Gordon Johnson, Ph.D, CFA Co-Portfolio Manager Shannon Ericson, CFA Co-Portfolio Manager for the LMCG International Small Cap Fund ISMIX, ISMRX Endeavour Investment Partners, LLC 781-749-6040 Partnering with Boutique Managers and Institutions Worldwide
Q&A with Gordon Johnson, Ph.D, CFA & Shannon Ericson, CFA Many RIAs are not currently allocating to international small caps. Why do you believe they should consider the asset class?... we believe active management can identify and capture inefficiencies. We think there are some compelling reasons to consider investing in a fund focusing on international small cap companies these are spelled out in more detail in our white paper on the lmcgfunds.com website, Four Reasons to Consider Investing in international Small Cap. One reason is just the sheer breadth of companies in our universe, creating numerous opportunities for active managers to identify some under-followed gems. We believe that inefficiencies exist in this space because there is a dearth of institutional managers who focus on it. In our white paper, we demonstrate that there has been a greater opportunity for active managers to generate excess returns in the international small cap arena versus the international large cap arena so we like the idea of a dedicated international small cap strategy. Also, it can offer a nice diversification element to a portfolio, as these companies stocks have historically had lower correlation to their large cap US counterparts than either US small cap or international large cap 1 stocks. In a marketplace that increasingly favors passive/index strategies, why should investors consider this Fund? How do you believe this approach is different than a Smart Beta Fund or ETF? We have no quarrel with passive or smart beta strategies in asset classes that appear to be fairly efficiently priced, such as US or international large cap. Here at LMCG Investments, our goal is to offer strategies in areas where we believe active management can identify and capture inefficiencies. Typically, inefficiencies exist because of a lack of Gordon Johnson Gordon is the Co-Portfolio Manager for the LMCG International Small Cap Fund and leads the LMCG Global Equity Team. Before joining LMCG in 2006, Gordon spent 6 years at Evergreen Investments, as Senior Portfolio Manager and SVP/Director for the firm s Global Structured Products. Gordon developed the department s domestic and international quantitative stock selection models and portfolio construction tools, and managed equity portfolios in the large-cap core, large-cap value, all-cap, smallcap core, small-cap growth, and EAFE assets classes. Before Evergreen, Gordon spent seven years at Colonial Management, where he served as portfolio manager for their Colonial Fund, a quantitative/ fundamental mid-cap balanced fund and was Director and V.P. of Quantitative Research. Gordon has also held teaching positions at the University of Massachusetts and California State University. Gordon is a graduate of California State University, holds an MBA from the University of Washington, Seattle and a PhD in Finance from the University of Massachusetts, Amherst. He is a CFA charterholder. Shannon Ericson Shannon is the Co-Portfolio Manager for the LMCG International Small Cap Fund and a portfolio manager and analyst in LMCG s Global Equity Team. Prior to joining LMCG in 2006, Ms. Ericson spent six years at Evergreen Investments Group, where she served as Vice President, Quantitative Equities Analyst for the firm s Global Structural Products group. Her responsibilities included strategy design, new product development, and the rebalancing and optimization of portfolios. Prior to joining Evergreen, Ms. Ericson spent six years at Independence International Associates, Inc., where she served as Vice President, Quantitative International Equities and Marketing Officer, Quantitative International Equities. Prior to joining Independence International Associates, Inc., she spent four years at Mellon Trust Company, where she served as Investment Communications Officer in the Private Asset Management Group. Ms. Ericson is a graduate of Bentley College and holds a BS in Finance and an MBA. She is a CFA charterholder. 1
institutional coverage. In US small cap stocks for example, the significant number of small cap stocks in the investable universe precludes these stocks from gaining wide analyst coverage. This holds true in the international small cap arena as well and the dearth of international small cap products suggests there are fewer buy-side analysts as well. If you are referring to smart beta and ETF portfolio construction techniques that are completely passive like revenue weighting versus capitalization weighting our approach is very different than that. We are much more analogous to an active fundamental stock picker who uses many of the same fundamental metrics, such as Value and Quality. Our team, rather than meeting with company management and applying our judgment to which stocks are more likely to outperform, takes the emotion out of picking stocks by relying on the numbers and using a quantitative approach to surface stock ideas. According to Morningstar data, you have been managing the LMCG International Small Cap strategy since August 2010. What investment vehicle was it offered in prior to the mutual fund? We actually launched the International Small Cap strategy back in 2006, which we initially managed in a limited partnership. The performance that Morningstar shows begins with the inception of the LMCG International Small Cap Collective Fund in August 2010, which was converted