Q: What is the history of the fund and what sets it apart?

The fund has been around for 15 years, since 2001, and during that time the investment approach and senior management team have been stable, with just the occasional change in portfolio manager or analyst. The investment strategy has evolved somewhat since the beginning, but not markedly. In fact, we manage one third of the firm’s entire equity assets in the precise way that we manage this fund. 

The firm has about $20 billion in total assets, with about $4.5 billion of that in equity investments. This fund’s current assets are roughly $80 million. 

A key difference is our integration of alpha and tax management—we don’t simply overlay tax management onto an existing investment process. In terms of our investment approach, we use our own proprietary factors in addition to enhanced versions of traditional factors such as value, and momentum, in order to boost performance and remove unrewarded risk.

First Quadrant has a long history in tax-managed equity, and we are recognized as a thought leader in this area. The track record of this fund shows we have been successful at putting into practice the principles we have long been recommending.

Q: How would you describe your investment strategy?

The market rewards companies that exhibit particular fundamental characteristics. Our alpha focus is to divide such characteristics, or factors, into the following five categories:

- Corporate policy
- Profitable growth
- Momentum/sentiment
- Value
- Earnings quality

Two less well-known characteristics are corporate policy—the decisions a company makes on issues like capital allocation, fiscal conservatism, efficiency, and use of corporate resources like labor and capital—and profitable growth. 

Growth is typically gauged by the market in terms of earnings expectations. We do not look for stocks that have already been identified by the investment community as top future growers. These are ‘glamour’ stocks, where the good news is already in the price. We prefer companies with solid historical growth as assessed across a broad set of measures, generating profitability with reasonable margins and sales growth; the companies that fall below the radar but are attractive to us based on the weighted average of our five measures.

While the value and momentum factors are well-known, we believe they will continue to generate attractive returns. Moreover, we have enhanced them by removing unrewarded risks and thereby improved their robustness.

We rank every stock in the universe on each of the five factors individually. Next, we compute the weighted average rank across all of the five factors to come up with the overall rank for each stock. We repeat this process every day. Most days there aren’t big changes to the rankings, but when there is significant new information such as the release of quarterly earnings, we can respond rapidly. 

In terms of tax management, we have several key techniques. The first is to maximize deferring the realization of capital gains. If a stock has considerable capital gains, we avoid selling it, if possible, unless it has become unattractive. A second form of tax management is to continuously look for losses in the portfolio, which we can then use to offset any gains. 

Another tax management strategy is to reduce the dividend yield while maintaining the total return and without distorting the portfolio’s composition. Dividend yield is a silent killer in the tax industry. 

An additional way to reduce the tax bite is to manage individual tax lots. When you build a position in a company over a period of time, you are naturally buying at different price points or tax lots. When we start liquidating a position over time, we manage tax losses by selling the tax lots with the highest cost basis first, to limit taxable capital gains.

On one side we have the alpha process that ranks securities. On the other side, the tax process operates simultaneously. While there is always a degree of uncertainty concerning expectations for stock performance, the tax consequences are generally concrete. Therefore, we weigh the uncertainty of future performance against the certainty of the tax consequences.

Q: Should investors be interested in tax-managed strategies?

Absolutely. To begin with, tax rates have been historically much higher on both capital gains and dividends, with higher rates on dividends than long-term gains, before bottoming under President George W. Bush. At that point, investors stopped focusing as much on taxes because they were perceived to be relatively low. That’s a mistake for two reasons. One, there is still the 20%-plus tax that a tax-efficient strategy can reduce in a way that’s worthwhile for the investor; and, two, tax rates are starting to rise. And there are good reasons to think they’ll continue to rise.

One reason is that following the financial crisis federal debt ballooned. The government borrowed heavily and in order to pay off that debt and continue to provide all of the services and revenues that people expect, like Social Security and Medicare, the only likely solution is to raise tax rates. And when rates rise, it invariably makes investors more tax-conscious.

Right now, many investors do not focus much on the after-tax side of performance. But if you care about what your after-tax income will be, after-tax performance is important. A tax-managed strategy, if correctly executed, always focuses on after-tax performance. That is what drives the investment operations in this fund, not pre-tax performance. Again, total return expectations are uncertain; tax consequences are relatively predictable.

