Q: What is the history of the fund?

In 1987, we launched American Advantage Funds, which are now the American Beacon Funds. We based the funds on the principles that we used to manage the pension plan and hired multiple best-in-class sub-advisors for these funds. These are multi-manager funds and not “funds of funds”.

The American Beacon Small Cap Value Fund was launched December 31, 1998. Hotchkis and Wiley Capital Management, LLC and Brandywine Global Investment Management, LLC were the two initial sub-advisors, and they actually provided the seed capital to launch the fund. Over time, we have added some additional sub-advisors. Currently, the fund has six sub-advisors for seven different products.

Q: How is this fund different from a fund of funds?

I would say that it is different from a fund of funds primarily due to the cost structure. There are no added layers here. Another advantage is that we aggregate assets with our pensions and other assets within our company to achieve favorable break-point pricing.

Q: What are the key advantages of a multi-manager fund versus a single-manager fund?

There are many advantages to a multi-manager fund. First of all, there is an additional layer of oversight. Also, we have reduced manager risk. For instance, if a key portfolio manager or team member of a sub-advisory firm leaves, assets can be allocated to the other sub-advisors to remedy that situation quickly.

We also mitigate the risk of having a star manager, who might be an employee of a single-manager fund, and begins to underperform or changes an investment process. Such a situation will be dealt with by simply terminating and choosing a new sub-advisor.

Overall, we find the multi-manager process gives us a smoother ride. By avoiding big losses, we tend to outperform over the long run.

We also outperform over time by avoiding returns in the fourth quartile. Since inception, we have been above the median performance of our peer group on three-year rolling periods 85% of the time, 83% of the time on five-year rolling periods, and 100% of the time on 10-year rolling periods.

Another aspect of the multi-manager approach is some people like to pick from hundreds of thousands of advisors or asset managers on their own. Instead, American Beacon does that selection for them. We also have direct access to numerous sub-advisors who are not available to a single-manager product.

We also fit so nicely in this asset class. Funds reach capacity quickly in small cap. If our backs are against the wall and our clients are relying on us to keep a fund open because it is on a 401(k) platform or part of a model, we can add another sub-advisor. 

Q: How do these sub-advisors differ?

We hire value managers who are buying cheap stocks they believe will grow faster than the overall market. We ask them to put their portfolio in a quadrant analysis. The prerequisite is that 85% of their names or holdings have price-to-earnings as well as the manager’s expected growth rate higher than that of the core benchmark, the Russell 2000 Index.

We also use this model as somewhat of a holdings-based style analysis over time. It’s part of our process of monitoring these managers. We require them to analyze their portfolio through using this process before they meet with us on a quarterly basis.

And even though we require that they beat us, and that their portfolios fit this tool, they come about it in different ways. For instance, we consider Hotchkis to be more of a deep, disciplined value manager, but they will go into certain sectors with low speed, and it makes for a volatile single manager ride, but fits very nicely in a multi-manager portfolio.

I would also call the Barrow, Hanley, Mewhinney & Strauss, LLC portfolio more of that deep value, traditional value approach. The Barrow team is not afraid to be entirely out of a sector for several years.

However, Brandywine and Foundry Partners, LLC is more traditional value. And then The Boston Company Asset Management, LLC and Hillcrest Asset Management, LLC have some relative value in their approach to investing.

Q: How many sub-advisors are there in your fund? 

We have six advisors right now, but because they use seven different processes, there are actually seven different portfolios in place. Barrow manages two different portfolios for us, and has been a sub-advisor to the fund since September 2003. 

The portfolio managers John Harloe and James McClure are looking for two characteristics— depressed earnings and depressed valuation. However, they like companies with durable business models and are only buying turnarounds. A lot of the time they don’t know when it’s going to turn, but because they are buying durable business models that are undervalued they know that it will.

Since this product has been closed since 2004, they were searching for a way to leverage their intellectual capital, and it so happens that they had a sister company at that time called Analytic Investors LLC. Analytic Investors came up with a process where each day the Barrow fundamental team sends their holdings to the Analytic’s team, who apply over 60 different models to identify factors driving the fundamental decisions in the fundamental portfolio. 

Then they apply those same 60 factors to the remaining stocks in the Russell 2000 Index. They optimize this and come up with a quant portfolio that reflects the factors that the fundamental portfolio. We’ve had the Barrow quantitative small cap value product since 2014.

Q: Would you describe the other sub-advisors?

