Los Angeles Capital’s investment philosophy is based on its proprietary concept of Investor Preference Theory®. This innovative and dynamic concept forms the DNA of the investment process and guides the research team in its search for alpha. The unique aspect of the philosophy is that it allows the investment team to develop a “living” model that captures the views of today’s equity investor and is not based on backward biases and long history. The final result is a portfolio that adapts to today’s economic environment.
Watch Hal Reynolds, CIO discuss Los Angeles Capital's Distinctive Investment Approach.
Investor Preference Theory
Los Angeles Capital’s investment philosophy is based on Investor Preference Theory®, a concept unique to the firm and developed by the firm’s founders. Investor Preference Theory states that “an expected return of a stock is a function of its risk characteristics and the price (or expected risk premium) the market assigns to each characteristic.” The key to the philosophy is developing proprietary techniques to estimate how investors price risk in a global equity market given that equity risk premiums are not directly observable. Once estimated, the risk premiums are combined with the stock’s exposure to each premium to calculate today’s expected return for a stock. This innovative investment philosophy is applied throughout the security selection, portfolio construction, and trading steps of the process. Rather than making static assumptions about the characteristics of superior investments, the philosophy recognizes that investor preferences for specific characteristics evolve with changing economic and market conditions.
The firm's investment philosophy is designed to address fundamental investment questions, “How do investors view key equity risks in the current market environment? How are investor decisions influencing the price of risk?” Three decades of quantitative research suggests that shifts in valuations, business, and market conditions create new equilibrium prices for a variety of risk factors. Do investors care more about the risk of inflation or deflation? Forward looking earnings estimates or reported results? The safety of strong balance sheets or the opportunities of an improving economy on weaker balance sheets? These are just a few of the many factors captured in the process.
Whereas most pricing models (e.g., CAPM or APT) provide a framework for estimating risk and return based on a fixed, long-term definition of risk, Investor Preference Theory® provides a flexible framework for estimating returns and risks as market conditions change.
Why Adopt a New Approach?
Most managers focus on the identification of stock characteristics that have generated excess returns historically. By the end of the 1970s, the dominance of small stocks led investors to conclude smaller companies were better able to adapt to changing market conditions and had higher risk which provided them with a small stock premium. In the 1980s, value's dominance over growth led to the broadly held view that investors overpay for growth stocks. A decade later, investors shifted their views as global prosperity, a benign inflationary environment and falling trade barriers created an environment where multi-national growth companies held a competitive advantage. By the end of the decade with the capitalization of internet companies reaching $2 trillion, investors declared that the information revolution had just begun, that the destiny of brick and mortar companies was bleak, and that the valuations of the post venture sector of the market were in fact warranted. Today, investors talk about the impact of higher oil prices as capital chases alternative energy sources just as it did thirty years earlier.
History suggests that investors are overly influenced by the past in forming their investment views regarding tomorrow's investment opportunities and market inefficiencies. What's the risk with such thinking? Embracing the consensus view as to why past factor returns will likely repeat, regardless of how rational the argument, frequently contributes to under-performance in subsequent periods.
The problem extends beyond the obvious one of chasing yesterday's winners. In a more subtle fashion, changes in market structure can impact an investor's risk management process, forcing higher exposures to risks which have become over-priced. This in fact happened to many portfolio managers during the 1990's, who, despite their misgivings over the valuations of internet companies, succumbed to the pressures of risk management and purchased internet companies at their peak.
What are Investor Preferences?
Investor preferences include any stock characteristics that investors believe represent either a favorable or an unfavorable risk impacting the value of a stock. Over a market cycle, investors assign values or prices to a variety of risk characteristics such as market factors (e.g., market capitalization, price momentum), income statement and balance sheet measures (e.g., E/P or B/P), analyst expectations (e.g., estimate revision, earnings surprise), and sector risks (e.g., Technology, Internet, Health Care, etc.).
To better understand how these preferences change through time, one may look at historic factor returns, calculated to isolate one factor’s performance from another. By analyzing these returns it becomes quite clear that investor preferences are not random, but evolve as investor views change over the market cycle. Price movements are in fact quite similar to the more familiar pricing behavior of systematic risks in the fixed income markets, such as credit and prepayment spreads or duration risk.
Who Shapes Investor Preferences?
