A Managed Risk Approach to Equity Investing

Finance theory suggests investors taking higher risk should be compensated with higher returns. We completely agree. This is one reason why we are so passionate about our “Managed Risk Approach to Equities”. We believe investors are not being adequately or efficiently rewarded for bearing equity market risk. Our strategies take a different approach and investment view to maximize the risk/return trade-off. This knowledge, about investors not being compensated for bearing higher equity market risk, is not a recent trend or discovery. Academic research* has been publishing about it for decades. Our strategy is deeply rooted in and derived through academic research.

The strategy employs a multi-dimensional view to create a portfolio that by design seeks to provide more capital protection, consistent returns, and diversification with greater transparency over a full risk cycle. Some common characteristics of our strategy often include a high-dividend yield, a value orientation and a lower market cap or size compared to the market cap-weighted benchmarks. Due to our managed-risk approach to equity investing, we have experienced smaller drawdowns without sacrificing participation in up markets.

We managed the following strategies:

Investment Philosophy

Our philosophy is rooted in academic research and rigorous quantitative and fundamental financial analysis.

We believe markets do not stand alone, isolated from the world and the equity markets seldom stand still, but rather experience different economic, political and international cycles. While some cycles may vary in length and events differ in impact, we feel, for equity exposure, taking a lower volatile approach is merited.

We also believe publicly traded companies are global companies. Their revenue and sales, business plans, investment and ultimately success or failure is more correlated to global events than ever in history. Companies are unique in how each prepares, responds and survives the impact of world events and economic cycles.

We further believe taking a managed risk approach to equity investing provides many benefits to investors, including:

1 2 3
Our strategies are designed to provide smaller drawdowns during bear markets, and thus can more easily recover losses Our strategies are not constructed on the basis of market capitalization and tends to have less exposure to periodic bubbles Our strategies minimize market volatility allowing investors to gain better diversification of assets across asset classes and alternative investments
1
Our strategies are designed to provide smaller drawdowns during bear markets, and thus can more easily recover losses
2
Our strategies are not constructed on the basis of market capitalization and tends to have less exposure to periodic bubbles
3
Our strategies minimize market volatility allowing investors to gain better diversification of assets across asset classes and alternative investments
Implementation

If a picture is worth a thousand words, then an action is worth a thousand pictures. At SGI we follow a disciplined approach to guide our investment actions. Our strategies have four encompassing steps which start and ends with risk management.

Understanding Current Market Risk

We believe understanding the current market risk is crucial. Risks change daily, as such we analyze the current market on an ongoing basis. Our risk assessment analyzes and plots the efficient frontier and identifies the position along the curve where investing in equities may reward investors with the greatest return per unit of risk. This allows SGI to better understand what risks are present in the market and how those risks may affect equity portfolios. To perform these calculations and risk analysis, SGI utilizes an equity risk covariance matrix and cross correlations among all equities. Risk covariance and correlations seek to take advantage of the varying risks of equities and how these risks may enhance returns while lowering overall portfolio risk. In short, understanding the relationships between each company and the market enables SGI to take advantage of the opportunities to reduce risk and position our strategy on the efficient frontier.

Multi-Factor Alpha Model

We believe having a multi-factor dynamic, diversified and customized alpha model is key. We know there are many different definitions of alpha. To us, alpha is the active return of an equity security. To estimate future returns of an equity security is not trivial. There are many factors that contribute to equity returns and they may vary from security to security. We believe there are unique drivers for stocks and especially for defensive equity portfolios. Our alpha model diversifies among multiple factors that perform well, or successfully predict returns, across multiple economic and business cycles as well as across different industries and sectors. These factors may include valuation metrics, growth estimates, profitability, momentum and liquidity factors, risk factors, etc.

To consistently enhance our active return estimates, we constantly research our factors to ensure each has significant power to predict future returns and that we have adequate factor diversification. The goal in creating an alpha model is not to perfectly predict returns, this is NOT possible. The alpha model helps to ensure SGI takes advantage of the ‘steepness’ of the efficient frontier curve. By so doing, we feel we are able to create more optimized, alpha generating, portfolios.

