Q: What is the history and the objective of the fund?
AMG Chicago Equity Partners Balanced Fund was formed on January 2, 1997. Since 2000, Chicago Equity Partners, or CEP, manages the equity portion of the fund. In 2006, it started to manage the entire fund, including the fixed-income portion, and to determine the asset allocation. Affiliated Managers Group, or AMG, holds a 60% stake in CEP and advises the fund.
The objective of the Balanced Fund is to achieve strong total return, which is consistent with capital preservation and prudent investment risk.
Q: How is the fund different from its peers?
We differentiate ourselves in several ways. First, we have a team approach to fund management and we have an extremely experienced and stable investment team. The equity team consists of 12 members, who have worked together for 20 years on average. The six-member fixed-income team has worked together for 12 years on average. (All statistics are as of December 31, 2017, unless otherwise noted.)
Another differentiator is the management of the equity portion with a factor-based, quantitative method. The team utilizes three proprietary factor-based models and a dynamic approach to identify the top-ranked stocks, which are expected to outperform in the current market environment.
In fixed income, we build our portfolios with a view of the aggregate investment portfolio. We want the fixed-income sleeve to act like bonds. Through the bond allocation, we emphasize income, liquidity, safety, and risk diversification.
In the current environment, given the valuations in the credit space, the increase of leverage in corporate balance sheets and the relatively high positive correlation between credit and equities, we are overweight to U.S. Treasuries and government mortgage-backed securities. That probably is the most differentiating factor of our bond portfolio. Our bond portfolio has an average credit rating of AA, while many of our peers tend to emphasize exposure in BBB-rated or even lower quality companies for higher yield.
The separate equity and fixed-income teams and processes allow for each sleeve of the Fund to be independently more conservative or more aggressive depending on the market environment. Because of the various levers able to be pulled by each team, the Fund is tailored to the specific market environment – increasing its probability of outperformance. This is a key differentiator and competitive advantage for the Fund.
Q: How do you define your investment philosophy?
We believe that we should take only the risks, which we are compensated for. Of course, we have different approaches towards equity and fixed income, but we are always cognizant of the risk. We are not risk averse, but we know our skill and we apply that skill where we can get paid for taking that risk.
On the equity side, our philosophy is based on well-established financial and behavioral theory. We seek to generate alpha by exploring market inefficiencies through a very systematic and risk-controlled process. We believe that the U.S. and the global markets are close to being efficient, but they are not perfectly efficient. The best way to exploit the inefficiencies, generated through fundamental and behavioral biases, is through a systematic and research-intensive process.
With respect to fixed income, we believe the role of fixed income is to provide income, stability and to reduce overall portfolio risk, which we achieve through the three pillars of our process: sector allocation, security selection, and risk management.
Q: What factors determine your allocation to equities and fixed income?
Asset allocation, which is done by a committee, is the first step. I (Trish) am the head of the asset allocation committee, which includes the CIO of Fixed Income Curt Mitchell, the Head of Research Keith Gustafson, and the Head of Client Service James DeZellar.
We utilize quantitative and qualitative analysis. We start with our Market Phase Identification, or “MPI,” which is a model that looks at the current market environment and the securities we want to be allocated to. The output of our MPI model guides us whether to be overweight or underweight in equities.
We also consider qualitative measures like capital market trends and valuations. Macro data that are not explicitly included in that modeling, will be discussed at our meeting and then we will make a decision as a team.
Since 2006, when we started managing the fund in its entirety, we’ve made 13 deliberate asset allocation shifts. At year-end, we were at 65% equities and 35% fixed income. The process starts with a strategic allocation of 60/40, but we deviate around that depending on the environment.
Q: What is the investment process on the equity side?
On the equity side, the process combines three proprietary systematic factor-based models to construct the equity portfolio. First, our quantitative stock selection model ranks every stock across multiple factors. We look at valuations, different measures of quality, momentum and growth characteristics on the individual stock level through a systematic model.
We also utilize our MPI model to identify the current market environment. There are three market environments that we can be in - expansion, downturn, and rebound. Depending on where we are today, we determine how to structure the equity portfolio. Our research has shown in expansion a preference for momentum and growth factors, a tilt towards growth sectors, and neutrality on volatility. The goal of our MPI model is not to capture every short-term movement. We look for sustained market environments, where allocation and portfolio positioning can benefit.
We use our third proprietary model, the integrated risk model, to build the portfolio. We optimize the portfolio quarterly and the risk model gives us factor alignment with the quantitative stock selection. It helps us to provide targeted factor exposures and to control unintended bets. We are very deliberate in our factor exposures. We make sure that they are intended and our proprietary risk model provides that information.
Q: What is your process on the fixed-income side?
On the fixed-income side, we emphasize liquidity, safety and diversification in the portfolio. We start with sector allocation between the broad investment grade sectors. If we are very optimistic about the outlook for the credit space, we would overweight corporate bonds versus the benchmark. Alternatively, we would emphasize government bonds and that’s what we are doing in this environment.
The sector allocation is driven by a variety of macro-related factors, which include valuations, fundamentals, as well as sentiment and momentum, which is largely driven by the central bank policy. If you examine the history of interest rates and credit risk premiums, you’ll see that the willingness of the central bank to provide or withdraw liquidity has a significant impact on the sentiment and the risk-seeking behavior in the marketplace. So, our sector allocation depends on the broad view of how much risk we want.
In terms of security selection, our factor-based model looks at individual companies. We value and rank those names along with a consideration of valuations in the marketplace, because it is important to know what we are compensated for.
