What differentiates your fund?
Our philosophy is based on the thoughtful combination of quantitative and fundamental investing. We believe that both quantitative and fundamental investing bring benefits to investors but neither one is perfect. And when you combine them together in a smart way, you can take advantage of the benefits of both while limiting the drawbacks of either one.
One thing we have done differently at BMO is create a differentiated model in which quant and fundamental investors work together. We do not have separate quant and fundamental teams but instead we have one integrated team. We work together with joint decision-making, joint accountability, and joint ownership of our clients’ portfolios. That is a fairly large differentiator because, culturally, quant and fundamental don't always co-exist very well and we have developed a model that enables that collaboration to thrive.
To elaborate, quants typically build models that are meant to exploit behavioral biases that individual investors make and, once they've built a model that is based on systematic data-driven beliefs, they don't typically like fundamental opinions overriding their models because they view it as reintroducing the biases that they're trying to exploit. Conversely, fundamental investors typically don't like the influence of quants because they worry that the quants are going to try to systematize what they're doing and potentially measure their impact from overriding the model. They also don't believe that quant models understand the companies they're buying and while quants can build a really good backtest, their models don't know enough about individual companies.
These cultural mismatches between quantitative and fundamental investors explain why it is hard for them to work together. Typically with separate groups, the leader of the team is going to come from one side or the other. Whichever side they come from is the side that they're going to be biased towards and you end up with an unequal team structure where you're either primarily a quant team that pays lip service to fundamental, or you're primarily a fundamental team that pays lip service to quant.
At BMO, instead of the us versus them mentality, it's all about how we can work together to make our process better for the benefit of our clients. We hire specific types of quant and fundamental investors. The quants that we hire have humility about the limitations of their models. They understand that the best models are still going to be wrong a decent amount of the time and no model's perfect. And even if you build a really great quant model there are still areas that you can improve on via fundamental analysis.
We also hire fundamental people that also have humility that no matter how well they know individual stocks there are areas where quant can contribute, such as surveying large groups of stocks every day and looking at them in a consistent manner, managing risk, managing liquidity and transaction costs, and constructing portfolios. All of those are areas where quant can typically be viewed as an advantage versus fundamental. So when we put the teams together we have the quants that understand the strengths and weaknesses of quant and the fundamental investors understand the strengths and weaknesses of fundamental. We all buy into the idea of how both disciplines can complement each other.
Does quantitative investing work in growth?
In our experience, specific to the Large Growth fund, there is a perception that growth is harder for quants to do because so much of growth has to do with forward-looking fundamentals. We disagree with this perception and have found that our process works incredibly well in growth. And the reason for that is that the types of biases that quant managers can take advantage of are particularly acute in growth investing. I'm going to give you two very specific examples.
The first is that growth is the area of the market where people are most likely to fall in love with stocks. And when managers fall in love with stocks, they often commit a couple predictable mistakes. The first is that they hold position sizes that are too large. In other words, they get overconfident and because of their overconfidence they take positions that we think are too large. The second thing is they don't have a good sell discipline because when they fall in love with a story and the thesis plays out, it's very hard to then divorce themselves of the stock.
Our quantitative approach is systematic about both buying and selling and that introduces better sell discipline. The other consequence of falling in love with stocks is that fundamental investors will typically take too little turnover in the portfolio. The reason they take too little turnover is that as they anchor themselves in the stocks that they've fallen in love with, they're not quick to update their beliefs and therefore the result istoo little turnover. However, if you allow yourself to become dispassionate and not anchored in individual stocks, it may be optimal to have more turnover and our research allows us to figure out what we think the optimal amount of turnover is. So all of these are reasons why we think falling in love with growth stocks is a pervasive behavioral bias that creates inefficiencies that quant can exploit.
The second area within growth where quant adds a lot of value is with risk management and portfolio construction. The example I'd give here is that the large-cap growth benchmark is the most concentrated benchmark in the US equity space right now because of the impact of the mega-cap tech names like the FAANGs. And when you have a large concentrated benchmark, you have to think equally about your underweight positions and your overweight positions. And if you don't think carefully about the large benchmark weights and how you choose to hold them-- for example, if you choose not to hold one of them at all -- the choice to not hold a mega-cap tech name is potentially a bigger risk than any overweight in the portfolio. So thinking about how you deal with this benchmark concentration from a risk management perspective and understanding that being very underweight in name is just as important an exposure as being very overweight in name is incredibly important. And a lot of fundamental investors don't think that way.
The other point here is that a lot of times, fundamental investors will think about these names idiosyncratically meaning they think about each name as being purely a stock-specific decision. What is going on with Facebook? What is going on with the Apple? What is going on with Amazon? They don’t fully appreciate the decision they make on one on one or more of those names introduces a systematic risk into a portfolio. A simple way of putting it is that the decision to underweight Apple, Google, Facebook and Amazon would not be independent stock-specific decisions. They have a commonality that introduces a factor risk to a portfolio such that if you decided that you wanted to overweight or underweight all of them, you're not taking four stock specific decisions, you're actually creating a systematic risk that in the portfolio that might lead you to be grossly overweight or underweight technology or market cap.
What industries/sectors do you favor?
Our overweight and underweight positions at the sector or industry level are most frequently the result of bottom-up stock selection where we happen to find stocks that we like. Also, because we manage risk relative to the Russell 1000 Growth benchmark and focus on stock selection, we're typically not significantly overweight or underweight any sectors or industries and we try to have more of our risk to be stock-specific while managing the industry and sector risk.
