HOW WE BUILD PORTFOLIOS
The ALTS Investment Process This paper was written by our Investment Team to help clients understand how we construct their portfolios.
How We Build Portfolios
How We Build Portfolios
The universe of mutual funds has grown drastically in recent years. Innovation in the financial services industry has spawned a new generation of mutual funds and fund managers. The most exciting part is that these funds exist to serve individual investors – their shareholders.
THE ALTS INVESTMENT PROCESS HOW IT WORKS Being a successful investor is one of life’s great challenges. The investment landscape is competitive, information moves quickly and finding value is tough. In The Indexing Myth, we discuss these challenges and explain why indexing (or passive, buy-andhold investing) is likely to be high-risk, low-return endeavor in the coming years.
Through our investment process, we strive to help investors discover and invest with the nation’s best active and alternative fund managers. Quarterly Investment Process
We believe investors are best served by adopting an active, disciplined investment process. Our mission is to help investors discover and invest with the nation’s best active and alternative fund managers. This paper explains how we do it.
INTRODUCTION Today, U.S. investors have access to over 24,000 mutual funds. There are also exchange-traded funds (ETFs), individual securities, hedge funds and many other investment vehicles to choose from. The investment choices are almost limitless. Morningstar classifies the mutual fund universe into over 100 categories. There are, of course, US and international stock and sector funds. There are domestic and foreign bond funds. There are alternative funds, market neutral funds managed futures funds and currency funds. There are even funds that invest in real estate, limited partnerships, natural resources – even managed futures funds. And every year, money managers are offering new and interesting investment strategies in a mutual fund structure.
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How We Build Portfolios
Our investment process begins with Morningstar Direct – a global investment analysis platform that combines all of Morningstar’s data and institutional research, private and third-party content, rigorous analytics, and portfolio construction tools. Our investment process ends with your portfolio, where our goal is to keep the nation’s best active and alternative investment managers working for you. Not only do we select managers for your portfolio, we monitor them, adjust asset allocations and replace managers when they underperform or when we identify a superior fund.
DISCOVERING TALENTED MANAGERS We have been in the active and alternative investment business since 1989 when our founder, Roger Schreiner, was among the nation’s first investment advisory firms to bring active investing to the retail investor. Back then, computers were new to the financial industry. Today, everything is done electronically and investing has become accessible to everyone. At the same time, the number of investment options has grown at an amazing rate. Finding talented managers is difficult. With thousands of choices across a wide range of investment styles and asset classes, it’s very hard for individual investors and even most professional advisors to find truly talented fund managers. Using software to identify the best managers isn’t new, but we are the first American company to offer our services online. Our investment process has two components: quantitative analysis and qualitative analysis. We study both historical data (quantitative analysis) and non-quantifiable information (qualitative analysis), such as philosophy, expertise and strength of research.
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QUANTITATIVE ANALYSI S Step 1: Classify We begin by removing all passively managed funds from the universe. We also remove all, so called, “closet indexers.” Closet indexers are fund managers that say they’re active, but are not – they perform almost exactly the same as a passively managed fund or index. Closet indexers, like passively managed funds, have no real investment process besides mimicking an index. They have no real risk-management technique and they don’t seek to outperform their benchmark. Certainly, they have no plan to address market volatility or preserve your assets during bear markets. The sole objective of an index fund is to mimic its benchmark. After removing all of the passively managed funds and closet indexers, we begin the work of finding active and alternative funds that provide real value. For most clients, we recommend a diversified mix of both relative return funds and absolute return funds. This step in our investment process splits the remaining funds into these two categories: relative return and absolute return. Relative returns are highly correlated with a particular index or sector. For example, a fund that invests in domestic large cap stocks will probably have returns that are highly correlated with the S&P 500 Index, meaning the fund will tend to move in a similar direction as the index.
Relative Return Illustration
How We Build Portfolios
Absolute returns, on the other hand, are not correlated with a particular index or sector. You might say that these funds march to the beat of a different drummer – their own. The direction of the market indices has little or no influence on the returns of a fund that seeks absolute returns.
