Q: Would you provide a brief overview of the fund?
The fund invests in large-cap companies and currently has just under $230 million in assets. The fund is subadvised by Boston Advisors LLC, where I have been working since 1997. Nationwide asked us to take over fund management just over a year ago. We were hired because of our track record on investing in large-cap growth for the past eight years.
Moreover, we have a risk control hedging program to minimize major drawdowns in the market that happen more than we like. We don’t have an active hedging program, but hedging is a tool that we may engage at any point in time, depending on the market environment.
Q: What are the tenets of your investment philosophy?
Our core investment philosophy is rooted in taking advantage of inefficiencies in the market. We are strong proponents of a disciplined, data-driven approach to the market. And yet, we do not believe that the ability to outperform can stop with just a complex linear estimation of market forces.
Q: Would you describe your investment strategy?
We apply a combination of quantitative and fundamental investment methods. Our quantitative measures begin with our market regime model, identifying the type of market regime we are in today. To our way of thinking, market regimes are divided into three categories.
The first is the bull market, indicated by good positive returns and relatively low levels of volatility. The second stage is bear/chaotic, which is basically the inverse: higher volatility and flat to negative returns. Historically, bull markets occur 60% of the time and bear markets 30%. For the remaining 10% of the time we have something called an efficient market, which is based on low volatility and low returns—a trending transitory market generally between the bull and the bear markets.
We focus on this model because we believe investors behave differently in the various regimes. They look for different investment ideas during a bull market than they do for a bear market.
For instance, in 2008 and 2009, investors were looking for companies that showed great stability, strong valuation characteristics mostly based on book value, and consistency of earnings that were not dependent on the economic cycle.
Q: How is your investment strategy in a bull market different from that in a bear market?
During a bull market, we use our regime model to identify the factor exposures that are best suited to the regime. We tilt factor exposures to take advantage of things that are more growth oriented and our portfolio tends to be a little bit smaller and more aggressive than the benchmark. There is less emphasis on valuation, so leverage is used in balance sheets and so on.
In a bear market, we do exactly the inverse. We tilt our portfolio to take advantage of factors that are more valuation based and look at the difference between the rankings that we generate every day from bull to bear markets.
Next, we look at four different factor families in all regimes and industry groups, namely growth, valuation, investor sentiment, and quality. All these get broken down into various individual components. At any one time in the model we probably have 30 or 40 different market factors; things like price-to-earnings ratios or price-to-book or earnings growth or long-term earnings growth versus short-term earnings growth. Every day we rank every stock in our universe on a scale from 1 to 10; one being the most attractive, ten being at the bottom.
That entire process helps with understanding what type of stocks investors are paying attention to and what combination of the factors have traditionally or historically led to outperformance. Then we take off our quantitative hat and put on our fundamental hat.
The fundamental work begins with focusing on names that are ranked 1 and 2 or are in the top 20% of let’s say 200 names. The question now is identifying what stocks in these 200 we really want to own today. Here we have fundamental analysts who concentrate on those top two quintiles and look at the company.
We describe our first process as REP, which stands for the rank, environment and price, and we go through these steps on every company.
Q: How does the REP process work?
In our stock selection, we first go through the rank, which is the quantitative tool and bridges between our quantitative into our fundamental. We have diagnostic tools on our own model that indicate the growth rate increased because it had earnings estimates or because the company did a recapitalization and re-levered their balance sheet and something changed. So, we understand what the rank says and why it does so.
Then, we take a look at the environment of the company. For example, let us consider Walgreens Boots Alliance Inc, the drug retailer. It ranks well, but the rank is beginning to fade. This is because stock valuations have gotten high and the valuation parameters that we set were becoming less attractive. Thus, on average, the whole score is beginning to trend down a little bit.
But when looking at the environment in Walgreens, it is still terrific in our opinion. They just merged with Europe-based Alliance Boots, a multinational pharmacy-led health and beauty group. This has led to all kinds of efficiencies and sales opportunities and growth rates around the rest of the European marketplace that they have never had before.
The company seems to be a wonderful executor in terms of efficiencies in business and business value add. They have done some things with their pharmacy benefit relationship and also through wholesaling. We see all kinds of interesting things happening at the company level, so the environment is terrific for us.
The third factor to consider is price. We spend a lot of time understanding the right entry and exit points. For every stock we own, we go through this rank, environment and price process, and that leads the portfolio manager to take that amalgamation of data and make a decision to buy or sell a stock.
Q: How do you identify inflection points in your three market scenarios?
The way we build the model is that its persistence is quite high. The most important thing about what market we are going to be in tomorrow is about what market we are in today. There is a high degree of persistence through this model, so we are not overly worried about that, mostly because these market states stick around for a while.
They are not designed to be traded; they are designed to be invested upon. The average length of the bear market is eight to 12 months, while the average length of the bull market is somewhere from nine or ten months to 36 months. By missing an inflection point or two, we are certainly not facing the end of the world, as long as we are able to react quickly enough.
We have built a number of tools around our regime model that serve as confidence indicators. The model tells us we are in a bull market, but if the market sells off, and we start to get a spike in volatility while the economy starts to slow down, we see the model beginning to wobble and the confidence indicator coming down to 60% or 70%, or even 50%. We need to see two consecutive weekly readings of a different state with a high level of confidence, above 90% to move from bear to bull and vice versa.
Again, we are not terribly worried about catching inflection points because we know that once the trend is actually established we get some confidence readings. We know that when we have changed regimes that will be there for a while, and as a result we feel confident and we get in sync with the market. A lot of stocks rank well in both bull and bear market. Naturally, we can anticipate a little bit, but the big takeaway is that we are able to get the big moves right, and that is our goal.