into a no-load mutual fund in 2016. We had a number of institutional clients who wanted exposure to small companies outside of the United States, so the Collective Fund made the most sense. Now we see an increasing interest from a variety of investors and their advisers. We felt a mutual fund would be the most efficient way to offer this type of investment to a much broader audience. No changes were made to the strategy we are using the same investment process that we used for the Collective Fund. Please describe your investment philosophy in-depth. How does that guide your stock selection methodology? Our investment philosophy is fairly straightforward. We believe that by applying fundamental factors in a quantitative way, we can identify stocks that, over the long haul, should outperform their peers. Additionally, we feel that our quantitative discipline is very efficient in the international small cap space, allowing us to cull thousands of stocks and create a much shorter focus list. Our stock selection process based on traditional fundamental metrics has been able to identify a subset of the overall universe that has outperformed the MSCI EAFE Small Cap Index over the three- and five-year periods, as well as the since strategy inception (8/26/2010) period, ending 12/31/2016.* Stock selection is driven by applying factors which include Market Dynamics, Value and Quality to a broad universe of stocks. Those stocks which rank high on our factors are buy opportunities that we could select to own in the Fund s portfolio. It s important to note that, as with any investment, the factors don t work all of the time, every time but we have found through our 25 years of working with Stock selection is driven by applying factors which include Market Dynamics, Value and Quality... them that, over time, they have helped us to identify a subset of securities that outperforms the benchmark. Because we want to construct a well-diversified portfolio, we look at these factors on a relative basis meaning relative to their peers. For example, we re looking at technology stocks versus other technology stocks and seeing how they rank, not comparing technology stocks to consumer staples stocks. You use a quantitative process. Can you describe how the process works and adds value to the portfolio construction? We use a quantitative process to identify what we believe to be the most attractive stocks for capital appreciation, while maintaining a risk profile of the Fund s portfolio that is also acceptable. To delve a bit more into the quantitative process we focus on three areas Market Dynamics, Value and Quality, which we refer to as factors : (1) Market Dynamics which is essentially price momentum and estimate revision; (2) Value how expensive (or cheap) stocks are on a variety of metrics; and finally (3) Quality what type of balance sheet the company has (for example, whether it has been conservative or aggressive with accruals). We attempt to balance the portfolio across each of these three categories, looking for stocks that rank highly on these metrics and discarding the stocks that do not. We rank stocks on their overall stock selection score, as well as on each of the individual factor categories, thus each stock is ranked by Market Dynamics, Value and Quality. Over the ten years that we have managed the International Small Cap strategy, we have seen these factors to be robust and, on average, stocks that have historically ranked well on these 2
factor metrics have outperformed the benchmark MSCI EAFE Small Cap Index. Please describe the Fund s investable universe, including its geographic exposure and market cap. The investable universe includes all stocks in the MSCI EAFE Small Cap Index. It s about 2500 securities. Additionally, we can invest up to 10% of the portfolio in emerging market small cap companies, and currently that portion is about 6%. We can also invest in small cap companies in Canada, which are not in the benchmark, and we have the flexibility to go up to 10% in the US as well. As of June 30, 2016, the market cap range of companies in the MSCI EAFE Small Cap Index was $23 million to $6.3 billion. Geographically, the universe spans six continents and includes over 20 countries. Significant country exposures in the portfolio (and the benchmark) include Japan, the United Kingdom and Australia. The largest regional concentrations are in Asia and Europe. Does the International Small Cap strategy emphasize any country, industry or sector weighting? If so, how is that determined and compared to the index? The strategy does not emphasize countries, industries or sectors instead searching for stocks that we believe have a higher likelihood to outperform. Our goal is to generate stock-specific alpha while maintaining country, industry and sector weightings that are roughly in line with those of the benchmark. We want to provide Fund investors with broad exposure to international small cap stocks without undue risk from allocation. There may be a particular market phase when stocks within one particular sector score the highest in our factor models. However, we are careful to maintain sector and industry weights similar to the benchmark so as not to take on too much risk from a particular sector over or underweight. As we ve discussed, international small cap stocks have a higher risk profile in general and we don t believe in layering on additional risk when we can easily mitigate that risk by maintaining weights similar to the benchmark. We think this is a positive quality from an investor s perspective. Some other international small cap