Why Small Cap Equity Will Continue To Be An Active Alpha Asset Class
My Interview with Greg Lai of Affinity Investment Advisors
By John Harline, Founder, Managing Partner, Elysian Capital Holdings, LLC
In the shadows of an ongoing six-year bull market and a progressive shift towards low cost, passive ETF alternatives for traditional asset classes, there rests one of the last great bastions of active asset management — the Small Cap Equity Asset Class.
As investors search for alpha in the face of unprecedented monetary policy, geo-political unrest, a colliding global economy and an endless list of active and passive investment vehicles, there lives what could be labeled the oldest emerging active asset manager in the retail marketplace.
Affinity Investment Advisors, domiciled in Irvine, California, has withstood the test of time, logging more than 23 years of active equity investment management, while standing tall atop a track record of performance in all of their asset classes that simply put, would make any institutional or retail investor proud.
They have achieved success by crafting a time-tested investment thesis centered on a proprietary quantitative process called the Affinity Score. It provides valuable output that seeks to identify stocks with the greatest expected outperformance within each sector, in an objective and efficient manner. In fact, it has generally provided a stronger and more consistent signal of positive excess returns than its underlying individual factors over time.
In addition to managing assets in the Large Cap, Large Value and Mid Cap classes, Affinity has seen the long-term benefits of their core abilities within the Small Cap Equity asset class.
I recently had the great pleasure of interviewing Greg Lai, Founder and Portfolio Manager at Affinity Investment Advisors. During our interview, we discussed the firm’s history and Lai’s brilliant career developing Affinity. He reflected upon the rewarding nature and various challenges associated with building an asset management firm and examined the evolution and systematic stock selection output of the Affinity Score and its importance to the Small Cap Strategy, which has delivered consistent alpha outperformance for better than 10 years running.
JOHN: Can you give us a brief history of Greg Lai and Affinity Investment Advisors?
GREG: Affinity was launched 23 years ago, in 1992. As for my background, I was born and raised here in Southern California, and I am fourth generation Chinese-Hawaiian. I went to UCLA and received my undergraduate degree in Chemistry. After, I worked as a chemist for a year and then went back to Business School at the Paul Merage School of Business at UC Irvine, where I graduated in 1988. My career in investment management started when I worked at PIMCO from late 1988 to June 1992.
JOHN: If I remember correctly, you worked on the original PIMCO equity team, right?
GREG: That is Correct. I worked on one of the early PIMCO equity teams in the late 80’s. This is actually where the story begins. I cut my teeth at PIMCO, which helped build the foundation of what Affinity is today. So, when you think about what we do, a lot like the foundation of PIMCO, it is in the context of what institutional investors are looking for on a daily basis. In fact, very early in my career, I had a great opportunity to poll various institutional clients about what they truly wanted in the investment universe. Even at that time, there was a continuous battle between passive and active investment strategies.
What I learned early on is that “information” matters in active investing. Conversely, if you are looking at a passive investment, information doesn’t matter as much. While, with an active investment, you can apply knowledge, intelligent research and a systematic process, and if all of it falls into place, you can beat the benchmark consistently. What we figured out at PIMCO, and ultimately today at Affinity, is that what really works is a hybrid approach; something that takes the best of passive and the best of active, and combines those two things into something of constructive output. That is the theme you will see in everything we do. We are pragmatists at our core. We don’t think that one thing will always work; we are not idealists who say, “this is the only way and there is no other way.”
Some of the things at Affinity, which are in line with our core beliefs, have allowed us to deliver great returns for our clients and are firmly entrenched in our culture; flexibility, but structured discipline in the process, which compliments our vast experience and judgment.
So, in 1992, Affinity was launched. We started our business in two channels; in the institutional space, by partnering with consultants, and in the retail space, where we have a rich history. I have spent more time walking “corner offices” than I am willing to admit, but it gave me an opportunity to learn about what is important to retail investors, and what is important to the financial advisors that advise them. I think those early days really blended into what we have done at Affinity over the years.
JOHN: You didn’t just leave PIMCO and a billion dollars instantly poured into the firm. It had to take time. What has been your biggest challenge along the way?
GREG: I think there are two parts to owning an asset management company. On any given day, you are running money as a portfolio manager, and simultaneously, you are an entrepreneur running a business. In fact, I tell people that those two decision-making processes can often come into conflict. One thing we have been successful at doing is reconciling those two potential conflicts, due in part to the diverse group of professionals we have put together in the firm.