Now, there are investors who think that investing in an index fund is effective tax management. But while an index fund is more tax efficient than most funds that are actively managed but not designed to be tax-efficient, it still lacks two key ingredients that our tax-managed strategy offers. One is a reduction in dividend yield while maintaining total return. The second is that an index fund doesn’t harvest losses, which is a proven way of enhancing after-tax returns.

Many funds have reaped substantial capital gains following the rally that occurred in the aftermath of the financial crisis, starting around April 2009, but the market has begun to level off and correct. Now, as funds generate turnover, they will start to realize substantial capital gains, and so taxable distributions from mutual funds and the resulting tax consequence will shed greater light on the importance of tax management.

Q: How do you conduct your research process?

The research process is focused on two main areas: developing proprietary factors and enhancing traditional factors. With respect to proprietary factors, the starting point is a hypothesis, or underlying economic rationale, as to why a particular company characteristic should be rewarded by the market. The next step is rigorous research. We want to see if the factor has added value consistently over time, and for the reasons that we expect. 

A new factor has to overcome several high hurdles before it can be added to the investment process. The payoff from developing proprietary factors is also high: more robust alpha than traditional factors and with better diversifying properties.

The second main area of research is to improve traditional factors. We enhance traditional factors by improving their robustness and removing unrewarded risks. (Traditional factors already have a reasonably well-understood rationale – one of the reasons we call them traditional.) Once again, we conduct extensive research to ensure that any enhancements have consistent performance benefits.

We take great care to avoid data mining—we do not let data drive the process, as such results can be deceptive. Instead, we start with the hypothesis and then follow that with research. We believe that a fundamentally based, systematic, and adaptive investment process generates steady and differentiated returns. And ours is a highly experienced team in this particular type of investment management. 

Q: How do you construct your portfolio?

We start off buying the highly ranked stocks and then, over time, when any of our highly ranked stocks drop out of the top decile of our rankings, it becomes a matter of not simply finding better companies but weighing the tax consequences of making such a switch. We also take into consideration the expected costs of trading.

An example will show how the research process drives portfolio construction. Delta Airlines is an overweight position in the portfolio (as of Oct 30) because it scores well on most of the characteristics we believe are important for superior returns. It has strong scores on momentum/sentiment and our profitable growth measure. It is in the top decile on corporate policy, our measure of capital allocation, fiscal conservatism and efficient use of corporate resources. Finally, it is also attractive on a valuation basis. It scores less well on earnings quality, but the positive characteristics far outweigh the negative, hence the sizable holding.

The portfolio is always well-diversified, with about 150 stocks, and without any particularly large sector bets or individual industry bets. We manage relative to our benchmark, the Russell 3000 Index. 

We have limits on all our exposures. We take positions of plus or minus 4% on industries. Sectors are more tightly constrained, about plus or minus 1%, and we manage individual assets at roughly plus or minus 2%. Our current turnover is around 50%.

Q: What triggers your buy and sell decisions?

The same process we use for portfolio construction also drives our buy and sell disciplines. We tend to buy the high-ranking securities and sell the low-ranking securities. When a high-ranking company has left the top decile, it is an indication that we should start to view it as a candidate for replacement, while balancing the tax consequences of such a sale. 

For example, if a company whose rank has slipped from the top decile down a few notches failed to perform well, that’s an easy decision—we would just sell it, harvest the loss, and replace it with something that we like better. But if selling a company would generate a substantial capital gain, then it’s a more complex decision. We would probably wait until it drops a bit further in the ranking before we would consider selling it. 

Q: How do you view and manage risk?

Risk is managed at several levels, and the management of risk is thoroughly integrated into the investment process. First, in the way we put together the individual alpha factors, we seek to reduce downside risk. Next, we have deliberately selected a diversifying set of factors in order to provide steady returns and reduce risk.

As mentioned in the section on portfolio construction, we limit concentrations in sectors, industries and individual stocks so as to ensure the portfolio is well diversified. A further layer of risk management is that we limit expected tracking error to 3% to 4%