managers make significant sector or country bets, which adds another risk dimension to their portfolios. I think it s important, though, to differentiate our approach of industry/sector/country neutrality to closet indexing. We have a high level of active share in the portfolio demonstrating that the Fund behaves We have a high level of active share in the portfolio... differently than the benchmark. Part of the reason for this is that most small cap indexes including the MSCI EAFE Small Cap are much less dominated by a handful of names than are large cap indexes. For example, as of the end of January, the top ten names in the MSCI EAFE Index accounted for almost 12% of that index s weight, versus just 3% for the top ten names in the MSCI EAFE Small Cap Index. How is country weighting determined for the Fund? We use a benchmark-relative approach. Target country weights are determined by the benchmark again, we try to provide a diversified portfolio without undue country, sector or industry risk. We seek alpha through stock selection, 3
not through sector/industry over/underweighting. We do have flexibility to go +/-10% versus the benchmark weight, but historically we have rarely deviated more than 5% away from the benchmark s country weight. For emerging markets, Canada and the US, which are not part of our benchmark, we similarly limit exposure to 10% in each. Can investors expect dividend income from international small caps? I am glad you asked about dividend income. Currently, there is a significant advantage for international small caps in terms of yield, or dividend income, versus their US counterparts. We believe this has mostly to do with investor preferences non-us investors appear to value dividends more than US investors do so international companies have delivered (on average) what those investors want. When yield is as challenging to find as it is in 2017, we believe that foreign small caps may provide investors with a solid tailwind of higher dividend income than their US small cap counterparts. Given your approach to this asset class, as well as its market cycle, when can investors expect your strategy to have its best performance, as well as its worst? It is a common question and we understand that advisors may be asking it to prepare their clients for a potential period when the strategy underperforms, but from our perspective it s a very difficult question to answer. The quantitative model underpinning our strategy is based on traditional fundamental metrics which typically become less important in macro-driven market environments. We have observed that oftentimes, when performance is challenging, there tends to be a macro event overhanging the markets. That does not mean that the model struggles in every macro-driven environment (or always outperforms in the absence of macro events). Let me cite a few recent examples: In the first quarter of 2016 the S&P 500 bottomed in mid-february after a 10% decline, but as the price of oil finally stabilized after a 70% sell-off and the equity market rally ensued, our models did not work very effectively. Conversely, in the fourth quarter, when the U.S. Presidential election was settled and equity markets surged ahead, fundamental factors became less important to investors however our strategy s performance was strong. Similarly, following Brexit, capital markets did not know quite how to react. At first, many global equity markets sold off but this decline was followed by a risk on rally. While the decline in late June proved challenging for our models, our strategy participated well in July s market rebound. Thus, when macro events drive the markets it s difficult to predict how our models will perform. The Fund s track record supports the robustness of the factors and models that we employ. While it has been difficult to predict precisely the periods of underperformance, the strategy historically has compensated for them with periods of outperformance and has delivered benchmark-beating results over three and five years as of December 31, 2016.* 4
What are the Fund s primary sources of risks and how are they managed within the portfolio? For a US-based investor in the Fund, there are three primary sources of risk. These manifest themselves among the Fund s various investment risks. First, currency risk comes from investing in local shares priced in non-us dollar currencies. If the US dollar strengthens, this provides a headwind for the international small cap strategy. Even in a situation where the stocks that we have invested in perform well in their local markets, their performance translated back to US dollars may be muted. We do not hedge currency risk, with an expectation that currencies will be net neutral over the long term. Our benchmark is also unhedged. The second source of risk is beta or market risk. We invest the Fund in international small cap equities, and when there is a correction or bear market, share prices will decline and investors may lose money. There is also slightly higher volatility in smaller company shares versus larger company shares, so investors should be aware that the Fund may have slightly higher volatility than a large cap international equity portfolio. The way we manage this risk is to have fairly small position sizes the Fund typically holds between 90 and 125 stocks and we also diversify country and sector exposure. We typically do not have significant overweights or underweights in sectors or countries. The third source of risk is that our investment meth- 5 odology may be out of favor, i.e., the factors that we employ to identify stocks