But most importantly, it is the simple act of growing a business that is so challenging. First, you have to build a brand by showing a track record and by developing relationships. It is very reasonable for investors, both institutional and retail investors, to require a period of time where they can watch you; take a look at your longer-term performance; and then, and almost only then, trust you. It’s a people business and it takes time to make it personal. A financial advisor has to have an opportunity to get to know you for a period of time, understand your process and how that aligns with his/her clients, before they can make a decision to use you as a money manager.
JOHN: There seems to be a co-dependency between being a portfolio manager and running a business?
GREG: Yes, especially with small managers, it aligns very well. You have a manager who wants to do all the right things in his business and in the portfolio. You have to convince your clients that you’re trustworthy and that you’re committed; you have to be an entrepreneur, but at the same time stay disciplined and focused on the deliverables, which is performance. Most financial advisors, in my mind, are entrepreneurs, so they have some understanding of the challenges.
JOHN: How important is it to be disciplined, unselfish and willing to check your ego at the door each day?
GREG: Well, having an ego in this business could be the kiss of death. It is very difficult to manage a portfolio effectively with an ego. Here’s a great example, the market doesn’t really care about what I think. If you think about all the mechanics that go into the market (who’s buying, who’s selling, what companies are doing, what CEOs and Boards of Advisors are doing, etcetera) they are not sitting around and wondering what Greg Lai thinks. So, it’s really not a battle between Greg Lai and the market. It is really a battle between myself and myself. Just because I think I know the right direction to take, doesn’t necessarily mean that is the direction we take. We question everything to make sure it is done without an irrational bias, and without an irrational ego.
JOHN: Shifting now to the thesis of finding winners for your clients, but more importantly, avoiding losers, can you define and explain how the Affinity Score is utilized in the Affinity investment process?
GREG: Well, by definition, the Affinity Score is a quantitative multifactor based upon a combination of independent investment anomalies that have identified stocks with positive excess returns. It starts with a universe of over 1,900 stocks, which includes the constituents of the Russell 2000 Index. It is a weighted average of the following key factors; Valuation, Expectations and Momentum, which rank stocks within each sector. The top quartile consists of “buy candidates,” and the bottom quartile, “sell candidates.” It is a model that tends to favor attractively valued stocks with improving expectations and favorable momentum in each of those sectors.
It is used because we need some sort of basis and structure to work from. It’s a quantitative measure, which are rules that you can follow that are objective in nature, rather than subjective. When you think of objectivity, you generally think of data and numbers. Numbers tend to be objective and you can have rules on how those numbers are constructed. That gets you part of the way. It’s a rule. How are these numbers calculated? Are they calculated consistently across all stocks?
Then, if they are objective, this gives us some form of a measuring stick. It’s not perfect. Although, I’m not looking for perfect; I am looking for some type of measuring stick. Everybody has a speedometer. Am I going too fast, too slow? You don’t need to know exactly how fast you’re going, you just need a general idea. So, “quantitative” is really code for “objective” rather than “subjective”. If it’s an objective, rules-based algorithm, then it can be used to help identify and give us a point of reference and some form of direction with which to build the portfolio.
JOHN: So, the Affinity Score is an objective, rules-based algorithm?
GREG: Yes, it’s an objective, rules-based algorithm, as opposed to a subjective one. It is a quantitative model that can process a lot of information, put it in a usable form and deliver it in a timely manner.
Generally speaking, it is about pragmatism. If you could be the greatest stock picker in the world, but you could only look at one stock every twelve months… great. Well, that doesn’t help me. I can’t diversify the portfolio; I can’t do all of the things necessary to deliver. So, we have to live in the real world. What can I really do in the real world? That’s truly the problem with pure quants, which we are not. The pure quants think they can do all the things necessary to deliver and that it can be perfectly done in the ‘laboratory.’ This is not pragmatic, because the world is not perfectly linear; it is imperfect and unpredictable at its core, thus, a process has to work in the real world. This is why we believe in being pragmatic. The real world has rules that say, if I have 200% turnover, then it is going to cost me money. The real world is, “I can have a great stock picker, but he can’t work quickly, and if he can’t process a lot of information quickly, then that is of no use to anyone.” This is where we are different. The quantitative model we utilize can process a lot of information and put it in a form that is usable, and all of it delivered in a time sensitive manner.
JOHN: Has the Affinity Score evolved or changed over time?
GREG: The Affinity Score was built to stand the test of time, and it really hasn’t changed because valuation and basic fundamentals of stock picking still matter and really have not changed. You still have to find inexpensive companies and even more so, if there is something good happening at a company that is inexpensive, even if you don’t know exactly what it is. That goodness has to then manifest itself into positive changes in expectations for its earnings and revenue. Ultimately if you don’t have earnings or revenues, at some point in time, then you don’t have a company. If you don’t have positive changes, particularly positive changes in earnings and revenues, then you won’t have a long-term successful company.