Brandywine is still open to us. Their process is highly quantitative with a fundamental element to it at the end. Brandywine selects stocks that fall in the bottom quartile of all the price-to-earnings (P/E) or price-to-book (P/B) ratios in their universe. The stocks pass through a disciplined fundamental analysis and exhibit attractive price momentum. The primary focus is to combine the discipline inherent in quantitative analysis with fundamental insights to produce excess returns. All stocks are purchased on a capitalization-weighted basis. While cash is a residual of the investment process, portfolios are managed with the goal of remaining fully invested at all times.

Hotchkis has been a manager in the fund since inception, but they closed capacity to us in 2003. They are a traditional, deep value manager, looking for high quality companies with temporary issues, priced at a discount. Hotchkis believes that a value approach can provide superior long-term performance with below-average volatility. Investor psychology can lead to irrational decisions resulting in the mispricing of stocks. They strive to exploit these opportunities by employing disciplined purchase and sell criteria, rigorous in- house fundamental research and a bottom-up stock selection process with emphasis on tangible valuation support.

We hired The Boston Company Asset Management, LLC in 2004. They closed capacity to us but have recently reopened. They have three portfolio managers and six dedicated sector analysts. I call them more relative value. They go to great pains to identify what the appropriate metrics are for every industry in which they invest.

The Boston Company believes that successful small-cap investing is achieved through a program that is focused on: valuation, to provide significant upside potential while mitigating downside risk; research, as a thorough understanding of company fundamentals is the key to determining value; and discipline, as consistent outperformance requires a disciplined, repeatable investment process.

Foundry is a good example of our relationship and in-depth knowledge of a process and a team. We hired the small-cap team while they were at a previous firm in August of 2005 but didn’t fund them until June of 2010. When the team was acquired by Foundry in June 2016, we stuck with the team.

Foundry is an independent, boutique asset-management company that specializing in providing active management to the institutional investment community. Foundry deploys a value-oriented philosophy in selecting small-cap stocks. While small-cap stocks may outperform large-cap stocks (“the small-cap effect”), Foundry’s research has shown the small-cap effect is, in fact, largely a low P/E effect. Thus, they believe that the best way to capture the higher potential returns in small cap is to employ a low P/E value approach.

Our final sub-advisor would be Hillcrest. We hired Hillcrest in 2014. This is a real small shop. We knew the founders, Brian Bruce and Douglas Stark, way back when they were at PanAgora Asset Management. The firm’s strengths lie in the combination of philosophy, people, process and the resulting performance. Hillcrest believes that a consistent and repeatable pattern of outperformance is achieved by combining the techniques and insights of traditional analysis with concepts related to behavioral finance. At the center of the Hillcrest investment philosophy is the belief that company information alone is not the only factor that affects the price of a stock. Instead, investors have behavioral biases that cause irrational price fluctuations, a human element often ignored. Hillcrest uses behavioral finance in its investment process to take advantage of mispricing opportunities derived from the human element.

Q: How do you allocate capital?

In a perfect environment, we would allocate equally. We do not try to tactically allocate among managers. Unfortunately, in small cap, several of our sub-advisors are closed and they have no additional capacity or we have no additional guaranteed capacity with them.  Thus, we are forced to allocate any new flows to the sub-advisors still available to us and with which we have additional guaranteed capacity. 

We don’t want our managers selling securities to enable us to reallocate, or, on the other side, a manager buys because we’ve reallocated to him. Such activities only drive commission costs.  So, we use cash flows to effectively reallocate among the remaining managers open to us.

Q: How do you select and monitor sub-advisors?

It boils down to people, performance, process and protection on the downside. We look at the depth and longevity of the team. In terms of their process, we see if it has changed over time or does their process make sense to us. Are they able to articulate their process? We also assess whether it is repeatable on an ongoing basis. When we meet with them each quarter, we ask them questions to determine whether they are continuing to follow that process.

From a performance standpoint, we are looking at consistency of performance, downside protection, and the process. 

Once we hire a sub-advisor then we strive to be patient. If we come to a period where there is underperformance, we will dig deeply to understand why that occurs and what market environment caused the underperformance, or the manager’s style, to be out of favor. However, when the market environment turns and once more becomes favorable to the manager’s process, we expect to see that manager turn as well. It’s important to us their process does not change and they participate in the upside when factors change to favor their process.

Guidelines are established the same manner across all sub-advisors. We keep the liquidity constraints, issuer constraints, and most sector or industry limits, the same across the sub-advisors. In that way, we reduce the risk of the fund violating the parameters.