Q: Would you describe the history and core mission of the fund?

The core mission of the U.S. Small Cap Equity Fund, which was launched on December 28, 1981, is to provide individual investors with long-term capital growth opportunities in the U.S. small-cap market segment using a unique multi-manager approach.

We believe that having multiple managers with their own investment philosophies and processes offers investors several benefits. On the risk side, we can diversify and provide a competitive level of excess returns, but do so at a lower level of tracking error relative to our benchmark, the Russell 2000 Index.

Another key differentiator is that we offer top-to-bottom exposure to the entire opportunity set of the Russell 2000 – from approximately $5-billion companies all the way down to micro-capitalization securities. Many peer funds with a single-manager philosophy underrepresent securities at the lower end of the index, perhaps due to capacity constraints or limited resources. 

Exposure to the full range of market capitalization represents a kind of luxury offered by our multi-manager approach. Some of the managers with assignments in the fund focus more on the bottom half of the index, where the pricing and informational inefficiencies can be extremely compelling and add significant value over the long term, while others lean toward the higher end of this range perhaps due to a quality tilt within their investment philosophy 

The fund was originally known as the Russell U.S. Small Cap Equity Fund, but effective March 1, 2017, the word “Russell” was removed from its name. Current assets under management are approximately $1.7 billion. Jon Eggins has been portfolio manager since 2011, and in 2015, I became co-manager after having been on Russell Investments’ small-cap manager research team since I joined the firm in 2005.

Q: How do you put the multi-manager strategy into practice?

We don’t use a “fund of funds” approach. The portfolio management team has separate accounts for all the external managers and for each of their sleeves, and we are responsible for the asset allocation and the strategic weight limits.

The long-term strategic weights for managers reflect their level of risk, how they contribute to the positioning we want for the total fund, and the level of correlation we expect between different pairs of managers. 

Because each manager is selected specifically to fulfill a unique role, we don’t expect too much overlap between managers or too much correlation among them. Were we to see an increasing correlation, we would discuss if it represents a great opportunity and if a concentration between the managers should persist. 

If, instead, we believe it’s a risk that doesn’t align with our preferred positioning, we may trim the allocation to one or both managers. In some cases, if we determine a manager no longer provides something complementary and differentiating to the fund in the long term that may drive a decision to remove them.

Our goal for portfolio construction is to express our primary belief that bottom-up stock selection by talented active managers is the most reliable and consistent source of excess return. We want this to be the key driver of risk and return in the fund. 

Beyond that, my co-manager and I make sure the direction and magnitude of other risk exposures – whether sector or industry misweights, or factor exposures – are purposeful and expected to add value.

Q: What is your manager selection process?

On the qualitative side, our research and portfolio management teams form and maintain relationships, so we get to know the external portfolio managers, analysts, traders, across the entire U.S. small cap money management community.  Our due diligence process includes face-to-face meetings, quarterly conference calls, and annual on-site visits regardless of where managers are in their excess-return cycle.

It’s important to be proactive in these relationships. We need to know immediately or in advance if someone is leaving a firm or retiring, if new analysts have been hired or new products introduced, and who the next generation of leaders may be.

We look for managers with a sustainable competitive advantage in their stock selection and portfolio construction processes, and focus on their research process, sell discipline, and how they make decisions within the team. In doing so, we develop a strong investment thesis and rationale for each – because when we hire someone, it’s meant to be for the long term. This is particularly important in small cap, because transitions or changing managers wholesale can be expensive from a transaction cost standpoint.

Quantitatively, our selection process is all about holding managers accountable. Before hiring anyone, we analyze their performance using a proprietary database. This gives us a view into their portfolio and decisions, so we can determine and monitor important metrics to ensure they are executing, and then assess the potential role they could play in a Russell Investments portfolio.

