Market Volatility & SGA s Active Returns By Pat Holway, CFA, CAIA, CIC & Steve Skatrud, CFA Client Portfolio Managers

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1 Market Volatility & SGA s Active Returns By Pat Holway, CFA, CAIA, CIC & Steve Skatrud, CFA Client Portfolio Managers Global equity markets have recently experienced extreme volatility unlike anything seen since As of the close of the U.S. markets on Monday August 24 th, 2015: - The VIX had spiked to over 40, a three-fold increase from just two weeks prior and a level it had not seen since August The primary benchmarks for SGA s U.S. and Global equity portfolios, the Russell 1000 Growth Index and MSCI ACWI, had both officially entered 10% correction territory after three torrid days of selling. As of the market close on August 24 th the Russell 1000 Growth Index had declined 9.1% over the previous three trading sessions and stood 11.2% below its closing high reached under a month earlier on July 20 th. Over the same period the MSCI ACWI declined 7.9% to extend its decline from its prior May 21 st high to -13.6%. While we understand the fact that such volatility can be unsettling for clients and shareholders, it is at times like these that our investment approach has historically demonstrated its merits most. Since the inception of SGA s U.S. Large Cap Growth composite in April 2000, the Russell 1000 Growth Index has delivered negative monthly returns on 83 occasions, during which SGA outperformed 56 times, a batting average 1 of 67%. In positive months for the index our batting average has been roughly half that, as we have outperformed in 34 of the 100 months when the Russell 1000 Growth Index delivered a positive return. We would be remiss however if we gave the impression that our portfolios are only capable of outperforming in negative market environments. In 2009 our U.S. portfolio gained 46.2% versus a 37.2% return for the Russell 1000 Growth, and in 2012 both our U.S. and Global portfolios outperformed their primary benchmarks despite index returns that exceeded 15%. Our global portfolio has provided a higher capture rate in positive markets since inception, beating the ACWI in 16 of 30 months when the index was positive, for a batting average of 53%. Relative performance in declining markets is even stronger, as we have outperformed on 16 of 23 occasions when the ACWI was negative for a batting average of 70% in declining markets. These results are summarized in the tables below along with since inception annualized excess returns, standard deviation, and peer ranks for each portfolio: SGA U.S. LCG Monthly Performance Versus Russell 1000 Growth SGA Global Monthly Performance Versus MSCI ACWI Down Markets Up Markets All Markets Down Markets Up Markets All Markets SGA Outperforms 56/83 34/100 90/183 SGA Outperforms 16/23 16/30 32/53 SGA Underperforms 27/83 66/100 93/183 SGA Underperforms 7/23 14/30 21/53 Batting Average 67% 34% 49% Batting Average 70% 53% 60% SGA U.S. LCG Since Inception Annualized Results SGA Global Since Inception Annualized Results Excess Return (Peer Rank) 4.1% (13th) Excess Return (Peer Rank) 3.2% (18th) Standard Deviation (Peer Rank) 15.4% (10th) Standard Deviation (Peer Rank) 12.8% (47th) Source: PSN Informa Investment Solutions database. Based on gross of fee monthly returns as 6/30/2015. SGA U.S. LCG composite inception is 3/31/2000. SGA Global Composite Inception is 1/31/2011. It should not be assumed that future results will be reflective of past performance. Our historical experience has been that our strategy serves to protect client capital in difficult markets while participating nicely in up markets though not always to the same extent as more aggressive strategies that will invest in lower quality, more cyclical, and/or more highly levered companies. In more volatile markets both our high-quality orientation and valuation discipline tend to be rewarded, while in advancing markets portfolio returns are driven by the strong underlying earnings and cash flow growth our companies deliver with a lower level of variability than the broader market. 1) Batting average is calculated as the percentage of time the portfolio returns are ahead of benchmark as a percentage of total return observations December, Page 1

2 We would be the first to caution against making investment decisions based on monthly performance that is largely noise in the context of our longer-term 3-5 year time horizon. However, we do recognize that many find this type of analysis useful in developing expectations for how portfolios can be expected to perform in different market environments. We are often reminded of the humorous and emotionally sobering observation made by another investment manager we have come to respect, Andy Brown of Cedar Rock Capital Partners: This means we usually fail to reap our clients the full bounty of rising markets or, in falling markets we re losing our clients money 2. For instant gratification you must look elsewhere. While instant gratification may not be available, volatility often creates opportunities for us to act on the conviction of our fundamental research and leverage our longer-term 3-5 year time horizon to our clients advantage. Over the fullness of a market cycle, this has allowed us to generate attractive excess returns with a lower level of return volatility than the benchmarks and the majority of our peers. Given the meteoric rise in stock prices since 2011, and the dramatic reduction in volatility we have witnessed, it has been quite some time since we have been presented with an opportunity to turn market volatility to our clients advantage. Accordingly, we find it appropriate to quote from our own Q portfolio commentary: Another key element of our strategy has been to take advantage of market volatility to improve the growth profile of the portfolio at attractive valuation levels without compromising on quality. The market decline in 2008 provided an outstanding opportunity to acquire sustainable growth companies at very attractive valuations, and many of the best performers in the portfolio since then were added in that year. The extreme market volatility in 2011 also provided a number of opportunities for us to enhance the portfolio s overall growth prospects, taking advantage of what we perceived to be short-term pricing inefficiencies utilizing the filter of our longer time horizon and our cash flow based valuation discipline. In both 2008 and 2011, portfolio turnover was higher than it has been historically as a result of these actions, but these contrarian moves were helpful in generating the strong results the portfolios have produced. In the rest of this note we examine how SGA s historical performance pattern in different volatility environments contrasts with that of other active managers and consider what the implications for this may be going forward. Is Volatility a Driver of Active Returns? The list of factors contributing to the recent underperformance of active managers is well documented 3. Non-benchmark allocations to underperforming assets like small cap and international equities that active managers often hold in at least modest amounts have served as a drag on relative performance, as have cash holdings in a rising market. Increased correlation of stock price returns and below average valuation dispersion have contributed to a lack of cross-sectional volatility that has exacerbated headwinds as well. The "extraordinary" measures undertaken following the Global Financial Crisis by the Federal Reserve and other global central banks, which were aimed at keeping interest rates low and stimulating economic growth, have also likely contributed to increased risk-taking on the part of investors. While the VIX 2) Please note that the comment in falling markets we re losing our clients money refers to absolute performance as opposed to relative returns. Similar to SGA s historical return pattern, Cedar Rock s superior downside protection has allowed them to generate excess returns for their clients over the long-term. 3) Is Skill Dead? Neil Constable and Matt Kadnar, GMO, White Paper, February Page 2

