -0.60 annually, but was not an important contributor to active return. Contribution to active return due to concentrated industry exposure varied year to year, but averaged a positive 0.83%. Finally, asset selection contributed an average of 0.55% per year to active return.

Interestingly, the portfolios were not significantly exposed to the Barra growth or value factors and these limited exposures did not yield a significant contribution to or detraction from active return. McKinley Capital is a growth manager whose process focuses on growth acceleration measures – upward analyst earnings and dividend expectations, earnings and dividend surprises, etc. The firm understands Barra growth definitions are, however, based primarily on absolute levels of growth and not on the consideration of acceleration.

McKinley Capital’s Equity Income portfolios seek to provide a total return in excess of the S&P 500 over full market cycles with lower volatility and a considerable level of current income. These goals have been realized. In summary, the firm shows how the portfolio returns can be explained by analyzing Barra factor exposures like yield, momentum, size, liquidity, leverage, industry, and asset selection. As always, your McKinley Capital account representative is available to discuss the firm’s research and investment process, and answer your questions.

TABLE 1: BARRA FACTOR EXPOSURE ANALYSIS

1406 The Impact Tab1-01

1 2001 is when McKinley Capital began to compute monthly returns data.

2 These are the years for which McKinley Capital has accurate Barra factor exposure and factor return data for the equity income portfolios. All active exposures data is versus the Russell 1000 Index.

 

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 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.

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.