We go out of our way to identify early lifecycle managers for a number of reasons. Often, these are portfolio managers we met when they worked at a larger organization who since have gone on to start their own boutique firm with fairly conservative capacity targets. We think this is important to maintain investment flexibility in the small-cap space. Moreover, managers who are in the early lifecycle stage and building a business tend to be extremely motivated to generate excess returns to create a long-term track record. 

Our manager research team ranks managers, and based on their recommendations, we hire the best. Currently, the fund has nine managers who provide exposure across the style spectrum –from deep value all the way to high growth and momentum strategies. Most are fundamental bottom-up stock pickers, but we do have quantitative strategies that are used to enhance and refine our exposure to some of the factor tilts that we like embedded at the total fund level.

Q: How do you combine different managers to suit your needs?

When coming up with target weights, we combine managers by considering how each tilts toward the strategic beliefs which are most important to us. Only in doing so are we able to deliver the total package and the excess return pattern expected by our investors.

Russell Investments’ philosophy for equity investing isolates the impact of stock selection at the fund level, ensuring there isn’t a sector or factor risk that unintentionally impacts the whole outcome. As a result, stock selection is the most primary driver when combining managers. 

Beyond that, managers are paired in such a way as to take advantage the significant academic research Russell Investments has done into factor tilts that can add value and work in our favor over a market cycle. These include tilts toward value, momentum, quality, and low volatility. Within our opportunity set, we’ve found these factor tilts work even better as we move down toward micro-cap stocks.

Q: How do you monitor the performance of your managers?

Our separate accounts provide us with a lot of granularity and transparency. All the managers have their sleeves of the portfolio with a custodian bank, which uploads data into our system each day, giving us every manager’s holdings, trades, and performance. We always know what we own and how we are currently positioned, which allows us to make near-term decisions more easily. 

Each manager is analyzed in isolation, where we compare their history with our expectations and perhaps against a custom peer group. As portfolio managers, however, our larger role is to monitor and analyze how the work of managers in combination affects the overall fund, making sure their approaches are complementary. We look for gaps, blind spots, and potential areas where managers may be herding together toward one part of the market.

Asset allocation among managers is not equal-weighted and ranges between 5% and 14%. The micro-cap managers have the lowest weight because of the greater amount of risk involved, while the manager with the largest weight is one of the fund’s anchors. 

Tactically, we change short-term weights when we see cyclical opportunities, offering a source of incremental value for shareholders through our dynamic portfolio management. We expect managers to experience periods of underperformance and understand that excess returns are cyclical. But as long as our original thesis remains intact, we challenge ourselves to “buy low, sell high” by maintaining or adding capital to managers who are at low points in their excess return cycle.

Q: What does risk mean to you? How do you contain it in the portfolio?

Because the managers we select for assignments in the portfolio represent the biggest risk to the fund over time, they are at the center of our risk-management processes. The same due diligence that is exercised during their selection continues after they are hired.

During our quarterly conference calls and annual on-site visits with managers, the research team tries to anticipate whether anything has changed with the thesis, their excess return potential, or the role they are expected to play in the fund. Though this can culminate in a hire or fire decision, a more frequent outcome is a shorter-term change in a manager’s weight to ensure at the fund level that we are not taking risks we won’t be compensated for – typically, this revolves around sectors, industries, and factors.

Mitigating risk at the security level is outsourced, in a sense, to the managers – we let them do what they’re good at – although our ongoing due diligence involves talking to them about how they assess company-specific risk.

Many internal resources help us assess the different dimensions of risk at the portfolio level, including an internal team of economic and capital markets strategists. In weekly, monthly, and quarterly meetings, they share their views on the U.S. business cycle and how economic and policy developments may impact the equity market, as well as what their indicators suggest about valuations and investor sentiment. 

We take this into account, and together with what we hear from the managers about their opportunity sets, develop our forward-looking views. Ultimately, my co-manager and I assess both risks and opportunities in the U.S. small cap market, form a game plan for positioning, and determine whether the best way to get there is through changing manager weight or making a manager change.