However, the one sector that we have a fairly strong view on, unfortunately, is the least relevant sector for the large-cap growth portfolio. But I think it's worth mentioning, the one sector right now that trumps off the page is utilities. The single biggest conviction view that we have on a sector right now is that we believe utilities are expensive. The sector became very expensive last year, especially in the fourth quarter with the flight to quality when the market fell. And as the market rebounded in the first quarter, utilities largely kept up and as a result, they have not reverted from a valuation perspective. That's not something that is very actionable in large-cap growth because utilities aren't part of the benchmark, but it is something that relates to other strategies we manage
What else are we seeing in the market?
Some other themes that we're seeing in the market are guiding the names we're buying from a factor perspective. Valuation has underperformed for the last few years and as a result of that, our measure of the opportunity for valuation has started to get to extreme levels in a way that would be positive for valuation going forward.
One of the key tools that we've built, Market Monitor, allows us to understand whether the opportunity for valuation should be better or worse than average going forward. And what we're seeing right now is that the valuation opportunity is one of the best that we've had over the last 30 years. The two periods that were more extreme were the Internet bubble and the financial crisis. And at the height of the Internet bubble and at the depths of the financial crisis, there was an outsized opportunity for valuations to matter. We are not at those levels right now but we are at the levels we were in early 2016, where for example, energy had gotten very cheap and where defensive stocks had gotten very expensive. And valuation subsequently worked very well later in the year.
We are in a similar type of environment this year where some defensive areas, like utilities, have gotten very expensive and other areas are still cheap and we think this valuation spread presents a good opportunity moving forward. With that said, I want to clarify that this is not a value versus growth benchmark call. We are not saying that we think the value benchmark will do better than the growth benchmark because we're talking about cheap versus expensive companies within sectors, and we remain long-term bullish on the large growth style. Within growth investing, we expect that some of the really expensive growth names are getting too rich and some of the cheaper growth names are attractive. So while we continue to be focused on growth, we think that valuation within growth is going to matter going forward.
How are you managing volatility?
Our main view is that volatility will continue to be elevated going forward. That doesn't necessarily mean markets are going to correct. We think that markets can continue moving upward in a measured pace but we think that there's going to be more volatility going forward than there has been over the past five-to-seven years on average.
One driver is the market’s growing concern that we may be towards the late end of the cycle and those concerns can lead to more volatility. Related to that would be concerns about whether corporate earnings are starting to slow, and I think the volatility in the fourth quarter was from investors fearing that we were at the end of the cycle. Then in the first quarter, investors realized that maybe those concerns were overstated and growth remains healthy. There seems to be a growing divergence in the market on how close we are to the end of the cycle and that can drive future volatility.
Another driver will be the possible volatility around trade wars and China trade, which is a source of volatility if it doesn't play out the way people think it will. Similarly, there's clearly volatility around politics and elections. For example, large cap growth has seen a politically-related sell-off recently in healthcare in part because of concerns that if Medicare for All takes off, that could be a big headwind for the healthcare industry.
Another driver of volatility would be seeing how Fed policy evolves. There had been concern for a while the Fed was going to be raising rates too aggressively to head off inflation. The expectations of that have shifted and there has now been speculation that maybe the Fed will cut instead. The Fed recently decided to keep rates flat but any future policy decisions could drive market volatility.
The unifying theme behind all of these points is that there are a lot of drivers that we're keeping our eyes on that we think could increase volatility, but we don’t view any of these as our base case.
Where do you see opportunities and risks?
We think valuation has a higher probability of mattering within growth companies going forward than it has the last year. The last couple years, valuation hasn't really mattered within growth companies. Expensive growth companies have continued doing very well and reasonably priced growth companies haven't necessarily rebounded and one of the opportunities that we see based on our valuation analysis is to pay more attention to valuations within the growth space.
Conversely, there are some defensive parts of the market that are expensive although these specific opportunities may be more relevant to value or low volatility investing than growth investing.
What is your outlook for the remainder of the year?
Our base case is the market is going to continue doing well but certainly, not at the pace that it started off the year. We think that the markets will do well because earnings growth is still strong. In Q1 so far, earnings and guidance have both been strong and the market's reacted well. Within large-cap growth, in particular, we’ve seen Facebook, Microsoft, and Apple all have good earnings reports in the last week or two. So I think continued earnings growth is going to be a tailwind.
Secondly, I think one thing we can take from the Fed is that it doesn't look like they’re rushing to raise rates and are not overly concerned about inflation, so that's still a fairly accommodative policy which should be a tailwind for the market.
Also, we think that heading into an election year the economy matters a lot to politicians and they typically have an incentive to keep economic growth going, so that should reduce political risk and be a potential tailwind.
So when I line all of these different things up, we’ve identified potential sources of volatility but our base case is that the market will continue doing well, driven by some of these concerns not materializing into problems and earnings growth continuing to do well. We do not expect the types of returns for the rest of the year that we saw in the first quarter, but positive single-digit returns would seem like a more probabilistic base case.
This material is provided for informational purposes and should not be taken as a recommendation to purchase any individual securities. Investors should seek advice regarding the appropriateness of investing in any securities or investment strategies discussed in this report and should understand that statements regarding future prospects may not be realized. Investment involves risk. The information provided is current as of the date listed and there is no guarantee that the opinions expressed herein will be valid beyond the date of this writing. There can be no assurance that the portfolio will continue to hold the same position in companies described herein, and the portfolio may change any portfolio position at any time. Investing involves risk, market conditions and trends will fluctuate, which will cause the value of investments to rise and fall. Accordingly, investors may receive back less than originally invested. The Russell 1000® Growth Index measures the performance of those Russell 1000 Companies with higher price-to-book ratios and higher forecasted growth values. Investments cannot be made in an index.
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