Absolute Return Illustration
transaction costs, loads and short-term trading fees, and liquidity. While we don’t have a strict threshold for a fund’s expense ratio, we consider it in our final analysis. We believe that funds should not be eliminated based on expenses alone because certain expenses may be justified either by exceptional performance or for industry specific reasons. For example, funds that invest in limited partnerships often have higher internal costs. Screening is a popular technique used by advisors who search large investment databases, however, we believe screening is often misused. By definition, screening is a blunt instrument because it eliminates potential candidates entirely, usually on a single factor. Screens are more appropriately applied to categories and classifications.
Generally speaking, absolute return funds seek ongoing positive returns regardless of the performance of traditional asset classes. Many alternative funds invest in asset classes other than stocks and bonds, such as hedge funds, managed futures, commodities, currencies or real estate and/or they may employ dynamic investment strategies such as long/short strategies, market neutral or arbitrage strategies. Absolute return funds are a growing segment of the investment marketplace. In constructing our clients’ portfolios we believe that blending active and alternative, relative and absolute return funds may achieve a level of diversification that is superior to traditional stock and bond portfolios. Blending these investment styles may also reduce volatility and enhance returns.
We screen on factors such as fund type, investment objective, asset class, or manager tenure, but we never screen on performance or risk. When measuring performance and risk, using factors such as return, standard deviation, correlation, alpha, beta, etc. we avoid drawing a line in the sand, especially in the early stages of our research. Risk and returns measures should be given full reign, since even the best funds may have low scores in one or more areas for a given time period. No fund is perfect, but the best funds tend to display consistency in a variety of market conditions, which is what we’re looking for.
Step 3: Analyze
Step 2: Screen
After our database has been classified and screened, we collect and analyze thousands of data points on the remaining funds.
After our database is classified into relative and absolute return funds, we begin our screening process. We seek funds with a minimum of five years of past performance and longer track records are preferred. We also screen funds based on
The saying, “past performance is not indicative of future results,” suggests that predicting future performance from looking only at historical results is not a very good idea. We agree.
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How We Build Portfolios
There is still a lot we can learn from analyzing historical track records. For example, we know that risk and correlation measurements tend to be more persistent and reliable than return data, meaning that funds’ risk and correlation tends to persist more than performance. We also believe that funds that perform poorly tend to be persistent, meaning that they often continue to perform relatively poorly. In this step, we analyze the remaining universe of funds based on historical data spanning several market cycles. Some of the factors we analyze include:
Risk & Return Data
▪ Active Share
▪ Information Ratio
▪ Alpha
▪ Kurtosis
▪ Appraisal Ratio
▪ Max Drawdown
▪ Batting Average
▪ Morningstar Return
▪ Beta
▪ Morningstar Risk
▪ Bull Beta
▪ Omega
▪ Bear Beta
▪ Relative Risk
▪ Correlation
▪ Total Return
▪ Bull Correlation
▪ Annualized Return
Step 4: Rank We have discovered what we believe is a very powerful technique to rank mutual funds: The Reynolds Technique. Osborne Reynolds was a 19th century English physicist and engineer who studied turbulence in fluid mechanics. In 1893 Reynolds experimented with conduits of varying dimensions, and developed a unique scoring method that could tell him when fluid systems reach turbulence. Selecting mutual funds may not have much in common with monitoring fluid systems, however, Mr. Reynold’s created a mathematical process that allows us to combine multiple factors into a single rank. It’s a very simple process that works by using number relationships rather than absolute cut-offs like those used in screening. We believe The Reynolds Technique is superior to traditional screening methods because it uses a process of weighting data rather than drawing a bunch of arbitrary lines in the sand. In the end, our software constructs a more complete picture of the mutual fund universe, allowing us to conduct more nuanced analysis of the funds within. After ranking funds with The Reynolds Technique, our software has reduced the fund universe dramatically – down to a few hundred funds. Next we are prepared to analyze individual funds more closely through the last and most detailed level of analysis, peer comparisons.