Constraints & SRI Utilization

Constraints are optimal when they bring more diversification, protection and suitable exposure while maintaining a higher transfer coefficient and ultimately greater return. To this end, we have spent significant effort and gained invaluable experience enabling us to have created an optimal constraint process. Following our process we answer the hard questions, i.e., how many securities are optimal to manage risk? How much exposure is best in any one name, industry or sector of the market? Having answers to these types of questions empowers SGI to manage with clarity and enhanced perspective.

Sustainable, responsible and impact investing (SRI) is an investment discipline that considers environmental, social and corporate governance (ESG) criteria to generate long-term competitive financial returns and positive societal impact. SGI goes further with extensive socially responsible and governance investing restrictions. We do not invest in industry that are on SGI’s SRI/ESG restriction list, e.g., gambling, pornography, alcohol and tobacco. We believe being social stewards is part of our investment mission.

Fundamental Risk Overlay

We believe identifying downside risk catalysts are vital to protecting against portfolio drawdowns. Quantitative alpha and risk models cannot adequately capture all of the future drivers of expected returns and downside risks. For example, a risk model will not tell you that the CFO or chairman resigned for misconduct. Quantitative models must have a reality check.

Our risk overlay process ensures our optimized risk and return characteristics are fully capable of being implemented. We analyze the trading ability (average daily volume, percentage change, tick data, etc.) and alpha ability (traditional fundamental analysis focused on downside risks) of each stock we buy or sell. We feel this extra effort is unique and substantially helps manage risk throughout the investment process and minimize portfolio drawdowns. We further believe that embracing downside risk analysis and continued SRI/ESG analysis helps to manage risk and fulfill SGI’s fiduciary duties.

There is a difference between real world portfolio management and academic or paper portfolios. A strategy must be scalable, flexible and incorporate such difficulties. The ability to professionally manage equity portfolios can only be fully appreciated through real world experience. At SGI we have such expertise and value wisdom over knowledge to efficiently construct optimized low volatility portfolios that effectively seek to enhance portfolio returns by managing equity risk.

* Markowitz, H.M. (March 1952). “Portfolio Selection”. The Journal of Finance 7 (1): 77-91. doi:10.2307/2975974. JSTOR 2975974.
* Markowitz, H.M. (1959). Portfolio Selection: Efficient Diversification of Investments. New York: John Wiley & Sons. (reprinted by Yale University Press, 1970, ISBN 978-0-300-01372-6;  2nd ed. Basil Blackwell, 1991, ISBN 978-1-55786-108-5)
* Haugen and Heins (1975)
* Blitz and Van Vliet (2007)
* Baker, Bradley and Wurgler (2011)
* Clarke, De Silva, Thorley. December 15, 2006. Economics and Portfolio Strategy, Peter L. Bernstein, Inc. RSP database, 1968-2005.
* Black, Jensen, Scholes(1972) –stocks with high betas deliver low risk-adjusted returns
* Ang, Hodrick, Xing, Zhang (2006, 2009) -stocks with high idiosyncratic volatility have low returns
* Frazzini, Pedersen (2010) -low beta assets outperform high beta assets, across many asset classes
* Markowitz, H.M. (March 1952). “Portfolio Selection”. The Journal of Finance 7 (1): 77-91. doi:10.2307/2975974. JSTOR 2975974.
* Markowitz, H.M. (1959). Portfolio Selection: Efficient Diversification of Investments. New York: John Wiley & Sons. (reprinted by Yale University Press, 1970, ISBN 978-0-300-01372-6;  2nd ed. Basil Blackwell, 1991, ISBN 978-1-55786-108-5)
* Haugen and Heins (1975)
* Blitz and Van Vliet (2007)
* Baker, Bradley and Wurgler (2011) * Clarke, De Silva, Thorley. December 15, 2006. Economics and Portfolio Strategy, Peter L. Bernstein, Inc. RSP database, 1968-2005.
* Black, Jensen, Scholes(1972) –stocks with high betas deliver low risk-adjusted returns
* Ang, Hodrick, Xing, Zhang (2006, 2009) -stocks with high idiosyncratic volatility have low returns
* Frazzini, Pedersen (2010) -low beta assets outperform high beta assets, across many asset classes
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