3 is commonly cited as an indicator of investor complacency, we find it instructive to look at a longer-term measure of volatility that more closely matches our own 3-5 year investment time horizon. This appears to show measures of "risk", as defined by volatility of returns, have returned to pre-crisis levels. The chart below illustrates the rolling 3-year standard deviation of returns for the Russell 1000 Growth Index (the primary performance benchmark for SGA s U.S. portfolio) since the inception of the index in Over this time period, the volatility reached 1 standard deviation on both the high and low side three times. Equity market volatility tends to run in cycles and be mean reverting with periods of low volatility being followed by periods of high volatility and vice versa. Source: evestment Alliance, Russell Investments, SGA calculations. Rolling 3-Year standard deviation of returns based on monthly return observations from January 1 st, 1979 through June 30 th, Many people have made the case that periods of high and low volatility can have a meaningful impact on the ability of active investment managers to outperform a broad market index. In the years since the financial crisis, equity market volatility steadily declined as stocks performed strongly in response to unprecedented monetary stimulus. The following chart, however, illustrates that only a weak relationship seems to exist between realized volatility and the median excess returns of growth managers over the period since the inception of SGA s GIPS compliant track record in April Page 3

4 If anything it appears to us that the periods of below average volatility, loosely defined as below 15% annualized standard deviation seem to cluster in positive territory for the median manager as denoted by the observations inside the red box. Why this is the case is uncertain. It could be due to the specific time period, or that other factors dominated manager return profiles during the period. Or, it could be that the median manager performs or underperforms irrespective of volatility. Interestingly, when you consider the performance of SGA over the period, it indicates a stronger relationship between realized volatility and the generation of excess returns. Page 4

5 As is always the case, there is no free lunch. Greater excess returns in periods of heightened volatility (illustrated in the above chart by the observations clustered inside the green box) are accompanied by lower relative returns in tranquil markets, when neither our high-quality bias nor our valuation discipline are likely fully appreciated or rewarded by the market (illustrated in the above chart by the observations clustered inside the red box). Over time, our experience has been that our process generates attractive absolute and relative returns with a lower level of absolute risk. It does not do so in every given quarter, or year, or even rolling multi-year period, and how it looks at any point in time will depend on the nature of the time period selected. Rather than a free lunch, we expect SGA s strategy to smooth out a return stream by participating nicely in up markets while providing a measure of downside protection in negative markets. In that way, it should contribute to our clients meeting their own return objectives and provide good value for active fees. Over the past 10 years, the market has witnessed a period of expanding and contracting volatility. The past 3 years have seen volatility decline to levels not seen since prior to the Global Financial Crisis, with the 3-year trailing standard deviation of the Russell 1000 Growth Index as of June 30, 2015 being slightly greater than 1 standard deviation below the average over the period (illustrated in the chart above). Consistent with our past experience, SGA s investment process underperformed over the most recent trailing 3-year period as volatility declined and less differentiation across stocks made it more difficult for a highly concentrated portfolio of stocks which relies for its success on identifying higher quality growth businesses that will be differentiated by the market (and thus rewarded). Page 5

6 We have sounded like a broken record at times, but it appears that the world is finally coming around to our long-held view that global economic growth is likely to remain modest by historical standards and that robust earnings growth cannot continue indefinitely with revenue growth anemic and profit margins elevated. We are not oblivious to the negative impact that a broad-based risk-off environment may have for our portfolios as investors who have bid up equity market valuation multiples for businesses of marginal quality reassess their positioning. As we have experienced painfully in the past, Q for instance when our U.S. portfolio underperformed the Russell 1000 Growth by 3.1%, the superior growth and high-quality profile of our portfolio will not be recognized immediately in all times of market stress as growth rates are questioned and emotions often cloud investor judgement. A blind search for liquidity combined with the short-term nature of the market voting machine can create noise that trumps fundamentals. But that ultimately sets the stage for even more attractive future opportunities as prices deviate further from true intrinsic business value. We will continue to devote our time to making sure we are poised to take advantage of valuation opportunities that present themselves in businesses where we have the highest conviction in the predictability, sustainability, and magnitude of future growth opportunities. Steadfastly adhering to that discipline in the context of our Qualified List of businesses that meet our demanding criteria should lay the foundation for attractive relative and absolute returns in a more volatile market environment where sustainable growth remains a scarce commodity. The opinions expressed herein reflect the opinions of Sustainable Growth Advisers, LP and are subject to change without notice. Past performance is no guarantee for future results. This information is supplemental and complements a full disclosure presentation that is available upon request by contacting us at This commentary is provided only for qualified and sophisticated institutional investors. Page 6