Q: What is the history and objective of the fund?

American Beacon Advisors, Inc. was originally a wholly owned subsidiary of AMR Corporation, the parent company of American Airlines, Inc. The firm evolved from the team of people who oversaw the pension and cash assets of American Airlines, Inc.

In 2008, AMR Corporation sold American Beacon Advisors to the private equity firms TPG Capital, L.P., and Pharos Capital Group, LLC. This year we were sold again, and closed the transaction on April 30th. We are now owned by Kelso & Company, in New York and Estancia Capital Management, in Scottsdale, Arizona. Although we’ve had a recent change in control, for all intents and purposes, nothing has changed at American Beacon.

In terms of the fund itself, the American Beacon Large Cap Value Fund is one of our two oldest funds, which launched simultaneously in 1987. Since inception, it has been a fund of multiple sub-advisors, and today we have four sub-advisors in the fund, two of which have been managing its assets from day one.

Of the four managers, Hotchkis & Wiley Capital Management, LLC, and Barrow, Hanley, Mewhinney & Strauss, LLC, have been managing assets of the fund since 1987. Brandywine Global Investment Management, LLC, joined the fund in 1996. And the newest manager, Massachusetts Financial Services Co., joined us at the end of 2010, replacing Metropolitan West Capital Management, LLC, which had been with the fund for 10 years.

The fund has a capital appreciation and current income objective and has been a value fund from inception. The managers have all been selected using American Beacon’s process, which has not changed either.

Q: What is your role in the fund?

My primary role is to identify, select, and monitor the managers from an investment perspective. I meet with them every quarter, but the detailed monitoring of the portfolios, in terms of guidelines, percentages, and exposures, is done by other people here. We have a large and competent compliance department that monitors daily tests on the fund and, to the extent that something is flagged, they pursue it with the manager directly.

My responsibility is oversight of the sub-advisors’ team, process and performance and supporting our marketing efforts in terms of reading questionnaires, helping with answers, participating in interviews, such as this and meeting with prospects and clients as necessary. My primary role is monitoring the managers to make sure they are the ones we want to have in the fund, and when a manager is not performing, to make the hard decision as to whether we need to replace them. Sometimes the hardest choice is to elect not to replace a manager.

Q: What are the assets under management at the company and each fund level? And how are they divided at the company level?

At the company level, our assets are currently $62.9 billion under management. We have products in a variety of asset classes but the majority of the firm’s assets are in domestic equities. One of the initiatives of our CEO, Gene L. Needles, Jr., has been to diversify the product line, precisely to avoid having so much in one asset class.

We have products across the board in fixed income and alternative asset classes, like unconstrained bonds and managed futures. As of March 31, 2015 the assets under management for each asset class are as follows: $32.1 billion in Separate Accounts, Private Funds and Investment Trusts; $24.1 billion in U.S. Equity; $3.2 billion in Non-U.S. Equity; $2.5 billion in Fixed Income; $1.0 billion in Money Markets; $52 million in Alternatives; and $13 million in Global Equity.

The Large Cap Value Fund has somewhere between $11 billion and $12 billion. The weighted average market cap of this fund is close to a $100 billion, so it is a true large-cap fund and also truly a value fund.

Q: Would you define the core philosophy that drives your manager selection process?

At American Beacon we have a very specific kind of value manager that we like to hire for our multiple-manager value funds. Our founder, William F. Quinn, described our approach as “growth at a reasonable discount.” I’ve always called it “common sense value,” because we like to hire investment managers that buy companies that are cheap today relative to what they calculate their potential growth will be over the next three to five years. We like portfolios of cheap but growing companies. That’s where the common sense part comes in.

The selection process for our multiple-manager value funds is defined and has been implemented consistently since the firm’s inception for each of our multiple-manager value products.

We use a mathematical model before we hire any manager to ensure they really do have a portfolio exhibiting common sense value characteristics, and it determines what sufficient growth to justify the price is. We are really only interested in pursuing managers whose portfolios have at least 85% of their market value in that cheap-yet-growing category. That is our driving philosophy.

We identify managers based more on process than on performance or any other characteristic. If you were to look at our four sub-advisors, you would see that their correlations for meaningful time periods, three years or longer, are high, which should not be surprising given that we have selected them all using the same model. By design, ours are more traditional value managers, who are disciplined in their search for value.