For example, the corporate bonds we hold in the portfolio are industry leaders with very large market capitalization, strong balance sheets, and high-quality ratings. We have a significant underweight to BBB-rated names, an area that many people favor late in the business cycle as they try to add yield. We take a countercyclical view and believe that is precisely the time to take risk down.
The last component, risk management, is built around identifying the tracking error of the portfolio relative to the benchmark. We gauge our exposures through a contribution to duration at the sector, quality, and issue-specific level. Our duration exposure is generally matched to the benchmark and we don’t make interest rate bets. We receive a daily report, which looks at all the different strategies, including the fixed-income sleeve of the Balanced Fund, and identifies precisely where we are positioned relative to the benchmark.
Q: Could you illustrate your process with several examples of holdings?
As factor-based investors, we don’t really go through stock examples, but I can illustrate from a sector standpoint. In an expansion phase, the stock portfolio has targeted exposure to momentum and growth factors. We have a preference for secular growth sectors, so we are overweight in discretionary and technology. During a downturn, there would be a preference for stable defensive value sectors, like staples and healthcare. And during a rebound, the preference would be for more cyclical value sectors.
Q: How do you select stocks in an environment of low or negative return?
In every environment, there is always something more attractive than something else. We identify the best versus the worst companies as we seek the best relative value. The model is built relative to super sectors. We look at every factor relative to the names within that super sector.
Since we are invested in equities in a negative return environment, we aim to be in the ones that go down the least. From a total return standpoint, they may be all trending down, but that’s where the structure of the fund comes in. In a negative return environment, we’ll be underweight in equities, so the conservative nature and the diversification from our fixed-income portfolio would really shine through.
In comparison to the large investment peer group (U.S. Fund Allocation – 50% to 70% Equity), the Fund’s downside capture ratio is ranked in the 98th percentile over the trailing 10-year period (for N shares). The standard deviation is ranked in the 98th percentile over the same period and is also one of the best in the group because of the structure of the fund. In a downturn, fixed income provides diversification and return and we manage to avoid unintended risk and to preserve capital.
Q: Is dividend a significant factor in your investment process?
It is one of many factors that we look at. Dividend yield is incorporated into our shareholder yield factor, which is one of the quality factors in our model. So, while dividend is considered, it is not a deciding factor.
Q: How do you identify better relative value on the fixed-income side? Could you give us some examples?
Let’s take the example of energy. We have been underweight in that area relative to our investment universe for several quarters. That trend emanated from the security selection model. Historically, we know that stock price volatility, leveraged earnings volatility and relative valuations are the key ingredients in providing information about our security selection.
Starting in 2015, the commodity price decline resulted in significant stock price volatility. Many of those companies are highly leveraged by design, while earnings were very volatile, and we chose to be underweight in that segment of the broad corporate universe.
The other example is our very low exposure in the BBB-rated area of the corporate market. From a valuation perspective, we recognize that risk premiums can vary over time. The BBB-rated segment is particularly expensive right now, so the risk/return and the relative value exposure are not very rewarding. It also has the highest volatility of any of the sectors of the investment grade corporate market.
Q: What other debt instruments do you invest in?
We are overweight the government sponsored mortgage-backed security sector. Historically, these securities represent a very good alternative to corporate bonds and can replace some of the yield that we give up by underweighting corporate bonds. However, they behaviorally correlate strongly with U.S. Treasuries and government bonds. That’s a high-quality income instrument that is one of the largest components of the Bloomberg Barclays US Aggregate Bond Index.
Q: Could you explain your portfolio construction process?
On the equity side, we optimize the portfolio quarterly. We use Axioma software as the shell for optimization, but the inputs are determined by our MPI model. The factors that we emphasize depend on the phase of the market. In the current expansion phase, we emphasize top-ranked stocks with exposure to momentum and growth.
The equity portfolio has an annual turnover of about 100 percent. We do maintain industry and sector constraints relative to the Russell 1000 index of about 5%, so there is an additional risk control in the construction process.
On the fixed-income side, our benchmark is the Bloomberg Barclays U.S. Aggregate Bond Index. We have a portfolio analytics system provided by Wilshire. Their Axiom product gives us a methodology for portfolio construction and risk management. The security selection is an optimized element of the process.
Q: How do you define and manage risk?
We define risk on the equity and fixed-income portion via tracking error. There is embedded risk of just being invested in equities. The structure of the fund can limit that risk through the varying exposure to fixed income. The strategic 60/40 asset allocation with deliberate deviation also helps to control the risk of the fund.
The tracking error is typically 3% to 5% on the equity side and closer to 1% in fixed income, relative to respective benchmarks. Historically, the tracking error for the trailing 10-year period has been about 2% for the entire fund relative to the 60/40 blend benchmark.
We are always thoughtful about risk and risk management is part of the process. Again, we are not risk-averse as a firm or as individual teams, but we are very cognizant of the risk we take. We have very strict constraints and sell disciplines. The overall risk profile of the fund over the last decade speaks for itself as its downside capture ratio and standard deviation are some of the best out there.
In terms of fixed income, the big risk contributors over time are interest rate risk, credit risk and liquidity risk. The period of 2007 and 2008 was one of the best performing times for our strategy, because we stuck with our conviction of taking risk when we believe we are compensated, but also focusing only on risks that are appropriate for this strategy.
Q: What lessons did you learn from the global financial crisis?
Markets don’t always go up and it is really important for investors to have a core allocation that provides downside protection. That’s what this fund does.
Equity returns are much more attractive than those of fixed income over time, but bond portfolios provide that downside protection. Fixed income accentuates the favorable return component and provides diversification. That’s why I believe investors should own it.
