Q: What is the genesis of the fund?

In 2010, following the 2008 credit crisis, the S&P 500 was said to have had a “lost decade,” meaning no one allegedly could make money by investing anymore. In fact, the problem was that advisers and their clients were not building effectively diversified portfolios and were exposing those portfolios to unusual events and all kinds of risk.

We built a model, starting with a plain-vanilla-asset 60/40 portfolio, the starting point of any investment process for almost any client, that demonstrated no such lost decade.

The brokerage team at Voya Financial Advisers (our sister company) was intrigued because they had also been unable to achieve our model’s returns and said, “Why don’t you build it?” Ultimately, we did, in late 2011, and it got approved as a separately managed account (SMA) model. 

We seeded four accounts, each with $10,000: conservative, moderate, and aggressive versions of the model portfolio and an all-income variation. When that succeeded, we did this ’40 Act 60/40 mutual fund version that was launched in March 2013. 

The assets under management in the fund now total more than $850 million. 

Q: How do you define your investment philosophy?

Fundamentals are what essentially drives markets. This guides our global market view and our investment process. We believe that paying attention to fundamentals leads to a proper outlook and positioning in global markets. Empirical research demonstrates that corporate earnings growth in the S&P 500 index is the bottom line in measuring fundamentals. We use the S&P 500 because it derives half its revenue from overseas, so the direction of earnings growth indicates future market direction as well. 

Our mission is to have a core holding that protects investors doubly from downside risk, to provide a core, diversified portfolio, targeted to retail investors, with a tactical approach. 

Rather than tell investors to “stay the course,” we have a plan that follows our belief in the power of fundamentals: when fundamentals are positive, investors should be fully allocated, and when fundamentals are negative, then it’s time to get defensive and sell equities. Investors want to know their portfolio will adapt to sustained market declines. 

Nobel Prize winners Kahneman and Tversky coined the term “prospect theory,” saying that investors hate losses twice as much they like gains. Bearing that in mind, diversification is just the first level of protection we apply. The second level is to adapt or tactically adjust the portfolio to be more defensive during prospective bear markets. 

However, building effectively diversified portfolios is harder than it seems, and is vastly underestimated, if not downright misunderstood. There are times when investors need to sell equities, but it is difficult to make these sell decisions thoughtfully—investors tend to sell at the drop of a hat. 

Staying in the market during normal volatility may be uncomfortable but it is critical. Investors also make the mistake of concentrating too much in a favored equity asset class, such as in large–cap stocks, and worry excessively about interest rates, causing them to avoid bonds when they shouldn’t. We call it the folly of gaming diversification. Our approach solves both problems. 

Q: What is your investment strategy and process?

Ours is a rules-based investment process, with transparent risk management based on the fundamentals that drive markets. We use broad global diversification to avoid concentrating too much in U.S. markets, another mistake investors make. Equally weighted allocations help control risk and enhance returns, but it is not necessary to go through layer upon layer of optimization and sophisticated analysis to achieve equal weighting. Simply spread out your risk. 

Over the past 20 years, the S&P 500 has been one of the worst performing equity asset classes. U.S. mid and small caps handily beat the S&P 500, and global REITs are a good diversifier. Emerging markets, while recently out of favor, add diversity in normal times. 

Our process will never change. We have so much conviction in this model that we state it right in the prospectus—we have zero intention of ever changing it. We have a clear transparent plan to get us out of the market when things go bad. But the key innovation is that because we have a plan to get our investors out, and they know that, so they tend to stay in the fund when we hit normal volatility. As a result, we have very little net outflows.

When we get our tactical signal that fundamentals may be in trouble, we go from a 60/40 portfolio allocation to a 30/70; that is, we cut the equity in half so the 60% is reduced to 30% and we roll it into bonds. 

Q: Would you give us an overview of the fixed-income segment of the portfolio?

While everyone focuses on equities, the key differentiator in our model has been our fixed income portfolio construction. We are long U.S. Treasuries, corporate bonds, global aggregate bonds, and high yield, all long-duration assets. Most money managers have been so worried about rising inflation for the past six or seven years that they missed tremendous bond returns as yields went down. The reason we own long bonds is to lower risk and increase return, because as yields go lower you get capital gains. 

Fixed income adds balance to a portfolio. And because we own a lot of fixed income, long duration, we can own a lot more equity. The length of duration is a proxy for risk control. The longer duration you have in your fixed income, the better the risk control is. It is the best way to hedge, because as equity markets get hit, the longer bond goes up. 

It is an uncommon form of risk control, one not utilized in many investment portfolios. You have to be different. You cannot get good absolute returns over time if you are not somehow different from the rest of the crowd. There simply aren’t many equal-weighted portfolios in the industry. 

We do not add alternatives, hedge funds, or commodities into our model. We set this up with recognizable, plain-vanilla asset classes, intent on building a sophisticated — but also simple —portfolio, one without exotic instruments, so no one can point to our positive returns and attribute it to our having had some esoteric investments in there. We have demonstrated how it is not difficult to beat the S&P if you are effectively diversified. 