Investor preferences are shaped by Wall Street analysts, academics, institutional account managers, retail mutual fund managers, and private equity investors. While stock prices may display random walk characteristics, investor preferences evolve through time, creating discernible prices.
Research shows that investor preferences are generally applied across the market with a couple of exceptions. While capital flows freely across the growth and value spectrum, plan sponsors generally control the allocation between large and small cap stocks. In fact, given the segmentation in the management of large vs. small capitalization portfolios, it is not surprising that preferences would differ. In addition, while global capital flows across regions we observe that investors in different regions frequently price risk differently. Thus, we need to take into account the fact that global markets are not fully integrated in terms of pricing specific components of risk.
How Are Preferences Measured?
For more than twenty-five years, quantitative managers have measured factor returns through an analysis of monthly stock returns. By disaggregating common factor and sector effects, as much as two-thirds of a stock's excess return can be explained. While traditional methods are useful for performance attribution and risk measurement, Los Angeles Capital has identified several enhancements that extract greater information content from the analysis, providing more stable and reliable returns.
Once returns for each factor have been estimated, a forecast is made to determine the new equilibrium price of each risk today. This information is translated into discrete alpha estimates for each security in our universe. Each alpha estimate is derived by multiplying each security's exposure to approximately 20 risk characteristics, by the price, (i.e., expected return) of each those characteristics.
How Accurate is the Forecasting Process?
The following charts look at projected vs. actual returns for two sample factors; Share Growth and Distress. The solid line depicts the historical factor return, the grey area the volatility around the return series, and the dotted line represents the forecast.
The following chart shows that U.S. companies that buy back their shares (as defined by a negative change in their shares outstanding) have generated excess returns over the last decade. This is consistent with most academic and institutional research pointing to the positive aspects of share repurchases and negative impact on returns from share issuances. The graph points out however that there are periods where investors embrace companies that are issuing rather than buying back shares as depicted by a positive slope in the factor return line. This highlights the importance of pricing these factors dynamically since current investor preferences may diverge from longer term expectations.
The next chart looks at the pricing of distress. The distress factor looks at key fundamentals that together gauge the health of a company with more highly distressed companies receiving a high score. The graph shows that during the financial crisis (and even slightly before), investors began to develop a negative view of stocks that were characterized as distressed. This is seen in the large negative expectations to distressed companies in 2007 and 2008. However, over an extended period of time there has been a positive excess return associated with stocks that possess higher levels of distress as their cost of capitals are high in order to compensate for their risks.
In summary, Los Angeles Capital’s investment philosophy is contrarian to conventional philosophies that rely on static market inefficiencies. We believe that the nature of inefficiencies is always changing and that prices of key risks are not based on the past but reflect current market conditions.
Generating consistent performance requires that managers consistently identify a changing set of investment opportunities. The one thing investors can say about the decade to come is that it will present challenges and opportunities beyond what investors can imagine today.
Los Angeles Capital employs an innovative investment process for security selection and portfolio construction that gradually adjusts a portfolio to changes in market conditions. We recognize that investor preferences for specific risk characteristics evolve with shifts in the economic environment, and thus we believe a dynamic process is critical to achieving consistent results. Our quantitative valuation model provides transparency with regard to the source of both risk and return for each stock in a client's portfolio and risk budgets are managed dynamically to ensure the best return to risk trade-off at each point in time. The firm’s investment process is outlined below.
The process is split into two main phases. Developing a stock’s alpha is performed within the Dynamic Alpha Stock Selection Model® in the first three steps. Then, using these alphas, Portfolio Management constructs customized portfolios and executes trades through the firm’s trading desk.
Dynamic Alpha Model
Los Angeles Capital's Dynamic Stock Selection Model® (the "Model") generates alpha estimates on more than 6,000 global securities. It employs a factor-based approach, rigorously measuring and analyzing fundamental, sector, and country variables that Los Angeles Capital believes are important to investors as they buy and sell securities. Returns are calculated for each factor. Next, forecasts for each factor are generated. There is no bias or preconception of what that forecast should be, nor is it forced to be zero if it is negative. It is accepted that investors understand how and why a factor is priced, based on their appetite for risk. Once the expectation is determined for each factor, then each stock’s exposure to that factor is considered. Stock alphas are a function of exposures to each factor multiplied by the factor forecast. Because of the strict adherence to the above process, the criteria for selecting stocks are systematic and comprehensive. However, since the Model is adaptive, it does not have the same difficulty at inflection points that static quantitative models face.