Q: What is your research process?
The research process starts with our stock selection tool. Our first step is using the 1-to-10 ranking of Boston Advisors’ stock selection. We run those every day based on the regime we are currently in.
Since we are running a large-cap growth portfolio, we start out with growth names and narrow that universe down to companies with a market cap of at least a billion dollars. When we are risk aware and know where we are relative to the benchmark in terms of capitalization, we are never going to be too far off.
For instance, Walgreens and CVS Health Corp both rank well in our work. How do we choose which one to own? The fundamental analyst goes through the REP process, looking at the rank. The focus is on subpieces of the rank of our decile scores that are doing well, like growth, value, and quality.
CVS is more of a domestic company that has done quite well with their pharmacy benefits partners. It has become much more efficient as a company, and earnings have been growing nicely. Overall, it is a good story, but is Walgreens a better story because of their international exposure? We look at those environments and line them up next to each other with price in mind before we can identify a better entry point.
Both of them rank well as good growth names, and we either buy them both or we buy one. Here the fundamental process comes into play to decide whether we buy CVS or Walgreens, or Pepsi or Coke, or Home Depot or Lowe’s.
Q: Who has the final say in your stock selection process?
The portfolio manager makes the final decision on a stock. They have to be able to justify every decision that they make based on our stock selection score and the REP process. That’s all documented in our research database, Boston Advisors Research Database (BARD), and so everything gets clarified and saved through this institutionalized memory.
Everything we do is based on team work from a quality assurance perspective. Every week, we have a meeting with all of our portfolio managers and research analysts to go through all the different portfolios in the firm. We review them cross-sectionally and look at the average rank in the portfolio.
We want to grow our earnings and sales in a consistent and stable way, so our growth portfolio is much more enduring rather than oriented toward a two- or three-year period of hyper growth.
Q: How do you construct the portfolio?
Portfolio construction is all a function of the bottom-up stock selection process. We build our portfolios heuristically by understanding and knowing the companies we invest in based on our quantitative ranking. However, we do not optimize our portfolio construction.
The quantitative process is driven by the regime model and the individual analysts make decisions between those stocks that rank well. The net output for a portfolio is this idea of stocks that rank well quantitatively and statistically, bearing in mind that our portfolios are more likely to outperform than not. We put each one in place for a very specific reason, whether that is because we really like the business case or due to other factors from a risk perspective.
We build the portfolio in line with our analysis at an industry level. First, it must rank well quantitatively. Then, each individual company is analyzed and understood for its environment and its positioning relative to competition. Finally, in addition to these fundamental building blocks, we take into account our team’s outlook in the individual sector.
The Nationwide Growth portfolio currently has around 80 individual holdings. The turnover tends to be between 75% and 100% a year. For benchmarking purposes, we use the Russell 1000 Growth Index.
Q: How do you measure risk? How do you control and mitigate it?
We measure risk in a number of different ways. We have the traditional risk awareness of factor exposures and how our portfolio skews, whether it is small or large.
However, we are different in that we use contribution to risk on an individual stock idea. We make sure that none of our stocks adds more than 6%, 7% or 8% of its total contribution to active risk in the portfolio. While it is generally easy to own a 2% position in Walgreens, a large-cap company that should not add much to the overall risk in the portfolio, if we allocate a smaller portion to a $3 billion biotech firm, it might act as an incredibly volatile name. Apparently, the contribution to risk in this case is actually bigger than the 2% in Walgreens.
When it comes to controlling risk, we use a lot of different factors. The first of them relates to the idea of not taking huge bets on sectors and industry groups. We know that most of the outperformance that we have generated over the years comes from our stock selection, so we are not looking to have a huge impact on our allocation decisions that is cash versus stocks or different sector tilts and bends.
We generally prefer to be within 3% to 5% of the benchmark from any sector or industry group that we have. Also, going back to contribution to active risk, we make sure we scale our positions, our individual stocks, based on the contribution on how much risk they generate.
I think the takeaway for a large-cap growth portfolio is that we are very much risk aware and benchmark aware. We are cognizant of where the benchmark is, what risks are in the benchmark, and where we stand relative to those reference points. Our objective is to outperform the benchmark by 200 or 300 basis points a year. We do not always hit that, but most years we have.
Q: What are your views on portfolio hedging?
We believe that the Federal Reserve has built an environment where we are likely to see additional periods of hypervaluation both on the high and low ends. That means there are going to be some significant market corrections. The market is clearly getting closer to the top end here and that sets up the need for some type of portfolio insurance during periods of significant market drawdown.
The problem with having a perpetual insurance program, or a perpetual hedge in a portfolio, is that it is very expensive and eats up alpha. As we do not want to do that, we keep our long-term record intact based on our stock selection process.
Additionally, we employ some proprietary market stress models that tell us when market pressures, not just those related to the stock market but also in terms of fixed-income, commodity and the economy, are beginning to rise. So, we keep our hedge off until we see different types of market stress beginning to rise, and then we begin to hedge gradually. Basically, as market levels rise and fall we begin to hedge and trim the portfolio.
There are exchange-traded funds (ETFs), cash hedges, and futures, and we keep all of those available. One way to create a hedge is by raising cash. We are 100% invested in equities as of this moment, and we can raise cash levels to 15% over time. The real goal is to improve the long-term risk-reward ratio of the portfolio. If the market were to fall 25% or 30%, we would be thrilled if we only declined 15%.
Our risk control objective is to ensure that we will suffer in a relatively modest manner in proportion to a big market downturn.
