Q: What is the history of the company and the fund?
CLS Investments is known for its risk-budgeting strategies. That is the core belief that underlies how we manage money. After the financial crisis, we realized that investors, especially emotional investors, can focus more on downside risk than anything else. The Shelter Fund seeks to mitigate impacts of major market declines for investors seeking downside protection, those with a decidedly short time horizon or who are fearful of losing money.
The fund was launched on December 31, 2009. We utilized a sub-adviser up until December of 2012, at which point we agreed to take the strategy in-house to better serve our investors.
We provide various solutions to enable investors to stay in the market. Our approach centers on risk budgeting—we recommend that protection only be a portion of a portfolio, that it supplement a core risk-budgeted portfolio. People are generally loss averse, and if the market whipsaws or trends downward significantly, investors react to that loss more acutely than any commensurate market gain. We developed a strategy to help investors feel comfortable in the market. If investors can be encouraged to stay in the market long enough, long-term returns should be positive and overcome any short-term corrections.
Q: What is your investment philosophy?
We believe not only in protecting against the downside but protecting upside, through low volatility, namely low-volatility ETFs, exchange-traded funds, within the fund. Low volatility ETFs have historically performed relatively well, in line with—if not better than—the broad market, at a lower risk level.
When the market is at normal volatility, we move money from diversified equities into low-volatility ETFs to protect as well as participate on the upside. When volatility becomes abnormal, we move the remainder of any equities portion into cash.
Q: How do you build your investment strategy and process around this philosophy?
A lot of our peers try to time the market, making them much more tactical. We do not try to time the market as much as simply protect assets. For every 2% decline in net asset value of the fund, we move a portion of the portfolio into protection. When the market has been trending up for a period of time, with little volatility, we could be 100% invested in equities to reap the net upside benefit. And for every 2% decline in net asset value of the portfolio, we start moving portions out of diversified equities into low volatility.
We use nine triggers, the first five of which are movements in different proportions into low volatility, followed by every 2% decline triggering a move of more and more of the equities portion into cash.
The way the triggers work is if the NAV of the portfolio goes down by 2%, we will move money from equities into the first line of protection, which is low volatility ETFs. If the market continues to go down (and therefore for every additional 2% drop in the NAV of the portfolio), we will continue to move into low volatility until the portfolio reaches a level of 50% low volatility and 50% diversified equities. If the market continues to decline after this, we will move the remaining equity exposure into cash. The most conservative the fund can be is 50% in low volatility ETFs and 50% in cash.
On the contrary, if the market starts to rise, we will wait 30 days before we reinvest back into diversified equities in order to allow the volatility to subside and to avoid whipsaws. We do not wait 30 days to move further into protection, however, so the moves into protection will be faster than the moves back into opportunistic or more aggressive equities. If the market moves up, the NAV of the portfolio will determine how much we move back from protection and into opportunistic equities.
We protect on the upside too. If the portfolio’s net asset value hits 2.5% higher than its historical highest net asset value, we will lock that inner step up to a protection level.
We do not try to analyze where we are in a market cycle. Instead, we base our activity on where the portfolio’s net asset value is. This strategy performs best when the market is trending fairly strongly, becoming more aggressive as the market goes up. When the market goes down, and continues to go down, it goes into protection mode.
The strategy is less effective when the market oscillates, when it moves sideways with smaller, choppier moves. We explain that to our investors. The strategy is meant to protect against significant market declines, not small ones.
Q: What is your research process and how do you look for opportunities?
As far as the research process, the rules of the fund are pretty cut and dry. We do not try to determine where we are in a market cycle or time the market. What we do is try to protect against any price declines using low-volatility ETFs and cash or cash equivalents. We look carefully at low-volatility ETFs and what they provide in terms of protection and whether they perform relatively in line with the broad market, although with lower risk attributes.
As far as how we select ETFs, we can be quite active in the portfolio. We look at those with adequate assets under management, those which have fairly liquid underlying holdings and reasonably attractive bid/ask spread ratios, so that if and when there occurs a 2% drop in the portfolio’s net asset value, we can trade them efficiently, in larger blocks.