Q: How do you go about your manager selection process?

First, when looking for a firm, we want to make sure that the people responsible for the performance are still there. And we want to make sure that their investment people are sufficiently motivated and incentivized to stay, so we do due diligence on who the people are and what the compensation structure is, and as much as we can, get a good idea about the culture at the firm.

Second, we want to make sure that the succession path is clear in terms of who would replace the senior people as they retire and such. We do not want to be surprised when there are changes in the management team. For instance, at Hotchkis & Wiley, we have seen a succession of three lead portfolio managers on our product, but, in each case, we already knew who would be retiring and who would replace the person, so when those changes happened, it was never a cause for concern for us.

Finally, of course, there is the discipline. We want to understand what each of our managers do well enough to get our arms around it, so that when a manager is underperforming, we can gauge whether it’s something we should expect under the market circumstances, or if it’s something we would not expect, something that is a cause for concern.

Once all of that is done, we use the model I described earlier to make sure the manager’s process results in the kind of portfolio we are looking for.

We meet with each sub-advisors’ portfolio manager every quarter, in person, and have them refresh the model’s results to ensure they continue to maintain a portfolio with an overwhelming majority of its market value in that cheap-but-growing category.

It’s important to us that American Beacon retains a process that is defined and repeatable. That way, the investor can rest assured that when we do decide to change the manager lineup, the broad and basic characteristics of the fund, such as lower price-to-earnings ratios or higher growth rate, do not change. The performance patterns that investors expect in the fund should also not change.

Q: Is there any limit on the number of managers you can have?

We have done a lot of work to try to figure out what this optimum number is, but I can’t tell you whether three or four or five or six is better—it’s not necessarily a fixed number. It really depends on what managers you have at the time and the asset class.

In large cap, we are perfectly happy with the four managers we have now, given the size of the fund. We don’t generally have capacity issues in large cap, but if one of our managers were to limit their capacity available to us, that could be a reason to add a fifth. If you delve into the history of the fund, you’d see that we had five managers in 1998 and the fund was under $2 billion dollars, so capacity, flows and a lot of factors go into this decision.

I think that, in large-cap value, four is a good number, but that could drop to three if we had to terminate a manager and couldn’t find a manager that we liked enough as a replacement. So, it’s very much a judgment that is dependent upon the circumstances at the time. That part of our process is obviously more subjective. It has a lot to do with experience and judgment, and so we don’t have a fixed formula as to what the best number of managers is in this or any of our funds. It is very much tailored to the specific fund and the circumstances at the time.

Every time we meet with the managers, each quarter, we learn a little bit more about how their process is implemented, how they view the world, how the portfolio is constructed, and why they own the companies they own. This way, when there arises a period of underperformance, we know enough about their process to make the right decisions. We have been known, historically, to be patient with our managers, as long as we understand the sources of underperformance and that they are what we would expect.

Q: How is the portfolio constructed?

The fund, by design, is understandably diversified by way of the number of managers it uses. Accordingly, we end up with a portfolio that is quite large in terms of the aggregate number of securities.

The portfolio typically has between 150 and 200 names spanning the four portfolios that underlie it. There isn’t much overlap in those names, even though we select all the managers using the same process. Each manager has their own process and they end up with quite disparate portfolios.

At the end of March, for instance, there were approximately 205 companies in the aggregate portfolio. Only 42 of those names overlapped, 42 that were owned by two or more managers. There are very few that are owned by all four, so there’s less overlap than you might expect with a group of four traditional value managers that all fit very well with our model.

While we control the portfolio, we don’t micromanage it. With four managing firms, there are certain limits, often legal limits, and so we make sure that we never exceed those limits. To do this, we give each sub-advisor identical guidelines that limit things like position size, sector exposure, and industry exposure. For example, we limit them to no more than 5% in any single issuer at time of purchase.

That said, obviously with a portfolio of 200 securities, we rarely, if ever, get that close to 5%. Our largest holding is usually 3.5% to 4%. Right now it’s JPMorgan Chase & Co., with 3.9%, which is a company that is owned by all four sub-advisors.

