Sunday, 1 February 2015
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Jul 15 2013 | 7:12am ET
Here's the essence of the investment approach behind the Convergence Core Plus fund, a dynamic long/short quantitative equity mutual fund: “It's important to get in the right pond before you start fishing.”
“Most quant firms do a 30-year back test and find a combination of factors that come up with a good risk return profile and then they implement that,” David Schulz, president of Convergence Investment Partners, told FINalternatives during a recent phone interview.
“What we do is, we measure how investor preferences shift through the investment cycle and then the model actually changes, so the weights of the drivers of stock prices change in the model every single month.”
The approach, which Schulz and his partners have been running since 2005, seems to be working: the Core Plus Fund, launched in 2009, has a five-star Morningstar rating and a trailing three-year ranking in the Large Blend Category in the top 2%. Its institutional class shares are up 4.55% in May, 16.56% year to date and 18.09% since inception.
Three of CIP's four partners—Schulz, CIO David Abitz and technology director Todd Hanson—came from Milwaukee's M&I Investment Management, a $17 billion investment firm that is now part of BMO. A fourth partner, research head Jonathan Franklin, was at Fair Isaac.
They founded CIP in 2005 as a hedge fund. In 2008, the Montage Group bought into the firm and in 2009 they launched the Core Plus Fund for the “broader distribution and growth possibilities” of the mutual fund format. (CIP runs other strategies on a separate accounts basis, including an index-based tax efficient strategy, a fundamental index strategy and a dividend growth strategy.)
To illustrate the 'right pond' investment approach, Schulz offered an example:
“In 2011, 85% of managers lost to the market—that's small cap, large cap, value growth, hedge funds, you name it, everybody lost. But one area won: if you had bought large companies with consistent earnings, lots of cashflow, that paid dividends, you would have been up over 10% in 2011 and you know what? You didn't even have to buy the best dividend paying stocks, all you had to do was buy dividend paying stocks.”
“What our model focuses on is, given everything that's going on in the market today, let's measure first what the market says is important and then let's increase the weight to those characteristics within our model and then go hunt for, in effect, cheap stocks like everybody else does.”
CIP applies the same process to its active short book, which Schulz said is not just a hedge but a source of alpha:
“[I]n 2011, we actually made most of our incremental return through the short. In 2010 our shorts didn't give us extra return, in 2011 they gave us a lot of extra return, 2012 the long and the short contributed and the same is happening this year.
“What we have found is that the traditional model, whether it's the nine-box Morningstar approach or some derivation of that, it relies on managers to get all of their alpha through only one source, and that's stock picking. Well, if I can use my dynamic model to shift market cap, beta, risk on/risk off, pick up on all these fundamental tilts within the marketplace, I'm adding sources of alpha.
“In 2010, small caps beat large caps by a wide margin. [My] market cap was only $20 billion in 2010. I got a lot of advantage because I had a relatively low market cap to the overall market, it's another source of alpha. In 2011 my market cap was $104 billion, because large dividend paying stocks were winning. My market cap's actually fallen back to $66 billion now. The dynamic model says you can get alpha from all these different sources; the short is another source.”
CIP manages risk through a combination of risk controls and diversification.
“[W]e actually use this dynamic model to rank stocks in each of 24 industry groups and then we buy the top-ranked stocks in each of those industry groups,” said Schulz. “So we're always diversified, we have 135 or more names in our long at any one time and they're always in all the industry groups.”
“The short has anywhere from 80 to 100 names at any one time and they're all equal weighted, so they all represent a very small percentage because there's risks in shorting that you simply can't diversify away.
“We have found that if we can get the average return, as ranked by our model, of the top 10% of stocks, we're going to do very well. We don't need to own the one name, it's not the one name, it's the average of all of the top-ranking stocks.”
The Core Plus Fund's long book has turnover of about 100%, said Schulz, while the short book turns over a number of times a year.
“To make money shorting what you need to be able to do is not only identify a deteriorating situation but wait till the market recognizes it, then put your short position in place, get in late, get out early,” he said. “Shorting relies on the ability to leave something on the table. Unlike long positions, you can't get in and wait for six months because it can kill you.”
The Core Plus fund is in very liquid stocks, said Schulz, and the structure is very transparent, “[W]e're not worried about one super-secret name in the portfolio making the result, it's not built that way.” Moreover, he said, the strategy, which now manages $160 million—up from roughly $70 million a year ago—has huge capacity:
“We believe that it's scalable into several billion dollars because we're using the top 1,500 stocks in the Russell 3000 so it's all very liquid names. We have never used and will not use IPOs. On the short side, we don't use any hard-to-borrows, so we really, really emphasize liquidity, transparency, scalability.”
Asset flow has picked up significantly over the past nine months, said Schulz, and the Morningstar rating and the three-year track record are clearly positives.
“What it does is,” said Schulz, “it opens the door for people to take a look at it.”
Jan 23 2015 | 1:00pm ET
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