So as a portfolio manager, if you plan to outperform, then you better have the highest probability to choose from the best possible names. Thus, the Affinity Score is really good at screening through a large universe of names and data, versus a traditional fundamental approach that may screen through fewer names on an ad hoc basis.
JOHN: What makes the Affinity Score so effective in the Small Cap asset class?
GREG: In portfolio management, a repeatable process is key. We want to have a process that allows us to find the good companies and eliminates the bad ones, across a range of market environments and across many types of companies, large and small. This is a challenge because if we didn’t have that process, then it is quite possible that our emotions, or the noise in the marketplace would drive the investment decisions, too many times in the wrong direction of reality. These are not robust investment paradigms. Some stocks do fit the case; for example, Apple did well last year, so it must do well this year, right? Well, what if Apple does well 10 years in a row? What would that performance predict? So, I am being a bit facetious, but it’s not an investment paradigm any one would believe in. There has to be some combination of other fundamental things happening that drives stock performance. The Affinity Score and our experience working from its output, is just part of our pragmatic approach and has worked exceptionally well for our clients in all asset classes.
However, if we look at the Small Cap asset class in general, the process has worked even better. The Small Cap asset class is a broad universe, perhaps twice as large as the Large Cap universe. Even more so, we need to have a process, which allows us to find the best companies and eliminate the pitfalls, in a universe, which is twice as large. Also, the data available in the Small Cap space is amply available and often better today than it has been in the past. The key for us, the differentiator, is the Affinity Score, which allows us to save time by pouring through more companies to find the best and most advantageous fits for our portfolios, in a quicker period of time.
JOHN: What makes the Small Cap asset class so exciting?
GREG: There are many reasons to be invested in Small Cap equity. In Small Cap equity, you can actually add more value because there is an opportunity to find more alpha because the Small Cap space is less efficient. There tends to be a little higher probability of finding something that has yet to be discovered, and which has some opportunity because it is under followed and under invested in.
Even though the Small Cap marketplace can be more volatile at times, a Small Cap portfolio can benefit the total portfolio with higher overall diversification. Thus, we build higher overall diversified portfolios, while monitoring the risk in those portfolios, which is the same process we utilize over all of the asset classes we cover. So, all the things we do in the Large Cap space, translate very well into the Small Cap space, perhaps even more so.
JOHN: Does that necessarily mean that there is more risk associated with how you would manage a large cap value portfolio versus a Small Cap portfolio? Since you are potentially reducing losses using an objective quantitative process with the Affinity Score, doesn’t this theoretically lower the potential for volatility on Small Cap?
GREG: Volatility is always measured relative to something. Lower relative to the average manager? Lower relative to the benchmark? It really depends on how you define volatility. We believe our overall process with the Affinity Score, as an important piece of the puzzle, allows us to find the best stock values and reduce volatility over time by building risk aware portfolios.
JOHN: Obviously looking at the long-term performance in the Small Cap strategy, it appears that staying true to the rules of your investment process has been consistently impressive. Would you agree?
GREG: I would like to project that we are humble. I think the rules of an investment process do matter, even within the Small Cap equity space. If you are trying to convince investors that Small Cap equity is always about the story or the asset class in general, I would say that it is not the case. I think the rules of an investment process still matter in the Small Cap equity space. Buying value stocks with improving fundamentals will always win the day, regardless of the asset class.
JOHN: Does this mean that you always expect to out-perform?
GREG: There have been times that we have underperformed in the short run, but we expect that over the long run, our process and strategies will continue to perform well for our clients. Right now, with the market doing what it’s doing, it’s a good time for Small Cap equity. We know that fundamentals matter in Small Caps. As capital flows, it falls first into the large caps because that’s the easiest trade to make. As time goes on, there are fundamentals that start to drive the markets. The economy is growing, there’s growing activity in mergers and acquisitions, and the things that once made Large Caps attractive, now make them unattractive. Most Large Caps tend to be multi-nationals, so the strength of the dollar, energy costs, interest rates and the rise in valuations of the Large Cap, make them less attractive and have made Small Caps more attractive. So, people are going to start to look at Small Caps and as I said, when fundamentals meet flow, the good names are going to start to be rewarded.
Our model has afforded us the opportunity to make some great stock picks. So, stock picking is working inside the Small Cap arena. That’s why we are performing well. This is stock picking, based on fundamentals. In the Small Cap space, I don’t see that trend changing. So, one benefit of Small Cap is that it is a good diversifier; particularly in today’s world when you are not only diversifying against size, but diversifying against influence. So, Large Caps are influenced by interest rates, by energy and oil costs, by currency. Small Caps will give you diversification because the movements in these stocks are probably more company and sector specific. That’s why I would suggest people have some Small Cap allocation in their portfolio.