At the sector level, we allow them to invest in the larger of 30% or the benchmark weight in any given sector. However, we have no minimum sector requirement. If a sub-advisor cannot find a good value in a particular sector, we feel no obligation to have exposure to that sector, and as it turns out, occasionally some of them are completely out of certain sectors.

We do limit industry exposure to no more than 15% in any single industry. This way, if we did have 30% in a sector, they would have at least two industries within the sector. In other words, we don’t want the 30% we have, for example, in financials to be all banks—we want a minimum of two industries represented in that 30%.

These guidelines are the same for all four of our managers, and are not all that different from their self-imposed guidelines, so we are not changing the nature of what they do. We hire them for what they have proven they are able to do. We do need these controls, however, because of the multiple-manager structure.

Q: What is each manager’s process and how do they compare or differ?

They end up in quite different areas of the market because, when you look at their individual processes, their focuses differ. Hotchkis & Wiley, for instance, focuses primarily on price-to-normalized earnings, and in that way they are a good fit with our model. They tend to be 95%, 96%, or 97% in that cheap-but-growing category and they are deeper-value managers.

In comparison, Barrow Hanley focuses on delivering a portfolio that possesses three characteristics: 1) price-to-earnings that is lower than the market; 2) price to book value that is lower than the market; and 3) a dividend yield that is higher than the market. They don’t require dividends for every company they own, but they do require that their portfolio have a higher dividend yield than the market and so, for that reason alone, they tend to be a higher-dividend manager among the four that we use.

Meanwhile, Brandywine Global Investment Management appreciates companies that are cheap, as well as those with dividends. Once they narrow their universe to the companies they like, they are very deliberate in applying a macro view to the construction of the portfolio.

MFS focuses first on quality. They screen companies for quality as they define it—quality of the management and product line, sustainability and dependability of the earnings, and so on. First, they rank the companies by quality, and then they rank them by valuation, and they are willing to pay up a little bit for sustainable earnings. They are a great complement to the others but, again, they were selected because of their team, performance, and the fact that they are a great fit with our model.

So, each differs slightly in their process, and this is the primary reason their portfolios have very little overlap, despite all being value investors.

Q: How do you define large cap?

As you can see in our prospectus, large caps are considered to be any company with a market cap within the range of the Russell 1000 Index. But, by guidelines, they must be at least $1 billion, or larger.

We do not limit the managers to their benchmark securities only. In fact, of the 205 names in the portfolio at the end of this past March, 68 were not in the fund’s benchmark index, the Russell 1000 Value Index, and represented 29% of the fund’s market value. The remaining names we own are in different weights than the benchmark index. There are 575 index securities that we don’t own, which represent 37% of the index. We tend to differ noticeably from the index and that’s why we are able to add value relative to the index, with a portfolio of four managers and 200-plus securities.

Q: Could you describe your asset allocation process?

Our preferred allocation in the multiple-manager funds is equal allocation to each manager to minimize the risk that a single manager represents.

In this fund, Barrow Hanley, Brandywine, and Hotchkis & Wiley are allocated equally, while our newest manager, MFS, currently has a smaller allocation. In 2010, we hired MFS with 10% of the assets of the fund, but the fact that MFS has only 10%, 11%, or 12% of the fund is not a tactical decision—when an event occurs that is large enough, or significant enough, to rebalance, we will do so. Sooner or later there will be a large enough transaction or another reason to rebalance the fund, and at that point we will make MFS a larger portion of the fund.

Q: How do you define risk and what risk control measures do you have for the fund?

We don’t have any formal risk controls at American Beacon in the way of a risk overlay. We believe that the risk we face is simply the risk of losing money. That’s the biggest risk there is for us, and we believe that an effective way to reduce that risk is to diversify the portfolio not only by the number of securities but by the style of each sub-advisor.

One of the things that we favor in the multiple-manager structure is how it protects the investor from the significant swings in performance that you can often see with single-manager funds. The fund tends to be less volatile than many single-manager funds, encouraging the investor, by nature often quick to react, to stay in our fund longer and experience its longer term benefits.

With a multiple-manager format, the fund will likely never be as good as its best-performing manager, but also tends to stay out of the bottom quartile of its peer group. As long as American Beacon is able to identify managers that deliver performance that exceeds the median over longer periods of time, the combination of good managers and staying away from the bottom has resulted in good long-term performance.