Q: What is the history of the fund?
The QS U.S. Small Capitalization Equity Fund was launched on March 13, 2000 with a two-fold mission: providing clients with reliable exposure to the U.S. small-cap market while consistently outperforming relative to our benchmark and competitors.
We do not describe our investment approach as either growth or value; it is a core process that is grounded in fundamental concepts and investor sentiment. By systematically testing multiple drivers of return across all sectors, we identify the best opportunities and adapt to different market environments in order to deliver strong performance in a repeatable fashion.
Current assets under management in the fund are $980 million, and including our institutional separate accounts that are focused on small cap investing, the total exceeds $1 billion.
Q: What core beliefs drive your investment philosophy?
We believe company fundamentals drive stock returns, and that those fundamentals should be evaluated systematically with an investment process which reflects the insights of experienced investors. The process should be constantly evaluated so it evolves as markets change.
Also, it is our belief that small cap creates compelling opportunities for active managers because the spread between outperforming and underperforming stocks is wider than it is with larger-cap stocks. The small-cap part of the market is less liquid, however, and our investment process has been built and executed with this in mind.
Q: How would you describe your investment process?
It is a bottom-up approach with the goal of consistent, repeatable performance. Because of our belief that stock returns are driven by fundamentals, we look at a diverse set of drivers within the broad fundamental categories of value, cash flow, earnings growth, expectations, and technical measures. This captures information from company financial statements, along with information from Wall Street analysts and market data including prices, short interest, and options data.
Within these categories, we have a library of more than 60 factors, so our view of what drives returns is both granular and diversified. Each return indicator brings unique information to the process, adding to our understanding of what makes for an attractive company.
All the elements of our process make good fundamental sense and are backed by careful testing which is repeated on an ongoing basis to monitor the relationship between factors and evaluate whether factors are gaining or losing effectiveness.
Our investable universe includes more than 2,000 stocks. We systematically rank each one every day, and buy from among those that are most attractive.
Attractive stocks tend to score well along multiple dimensions. Since ours is a core approach, it’s not enough for a company to have attractive valuation; stocks may be cheap for a reason or stay cheap for longer than we’d like. Conversely, we don’t want to buy stocks just because they have good growth prospects because we might end up overpaying for that growth.
Q: What is your research process?
A large team of researchers, portfolio managers, and traders collaborate on portfolio research, and we all have strong quantitative skills as well as fundamental backgrounds – many of us have worked in more traditional places, so we understand the value of fundamental insight. However, being able to systematically capture these insights is an organizational advantage.
When a new data source becomes available, we add more return factors based on the opportunities identified within it. Also, to ensure information is captured effectively, factors are reformulated from time to time.
Just as important as new information, though, is how factors are put together – and that’s one of the key lessons we took away from the financial crisis. While the crisis itself didn’t shake our core principles, it did reinforce the importance of risk control at all stages of our process.
Q: Could you explain in more detail how the financial crisis affected your process?
Because of the dramatic changes in market conditions, we improved our analysis of the relationships between factors to ensure the fund is as diversified as possible and to help us identify extraordinary return opportunities.
We put additional emphasis on outsized opportunities which occur because they’re being overlooked by other investors, or when our experience tells us that a particular factor or set of factors will do well in a specific market environment. Conversely, if investors are crowding into a factor, it implies shrinking opportunity, so less emphasis is given.
For example, investors grew quite risk averse in 2008 and were skeptical of valuation measures. In their avoidance of value, they focused too much on momentum which became crowded in 2009, creating an opportunity.
Q: How do you construct your portfolio?
Our investable universe is a dynamic and rich opportunity set of small-cap stocks similar to the fund’s benchmark, the Russell 2000, but includes more names. In addition to appropriate capitalization, we seek companies with sufficient financial data available so we can make sound investment inferences, as well as adequate liquidity so they can be traded cheaply and effectively.
We want stocks with the highest expected 12-month return relative to their peers, determined by metrics appropriate to their sectors. Because these return estimates are based on a diversified set of information, they give us a better view of whether a company is attractive. Further, our daily evaluation allows us to see how the return estimates are changing and evolving, and thus trade when it makes sense.
Trading is driven primarily by sells. When stocks become unattractive, we sell them. If a stock appreciates dramatically and the position becomes too big a part of the portfolio, we trim it for risk-control reasons. What goes in the portfolio next generally depends on what was sold; for instance, if the fund is underweight a particular sector, the next buy idea will likely come from that sector.
Our manner of trading pays close attention to liquidity and market conditions, which helps us capture as much return as possible. The depth and diversity of experience in research and portfolio management contribute to our goal of consistency of returns.
Sector exposures tend to be modest relative to the benchmark because stock selection drives our returns rather than sector allocation or market timing.
This is definitely an active strategy. We select stocks that lead to better consistency of returns over time through exposure to those multiple drivers of return – value, cash flow, earnings growth, expectations, and technicals. Because it’s exposed to multiple return drivers, the fund is more attractively valued than the benchmark; our companies generate stronger cash flows, demonstrate better growth, have more positive earnings estimate revisions, and exhibit better price momentum.
Q: How do you define and manage risk?
Although risk is embedded in all parts of our process, we manage volatility at the portfolio level. Ours is not a strategy that was built on less-volatile stocks, but rather one where the portfolio has been constructed to achieve consistency of return and be less volatile.
To help construct the portfolio, we do use a risk model and an optimizer, but they are not relied on too heavily. We supplement these with proprietary tools as well as commonsense notions like ensuring the portfolio is well diversified by sector and name, and across factors.
When choosing factors, we chose ones that make good fundamental sense. Not only does this tend to lower risk, we think it’s more likely to work well over time.
Finally, the portfolio management team reviews risk and suggested trades to make sure that there isn’t important information that has yet to be captured in our data. We think this is an important source of risk control.