Performance attribution shows that the majority of the alpha generated historically comes from fundamental factors and a positive but smaller component from sector or country factors. Our approach to sector/country management is unique in that a sector/country represents one component of a stock’s return. In other words, sector/country classification is treated as a risk factor in a similar fashion to the fundamental factors mentioned above. As a result, sector and country weights in the portfolio are determined based on the attractiveness of individual securities on a bottom up basis.
Portfolio Management is responsible for using the output of the Model, risk estimates, and technology developed by the firm’s Research Department to build client tailored portfolios. Portfolio managers analyze and monitor client portfolios daily. While Los Angeles Capital's Dynamic Alpha Stock Selection Model® drives the investment process, the Portfolio Managers provide an integral link between Research, Trading, Operations, and clients. Portfolio managers monitor all aspects of the investment process and communicate findings to the Portfolio Review Committee ("PRC"). The PRC convenes monthly to discuss each portfolio’s risk profile and performance and to ensure compliance with client-mandated guidelines.
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The following exhibit describes how client requirements are combined with Los Angeles Capital's proprietary market expectations to develop a client portfolio.
Portfolios are rebalanced through a quadratic optimization process that combines each client’s objectives, risk tolerance, and cost budget with the updated return, risk, and correlation forecasts on a universe of stocks. Security weights are determined through a risk penalty optimization process whereby the firm maximizes alpha subject to a penalty for tracking error. Rather than maintain a constant risk budget, the firm dynamically manages risk as market conditions change through time. The firm also incorporates Robust Optimization features into the portfolio by explicitly forecasting the uncertainty in our stock alpha forecasts. Sector bets and security weights are controlled versus benchmark weights and additional controls on residual (company specific) risk ensure that the portfolios are well diversified.
Since client assets bear all the costs associated with trade implementation, Los Angeles Capital has an obligation to minimize these costs to maximize the value of client portfolios. With best execution guiding every aspect of the trading function, the firm has developed proprietary processes to manage and trade equities and foreign currency for the firm’s global accounts. These processes provide the firm’s traders with direct access to electronic communication networks, anonymous crossing platforms and broker algorithms.
Soon after its founding, Los Angeles Capital created a proprietary trading strategy for developed market portfolios tailored to its stock selection approach. This strategy coincides with the dynamic nature of the Model by incorporating live market prices into the trading decision. Additionally, control over the entire trade process, from order submission through trade execution, is facilitated along with an enhanced ability to monitor intraday brokerage execution. The firm has developed a trading algorithm ("wave optimization")* that creates highly liquid, risk controlled, program trades or “waves.” Once a program or “wave” is identified for trading, orders are electronically communicated via FIX ("Financial Information eXchange") protocol for rapid execution by the firm’s approved brokerage relationships. This brokerage network has been established over decades and is reviewed and verified through an annual questionnaire.
Most portfolios are traded on a weekly schedule with annual turnover ranging from 60%-80%, depending on the strategy. Since 2010, stock specific trading cost estimates have been utilized in the portfolio optimization process and block trading functionality was developed by the trading and investment technology teams to seamlessly integrate with the wave optimization strategy.
In 2009, Los Angeles Capital launched its first Emerging Markets commingled fund after registering as a manager in all MSCI Emerging Market Index countries. Today, the firm trades approximately $36 billion in assets in local market securities with leading brokers.
In 2016, Los Angeles Capital traded in excess of 7.86 billion shares on a global basis.
*Wave optimization is utilized in U.S. and most developed markets portfolios
Watch Stuart Matsuda discuss Los Angeles Capital's Trading Function.
Los Angeles Capital’s investment philosophy is based on its proprietary concept of Investor Preference Theory®. This innovative and dynamic concept forms the DNA of the investment process and guides the research team in search of alpha. The unique aspect of the philosophy is that it allows the investment team to develop a “living” model that captures the views of today’s equity investor and is not based on backward biases and long history. As shown below, investors have experienced a number of emblematic market environments over the last decade. Los Angeles Capital's portfolios are engineered to adapt to changing market environments.
While achieving clients’ return objectives is our primary focus, there is an ancillary benefit to the investment process. The process also produces returns that generally have a low correlation with other managers as the portfolios change with the market environment.