Step 5: Compare ▪ Bear Correlation
▪ R-Squared
▪ Downside/Upside
▪ Sharpe Ratio
▪ Capture Ratios
▪ Sortino Ratio
▪ Excess Return
▪ Standard Deviation
▪ Gain/Loss Ratio
▪ Tracking Error Devation
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Now that we have a manageable list of candidates, we are ready to compare the funds by evaluating them against their peers. Our analysis is done over rolling periods rather than specific data points. For example, instead of measuring volatility or correlation for a calendar year or calendar quarter, we look at 3-, 6-, and 12month periods, regardless of where they fall on the calendar.
How We Build Portfolios
Peer Comparison Assessments
example above, the manager had positive efficiency over 90% of the time over a period of about three years.
▪ Cumulative Drawdown
▪ Reynolds Ranking
At this stage in our analysis, we have identified what we believe are the highest-quality funds. Even though most of these funds have strong performance records, it’s nearly impossible for any single fund to remains in the top quartile consistently. This is due to changing market conditions and the competitive nature of the mutual funds – especially among the most successful fund managers.
High efficiency
▪ Relative Range Position
Low Efficiency
▪ Relative Efficiency
ROLLING EFFICIENCY RATIO
Points above the zero line indicate that a manager’s efficiency ratio is positive. Efficiency cycles up and down, but we have found that the best funds spend the majority of time above the zero line. In the example above, the manager had positive efficiency over 90% of the time over a period of about three years.
The good news is that the best managers are consistent enough over time and tend to outperform their peers and passively managed funds. The key is identifying consistency, not just good recent performance.
First, for each top-ranked fund, we calculate its 3month (60-day) efficiency ratio. The graph below is an example of a top-ranked fund. Points above the zero line indicate that a manager’s efficiency ratio is positive. Efficiency cycles up and down, but we have found that the best funds spend the majority of time above the zero line. In the
High Rank
The key element of our investment process is measuring a manager’s efficiency. Simply put, efficiency is the relative smoothness (or bumpiness) of reaching your investment objective.
EFFICIENCY COMPARISON VS. PEERS
Low Rank
We’re not just looking at a few data points on the far right side of a chart. Our software measures hundreds of rolling-periods and thousands of data points. Collectively, these measures tell a story about the consistency of a manager’s investment process.
To test managers’ efficiency ratios against their peers, our software compares each individual manager to the peer group. The chart below is an example of what this analysis looks like.
Each point on the graph represents the manager’s ranking relative to a peer group of 30 managers. In this example, the graph covers a time period of about
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How We Build Portfolios
three years. The bar-length represents the number of times a manager’s efficiency ranked at that level. Taller bars means it happen more often, shorter bars less frequently. Next, our software accumulates the relative rankings of each manager in the peer group. The histographs below show how frequently a given manager ranks at the various efficiency levels, from best (left side of the graph) to worst (right side). These graphs are examples of two funds from the same peer group.
Manager “A” Cumulative Efficiency Rank
NUMBER OF TIMES RANKED BEST TO WORST VS. PEERS
Although both funds spent some time at and near the top of the efficiency rankings, manager “B” spent far more time near the top than manager “A.” Even the best funds experience underperformance, resulting in poor efficiency rankings. However, over time, the best funds show more overall efficiency. The final step in our quantitative analysis is putting our selected funds in correlation matrix. This step is critical because we want funds that are providing unique streams of risk-adjusted returns. Investing in funds that are similar doesn’t provide diversification. And investing in index funds or passively managed funds that move in lock-step with a benchmark doesn’t add value either. We do three year rolling-correlations on various sets of funds in an attempt to find complementary relationships between our actively managed funds. When applied diligently, these lower-correlated funds may provide attractive returns in a diversified portfolio with less risk (lower volatility).