There are a decent number of ETFs in the low-volatility universe, although not nearly as many as plain equity ETFs. We choose maybe three or so low-volatility ETFs where the underlying holdings are more liquid and with assets under management at a high enough margin for us to be investable.
In the more aggressive portion of the portfolio, we seek opportunistic ETFs, where there is a qualitative overlay within the different components of the diversified equity portion. For example, an area we find attractive is emerging markets, so that will be in the more opportunistic side of the portfolio vs. diversified equities.
We have a portion of larger cap U.S. ETFs, which are safer from a protection standpoint than small cap or emerging markets, but we also want to be opportunistic in areas like emerging and developed international markets. So there will be portions of the portfolio when we are 100% invested, or when we are invested in a diversified equity portion that can be allocated to these emerging markets, as well as other international developed markets like Japan and Europe.
We try to invest wherever we find the most attractive relative valuations. Some of those areas, like emerging markets, or Europe and Japan, still look attractively valued. We look at dividend yields and ratios like price to sell, price to book, price to cash flow and price to earnings. We look at the valuation for that broad region and compare it relatively to either the U.S. or the rest of the world.
We also look at the overall quality trend—return on equity and net profit margin. We can see a lot of those statistics at the ETF level. We also look at more qualitative aspects, the economic environment, what central banks are doing in these other countries, and what effect that may have on that particular region’s stock markets.
We have about 14 portfolio managers and analysts on the CLS investment team. We have created specialized research teams, including a domestic team and an international team, and we talk to these teams when we identify a region that we like, as they have more of a bottom-up view from an ETF perspective.
We also, as a team, agree on certain investment themes. We have been big proponents of the international markets. Almost all of our portfolios will tilt toward international markets, particularly emerging markets.
Q: How does your portfolio construction process work?
The mechanics of the way the Shelter Fund works drives our buy and sell decisions. If, for example, all of a sudden the market starts to drop and we are 100% invested in equities—that is, we occupy the most aggressive position we can have in the fund—we have to quickly shift holdings in the diversified equity portion into low volatility or protection.
We measure the risk of every single security that we own or could possibly own. When your investors seek a protection strategy, you want to sell the securities in the opportunistic bucket first, the ones that are a little bit more aggressive. So, we start by selling the securities we perceive as the riskiest, according to our risk budget score. The larger cap domestic equities likely won’t be sold until a few triggers down because they are generally less volatile.
If the market is rising, we take the opposite tack. Depending on what level of protection we are at and how much we have moved out of the diversified equities into low volatility, and perhaps cash, we reverse the order of what we’ve done when going back in.
The portfolio primarily consists of ETFs, eight to 10 of them. And when we invest in cash, we use cash as a proxy, so we may invest in cash equivalents like Treasury bills. Treasuries would be the only non-ETF holding in the portfolio.
As a mutual fund, we cannot have more than 25% invested in any single ETF and so we try to keep our maximum positions to about 20% to give ourselves a little bit of a buffer there.
Q: How do you define and manage risk?
This fund is predicated on risk protection, on protecting principal against downturns.
We use a proprietary risk budget score system that we use to assign a risk budget score to each and every security in our database, both those we own and those we might potentially own, and we continually monitor changes in those risk levels.
When a client first comes to CLS, they fill out a risk profile questionnaire from which we assign them their own personalized risk budget score. By investing our core portfolio in securities that are diversified, global, and balanced, we can customize a client’s investment to the specific risk level we have calculated they are willing to take on.
For example, if a client scores 70 as their risk budget, a risk tolerance score of 70%, we tailor a portfolio for them to their individual level of risk. No matter what happens in the market the risk of that portfolio will stay consistent: 70% of that of a broad equity portfolio.
Now, there will always be environments where risk budgeting outperforms protection, and others where protection outperforms, or adds to the client’s appreciation, more so than risk budgeting. If the client is interested in downside protection, we recommend protection be anywhere from 20% to 40% of overall allocation. We believe this diversification of risk technique is beneficial to such investors.
We consider ourselves risk allocators more than asset allocators, and pride ourselves on being risk experts. We monitor risk closely and, as a protection-oriented fund, risk management is naturally what drives our portfolio construction.