for purchase may not be very productive. This typically occurs when stock fundamentals (like Valuation and Quality) are not driving investors decisions. Over the long term, these factors tend to produce positive returns, but there are certain market environments (such as earlier examples) where the factors are less effective. We manage this risk source by attempting to balance in the Fund s portfolio our three categories of factors, Market Dynamics, Value and Quality. That way, if one factor say, Quality is out of favor in the market, we have two other factors that may work to counterbalance the Fund s exposure to that factor. But at the end of the day, we tell the Fund s investors that there will be challenging environments for our factors. Over the years there have been many successful international managers, and most of them are not international small cap managers. Why do you think that is? That s an interesting question, which I ll answer in two parts. First, many managers choose to invest in large cap companies over small caps due to the capacity constraints typically associated with smaller company investing. As investor assets increase, the ability to make investments requires small cap managers to research additional stocks or limit the assets they take in. Large cap managers have much more capacity. This limitation occurs both on the domestic and international fronts. Thus, many managers may migrate towards large caps as a way to manage larger funds without having to add analysts to cover more stocks. Second, given the breadth of countries and economies that constitute
developed international investing, this dynamic is compounded. With fewer analysts covering this multitude of small company stocks and the travel associated with assessing them individually, it would not surprise us to hear that many managers opt to invest in a smaller universe with potential analytical assistance coming from publicly available research and avoid more daunting tasks themselves. As we noted earlier, with fewer active managers operating in the international small cap space, we feel there are significant opportunities for active management to deliver strong returns for investors. We take this challenge on using a fundamentally-driven quantitative approach that allows us to assess this broad universe of stocks very efficiently. Gordon Johnson, Ph.D, CFA, and Shannon Ericson, CFA, on behalf of Endeavour Investment Partners, thanks for your time today. 1 US large cap proxied by Russell 1000 Index, US small cap proxied by Russell 2000 Index and international large cap proxied by MSCI EAFE Index. * Past performance does not guarantee future results. This interview was prepared by Endeavour Investment Partners, LLC. The opinions expressed in this article by Gordon Johnson and Shannon Ericson who were interviewed by the authors are their own and do not necessarily reflect the view of LMCG Investments, LLC, or Investment Planners, Inc. (IPI) and are not intended to be investment recommendations. IMPORTANT RISKS AND INVESTMENT CONSIDERATIONS Equity Risk. The Fund s equity holdings, including common stocks, may decline in value. The value of a security may decline for a number of reasons, which are detailed in the prospectus. Foreign & Emerging Markets Investing Risks. As a result of political or economic instability in foreign countries, there can be special risks associated with investing in foreign securities, including fluctuations in currency exchange rates, increased price volatility and difficulty obtaining information. In addition, emerging markets may present additional risk due to potential for greater economic and political instability in less developed countries. Market Events Risk. Turbulence in the financial markets and reduced liquidity in equity, credit and fixed-income markets may negatively affect issuers, which could adversely affect the Fund. Small Cap Risk. The Fund s investments in small capitalization companies may be less liquid and their securities prices may fluctuate more than those of larger, more established companies. There can be no guarantee that any strategy (risk management or otherwise) will be successful. All investing involves risk, including the potential loss of principal. Investors should consider the investment objectives, risks, and charges and expenses of the Fund carefully before investing. The prospectus and SAI contain this and other information about the Fund. You may obtain a prospectus and SAI by calling (877) 591-4667. The prospectus should be read carefully before investing. Foreside Fund Services, LLC is the LMCG Fund s distributor and a member of FINRA and SIPC. Russell is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and / or Russell ratings or underlying data and no party may rely on any Russell Indexes and / or Russell ratings and / or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell s express written consent. Russell does not promote, sponsor or endorse the content of this communication. ADVISOR SUPPORT 781-749-6040 Endeavour Investment Partners, LLC has been contracted by the Fund to provide sales and marketing support on behalf of the LMCG Funds to Advisers. Endeavour representatives are registered with Investment Planners, Inc. ( IPI ). Endeavour and IPI are not affiliated with LMCG Funds or Foreside Fund Services, LLC. For additional information please call 781-749-6040 or by email at LMCGFUNDS@endeavourmanagers.com 2017 Endeavour Investment Partners, LLC LMCG Review 4985 (3/2017) Endeavour Investment Partners, LLC 781-749-6040 Partnering with Boutique Managers and Institutions Worldwide 6