We do not add commodities because it is double counting. In each equity asset class, there are materials and energy and industrials that have a lot of exposure to commodities. If you add commodities, you add extra volatility, without risk control. 

We believe there is a correlation, if not a perfect one, between earnings growth and the market. Earnings tend to trend. In 2000, corporate earnings were positive, but began to decrease around 2001. They went negative during the tech bubble recession for five quarters. We would have been defensive at the first sign of trouble in the first quarter of 2001, and then, around the fourth quarter of 2002, we would have been positive again. When corporate earnings are up, that is good news. When corporate earnings are down, that is bad news.

That kind of transparency is what we want to provide our investors. We say, “This is precisely how your portfolio is going to be managed.” 

If you look at what happened during the Great Financial Crisis, at the peak of the market, corporate earnings in the third quarter of 2007 went negative. Former Fed Chairmen Alan Greenspan and Ben Bernanke said they did not see the crisis coming. Well, the corporate earnings saw it coming. In the next two years or so, corporate earnings were negative and we entered the worst financial crisis since the Great Depression. 

When earnings turned positive in 2010, nobody believed it. Nobody paid attention. People were afraid to get into the equity market again. But the same data, the same corporate earnings growth, that got you out of the market should get you back in. Not only are we defensive, not only do we intend to protect investors on the downside, but we keep them in during times of normal volatility to withstand temporary downturns to then get participation in the bull market. 

Q: Can you give an example of another cycle where your strategy was successful?

We went defensive October 1, 2015, which was the period of the China crisis. During the ensuing volatilty, we missed some of the returns because we were defensive, but our clients didn’t waver. In January, we got all our returns back on a relative basis. The markets crumbled and our Global Perspectives Fund shot up to the top decile in its category. 

Then, in the second quarter, markets recovered but bond yields went down. Because we are relatively long duration bonds, we continued to beat the market and our relative peers, while in defensive mode. Corporate earnings growth has been negative for four quarters in a row now. We continue to be defensive currently, at 30/70, in this second quarter reporting season. 

Q: Won’t the market have already moved by the time corporate earnings information becomes available?

Yes. Because we look at actual earnings, there is a lag, but it also is a forecast. Earnings tend to trend. We prefer to wait because estimates that are expected to be negative can end up being positive. But once you get one negative quarter, it does tend to trend. 

In 2015, the second quarter was negative, followed by the third, the fourth, and then the first quarter of 2016. In January, commodities prices collapsed and almost created a market crash. Earnings growth, the canary in the coal mine, was an early signal that all was not well with the global economy. Half of the revenues of these corporations come from China, South America, and other parts of Asia, Europe, and Africa. 

So, yes, it is a lagged indicator, but once earnings shift direction to negative or positive, they tend to continue in that direction. The first positive reading in 2010 lasted for three years. 

Q: Does your earnings reporting model work for more than just equities?

Yes, it works for both equity and fixed income, globally. The S&P 500 is a global index, with half its revenue overseas. Corporate earnings attest to what is going on with earnings everywhere. These U.S. companies are highly invested in emerging markets, especially China. 

The reason we use the S&P 500 is because it is the most widely followed index in the world and the data is solid and clean. When you build a model, you must be very careful when selecting the data you rely on. Each of these S&P 500 companies has bond and equity holdings. Even bond and fixed income managers look at corporate earnings to ensure they can meet their bond interest payments. The beauty of this lies in its simplicity. It is good for emerging markets, mid caps, and small caps—it is a global signal proxy. 

We make our allocation decisions every quarter, after earnings come in. All of the earnings information tends to drip in toward the end, three months later, so we do this each quarter based on the previous quarter. For example, reporting for the second quarter of 2016 will finish in late August or early September. We made our decision based on the first quarter’s earnings on July 1st, and we will make it again on September 30th or October 1st for the second quarter. 

Q: Would you ever select something with an inflation-adjusted return?

There are a lot of asset classes that we miss—especially in fixed income, senior loans or floating rate notes. We believe that if you get 80% right, that’s sufficient to capture it. If I went to, say, 20 asset classes, instead of 10, then my starting point in each would be 5%, not 10%, and so if I cut it, it would fall to 2.5%. Any weighting below 5% has very little, if any, impact on a portfolio. The idea was to constrain the number of asset classes. Ten is an easy number to work with. 

If we were to expand it to 11, 12, 13, or 14 asset classes, the returns would likely be comparable. Having fewer asset classes simplifies everything while still giving good results. 

Q: How do you define and manage risk?

It boils down to strict adherence to our rules-based investment process. Many times, in money management, it’s when you fail to follow your discipline to the letter that you get in trouble. Risk management is benchmark relative. All of the information we use is readily available, including rolling returns, annual returns, excess returns, standard deviation, Sharpe ratio, tracking error, information ratio, up capture, down capture, beta, alpha, etc. But we also look at peer relative results. 

We have not changed our investment process, and we never intend to, something that is very rare in the industry.