Systematic Allocation Guided by Market Phase
AMG Chicago Equity Partners Balanced Fund
Patricia Halper, Michael Budd
Author: Ticker Magazine
Last Update: Apr 12, 1:53 PM EDT
|Stocks and bonds have their own volatility patterns and risk profiles, so it is important for investors to have allocation that provides downside protection, according to Patricia Halper and Michael Budd, portfolio managers of the AMG Chicago Equity Partners Balanced Fund. Investing in equity and fixed income, the fund strategically shifts its allocation depending on the environment with the help of a systematic process.
“We believe that we should take only the risks which we are compensated for.”
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.
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