QUALITATIVE ANALYSIS The 3 “P”s – People, Process & Philosophy High Ranking
Low Ranking
Manager “B” Cumulative Efficiency Rank
NUMBER OF TIMES RANKED BEST TO WORST VS. PEERS
High Ranking
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Low Ranking
Investment success depends on many things, but we believe a solid foundation of people, process and philosophy are essential for strong performance over the long run. Even in today’s tech-dominated world, people drive performance. People are behind everything that happens at every level within an organization from management to operations and, most importantly, the investment team. The quality and depth of their expertise is critical because it takes a high degree of knowledge and discipline to succeed in investing. Cooperation – everyone rowing in the same direction – is what helps teams navigate a dynamic, ever-changing marketplace. Successful investors and fund managers are processoriented, not results oriented. They understand that just because a particular outcome yielded a positive result, it does not mean their decision was the right
How We Build Portfolios
one. Likewise, they know that a bad outcome doesn’t necessarily mean they made a bad decision. The investor who focuses only on decision-making is wise and the investor who focuses exclusively on results is a fool. Since investing in stocks and bonds involves randomness and probabilities – not unlike gambling – to focus on outcomes is a fundamental mistake. An investment philosophy defines how a manager extracts returns from the asset market. Anyone can buy an index fund and their investments will rise and fall with the market. They’ll experience all of the gains and all of the losses and end up with whatever the market or asset class returns over time. Being an average investor isn’t appealing to us – especially going forward because average returns are expected to be low or negative over the coming decade. Therefore, our investment team works to identify managers who have a philosophy that seeks to provide superior risk-adjusted returns to shareholders. In other words, in order to be selected for our clients’ portfolios, the manager must demonstrate that he has an “exploitable edge” in the marketplace – and that it has worked effectively over time.
Manager Due Diligence Checklist Summary
Qualitative Manager Due Diligence Our manager due diligence process is summarized below and completed by our Investment Team. This list is not exhaustive because it does not include the many specific inquiries that may be unique to individual funds.
YOUR CUSTOM PORTFOLI O In order to build your custom portfolio, we need your risk profile – information about your investment objectives, risk tolerance and investment time horizon. Providing us with this information is easy. On our website, click “Invest Now,” which will launch a risk profile questionnaire. It only takes about five minutes to complete. After you click submit, our Investment Team will send you a proposal, complete with all of the funds, their weightings and detailed information on each of the managers we recommend for your portfolio. If you have questions or thoughts you want to share with us, you can speak with an Advisor directly or connect with him/her via email, chat or social media. When you’re ready to invest, the proposal contains a link – just click and fill in the online account set-up form. The entire process takes less than 20 minutes for most clients and is done entirely online.
▪ Investment & Management Teams
▪ Fees analysis
▪ Investment process
▪ Top ten holdings & position size review
▪ Investment philosophy
▪ Marketing materials review
▪ Compliance & risk control
▪ Market commentary & media report review
▪ How the fund fits in portfolios
▪ Percentage of manager’s own wealth in fund*
▪ Prospectus review
▪ Manager’s performance incentive compensation*
▪ Regulatory filings & litigation review
*If information is publically available.
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How We Build Portfolios
Manager Selection Your risk profile is matched with a specific blend of the best active and/or alternative funds that have been identified by our investment process. Your custom portfolio is designed to meet your specific investment goals within your profile. When choosing managers, we do not discriminate among fund families. We have the ability in invest in almost any mutual fund. We are just as likely to use Vanguard as we are to use Fidelity or a less familiar name. We are completely independent. We have no broker-dealer affiliation. We prefer funds with no-loads and no-transaction fees so that we can reduce investment expenses for our clients. We are compensated in only one way – through the low management fees paid by our clients.
For most clients, we recommend benchmarking their portfolio to a blend of these two indexes. The blend could be as much 90% of the MSCI Index and 10% IQ Hedge Multi-Strategy Index or vice versa, depending on your investment profile. The goal of your portfolio is to outperform your benchmark with less volatility.
