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Systematic Allocation Guided by Market Phase
AMG Chicago Equity Partners Balanced Fund
Interview with: Patricia Halper, Michael Budd

Author: Ticker Magazine
Last Update: Apr 12, 1:53 PM EDT
Stocks and bonds have their own volatility patterns and risk profiles, so it is important for investors to have allocation that provides downside protection, according to Patricia Halper and Michael Budd, portfolio managers of the AMG Chicago Equity Partners Balanced Fund. Investing in equity and fixed income, the fund strategically shifts its allocation depending on the environment with the help of a systematic process.

ďWe believe that we should take only the risks which we are compensated for.Ē
In terms of security selection, our factor-based model looks at individual companies. We value and rank those names along with a consideration of valuations in the marketplace, because it is important to know what we are compensated for.

For example, the corporate bonds we hold in the portfolio are industry leaders with very large market capitalization, strong balance sheets, and high-quality ratings. We have a significant underweight to BBB-rated names, an area that many people favor late in the business cycle as they try to add yield. We take a countercyclical view and believe that is precisely the time to take risk down.

The last component, risk management, is built around identifying the tracking error of the portfolio relative to the benchmark. We gauge our exposures through a contribution to duration at the sector, quality, and issue-specific level. Our duration exposure is generally matched to the benchmark and we donít make interest rate bets. We receive a daily report, which looks at all the different strategies, including the fixed-income sleeve of the Balanced Fund, and identifies precisely where we are positioned relative to the benchmark.

Q: Could you illustrate your process with several examples of holdings?

A: As factor-based investors, we donít really go through stock examples, but I can illustrate from a sector standpoint. In an expansion phase, the stock portfolio has targeted exposure to momentum and growth factors. We have a preference for secular growth sectors, so we are overweight in discretionary and technology. During a downturn, there would be a preference for stable defensive value sectors, like staples and healthcare. And during a rebound, the preference would be for more cyclical value sectors.

Q: How do you select stocks in an environment of low or negative return?

A: In every environment, there is always something more attractive than something else. We identify the best versus the worst companies as we seek the best relative value. The model is built relative to super sectors. We look at every factor relative to the names within that super sector.

Since we are invested in equities in a negative return environment, we aim to be in the ones that go down the least. From a total return standpoint, they may be all trending down, but thatís where the structure of the fund comes in. In a negative return environment, weíll be underweight in equities, so the conservative nature and the diversification from our fixed-income portfolio would really shine through.

In comparison to the large investment peer group (U.S. Fund Allocation Ė 50% to 70% Equity), the Fundís downside capture ratio is ranked in the 98th percentile over the trailing 10-year period (for N shares). The standard deviation is ranked in the 98th percentile over the same period and is also one of the best in the group because of the structure of the fund. In a downturn, fixed income provides diversification and return and we manage to avoid unintended risk and to preserve capital.

Q: Is dividend a significant factor in your investment process?

A: It is one of many factors that we look at. Dividend yield is incorporated into our shareholder yield factor, which is one of the quality factors in our model. So, while dividend is considered, it is not a deciding factor.

Q: How do you identify better relative value on the fixed-income side? Could you give us some examples?

A: Letís take the example of energy. We have been underweight in that area relative to our investment universe for several quarters. That trend emanated from the security selection model. Historically, we know that stock price volatility, leveraged earnings volatility and relative valuations are the key ingredients in providing information about our security selection.

Starting in 2015, the commodity price decline resulted in significant stock price volatility. Many of those companies are highly leveraged by design, while earnings were very volatile, and we chose to be underweight in that segment of the broad corporate universe.

The other example is our very low exposure in the BBB-rated area of the corporate market. From a valuation perspective, we recognize that risk premiums can vary over time. The BBB-rated segment is particularly expensive right now, so the risk/return and the relative value exposure are not very rewarding. It also has the highest volatility of any of the sectors of the investment grade corporate market.

Q: What other debt instruments do you invest in?

A: We are overweight the government sponsored mortgage-backed security sector. Historically, these securities represent a very good alternative to corporate bonds and can replace some of the yield that we give up by underweighting corporate bonds. However, they behaviorally correlate strongly with U.S. Treasuries and government bonds. Thatís a high-quality income instrument that is one of the largest components of the Bloomberg Barclays US Aggregate Bond Index.

Q: Could you explain your portfolio construction process?

A: On the equity side, we optimize the portfolio quarterly. We use Axioma software as the shell for optimization, but the inputs are determined by our MPI model. The factors that we emphasize depend on the phase of the market. In the current expansion phase, we emphasize top-ranked stocks with exposure to momentum and growth.

The equity portfolio has an annual turnover of about 100 percent. We do maintain industry and sector constraints relative to the Russell 1000 index of about 5%, so there is an additional risk control in the construction process.

On the fixed-income side, our benchmark is the Bloomberg Barclays U.S. Aggregate Bond Index. We have a portfolio analytics system provided by Wilshire. Their Axiom product gives us a methodology for portfolio construction and risk management. The security selection is an optimized element of the process.

Q: How do you define and manage risk?

A: We define risk on the equity and fixed-income portion via tracking error. There is embedded risk of just being invested in equities. The structure of the fund can limit that risk through the varying exposure to fixed income. The strategic 60/40 asset allocation with deliberate deviation also helps to control the risk of the fund.

The tracking error is typically 3% to 5% on the equity side and closer to 1% in fixed income, relative to respective benchmarks. Historically, the tracking error for the trailing 10-year period has been about 2% for the entire fund relative to the 60/40 blend benchmark.

We are always thoughtful about risk and risk management is part of the process. Again, we are not risk-averse as a firm or as individual teams, but we are very cognizant of the risk we take. We have very strict constraints and sell disciplines. The overall risk profile of the fund over the last decade speaks for itself as its downside capture ratio and standard deviation are some of the best out there.

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