Client Services We pride ourselves in creating the ultimate client experience. You will receive exceptional client service for one low fee. Our services include: • Portfolio Construction – Have the nation’s best active and alternative managers in your portfolio. • Portfolio Monitoring – We monitor your investments and make changes so you don’t have to.
Benchmarking To measure the performance of your portfolio, it’s important to select a relevant benchmark. For most of our clients, we recommend a blend of relative and absolute return benchmarks.
• Monthly Statements - Receive monthly account statements from the custodian, Fidelity Investments. • Performance Reporting - Track your progress with quarterly performance delivered to your email.
For example, for relative return benchmarking, we commonly recommend the MSCI ACWI (AllCountry World Index).
• Web and Mobile App - View positions, values, download statements/reports and connect with us.
This index tracks the investment results of approximately 14,000 large and mid-capitalization developed and emerging market equities across 23 developed market and 23 emerging market economies. With almost 2,500 constituents, the index covers approximately 85% of the global investable equity opportunity set. We believe the MSCI ACWI is a good representation of the global stock market.
• Automated Billing - Advisory fees are deducted automatically from your investment account.
For absolute return benchmarking, we commonly recommend the IQ Hedge Multi-Strategy Index. The Index attempts to replicate the risk-adjusted return characteristics of hedge funds using various alternative investment styles, including long/short equity, global macro, market neutral, event-driven, fixed income arbitrage and emerging markets.
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• Tax Reporting – Access your tax reports quickly.
• Personal Service - You have a licensed advisor and dedicated client service rep. • Great Communication - We work by email, phone, text, video chat – whatever you like.
WE BELIEVE IN ACTIVE INVESTING. LEARN WHY… ► GO TO ALTSINVEST.COM AND IIIIREAD OUR WHITE PAPER, “THE IIIIINDEXING MYTH”
Schreiner Capital Management, Inc. (“SCM”) is an SEC registered investment adviser with its principal place of business in the Commonwealth of Pennsylvania. SCM and its representatives are in compliance with the current registration requirements imposed upon registered investment advisers by those states in which SCM maintains clients. SCM may only transact business in those states in which it is registered, or qualifies for an exemption or exclusion from registration requirements. Any subsequent, direct communication by SCM with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For information pertaining to the registration status of SCM, please contact SCM or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about SCM including fees and services, send for our disclosure statement as set forth on Form ADV from SCM using the contact information herein. Please read the disclosure statement carefully before investing. “How We Build Portfolios” discusses general developments, financial events in the news and broad investment principles. It is limited to the dissemination of general information pertaining to SCM’s investment advisory/management services, is not suitable for everyone, and should not be construed as personalized investment advice or a solicitation or an offer or recommendation to buy or sell a security. The statements and opinions contained herein are solely those of SCM. SCM does not make any representations as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party incorporated herein, and takes no responsibility therefore. All such information is provided solely for convenience purposes only. There is no agreement or understanding that SCM will provide individual advice to any investor or advisor client in receipt of this document. Certain information constitutes “forward-looking statements” and due to various risks and uncertainties, actual events or results may vary materially from those reflected or contemplated in such forward looking statements. Investing in the stock market involves gains and losses. Past performance is no guarantee of future results. Any reference to a market index is included for illustrative purposes only, as it is not possible to directly invest in an index. Indices are unmanaged, hypothetical vehicles that serve as market indicators and do not account for the deduction of management fees or transaction costs generally associated with investable products, which otherwise have the effect of reducing the performance of an actual investment portfolio.
The information contained herein contains general information that is not suitable for everyone and should not be construed as personalized investment advice. Investing in the stock market involves gains and losses and may not be suitable for all investors. Past performance is no guarantee of future results.
©2014 Schreiner Capital Management, Inc. (SCM) All Rights Reserved. The ALTS Investor Program is an investment wrap program sponsored by SCM. For more information, visit www.altsinvest.com or www.scminvest.com.