JOHN: So, if you are thinking about it from that perspective, where a lot of people have replaced active management with ETF’s or passive investing in the larger space, it is almost the opposite effect in the Small Cap equity space because fundamentals matter and because information is readily available.
GREG: We believe that the information is going to be better and more actionable in the Small Cap space if it can be sorted and processed efficiently. Thus, investors should believe more in active stock picking in the Small Cap space and the potential alpha generation, than they do in any other asset class, at least at this point in time.
JOHN: The Affinity Score allows you an advantage to leverage across all asset classes, but would you say the Small Cap asset class provides an opportunity for better returns?
GREG: A quantitative process like the Affinity Score is leveragable and consistent, as we can apply it across Large Cap, Mid Cap, Small Cap and International.
Also, Small Cap stocks tend to be followed by fewer portfolio managers, so value can be abundantly found with a properly applied process, which can provide a higher potential for return, and they do. Historically, Small Caps show a higher return.
JOHN: Given the length of the current equity market increases over the past 6 years, is the trade still on in Small Cap Asset Class?
GREG: We believe it is and will continue to be. As we move later into the market cycle, the market is being driven upward by broad themes (energy, consumer discretionary spending). The economy is turning through an economic cycle and becoming more seasoned, but this is where fundamentals should start to matter more. This is when the questions start. Can the company drive top-line revenue growth? Is it a good company? Is there good management? Do they have a good product? We believe investors start looking closer at company fundamentals.
This is where Small Caps are at their best because it is more important to look at company fundamentals, than at broad themes. If you like energy and you are going to buy broad energy exposure, you wouldn’t buy Small Cap energy, more than likely; you would buy Large Cap energy and bet the allocation. So, we believe the trade in Small Cap is going to continue because fundamentals matter and the fundamentals in the Small Cap space remain positive.
JOHN: In the Small Cap, what percentage, if any, would be considered emerging markets, or do you pull from any emerging markets?
GREG: We are U.S. domestic, only
JOHN: In the Small Cap strategy, at what point, if at all, would you sell a company because it became a Mid Cap name, or would you carry it through as Small Cap?
GREG: We would tend to carry it, until it became really too large to own. I believe the Mid Caps start at somewhere between 5 and 10 billion, so we would hold a name as high as probably up to 5 to 10 billion for Small Cap.
JOHN: There isn’t a specific quantitative sell discipline when a stock in a Small Cap space rises up into a certain level?
GREG: If it’s kicked out of the Small Cap Index, then that would be a point in time to think about selling.
JOHN: How will the effect of larger companies acquiring smaller companies affect returns in the Small Cap strategy?
GREG: So we talked about Small Caps and the benefits of diversification; as investors think more about Large Caps being less diversified, then they want more diversification from Small Caps. I also think that with interest rates being low and cash still being cheap, there will be more merger and acquisition activity. It is our belief that a large percentage will be coming out of the Small Cap space, particularly with larger companies in technology and healthcare sectors. These technology and healthcare firms are looking for growth opportunities, and they are going to do it by acquisition. This is just another indication of why Small Caps will continue to do well.
JOHN: Why is a Small Cap asset class important to an overall portfolio, particularly in regard to endowments and pension plans?
GREG: Endowments and pensions are looking at the Small Cap space today, frankly because they need performance more than ever.
JOHN: So, they are looking at it from an active alpha play almost entirely?
GREG: Actually no, they are looking at it from both perspectives. They are looking at it from an active alpha play and from an absolute return play. If they believe there are higher returns in Small Cap, they need it because they need to hit the magic 7.5% return rates for their pension plans. So, the institutions are looking for places to generate these returns and it’s a conflict for them because in some respects, they’ve been putting money in hedge funds, because they thought hedge funds were the better risk-adjusted place for their money. But hedge funds aren’t getting 17% annually like equities have for the last 5 years, and they need the high absolute return to keep up with the liabilities. So, Small Cap equity is a nice way to go to get high absolute return and high potential for active alpha.
JOHN: Do you ever grow concerned with being 100% invested in equities all the time?
GREG: No, but my job is not to defeat the bears. Asset allocation defeats the bears. I’ve created this diversification because there will be a variability in returns. Some asset classes go down and some asset classes go up. But, I know if I build a diversified portfolio through asset allocation, that over time, the assets will grow and the risk will be manageable. So, if I am just investing, then am I investing for the short run or for the long run? If I have an asset allocation, I have already conceded that I am investing for the long run and markets will go through the cycles, and I believe the accumulation of wins will outweigh losses dramatically over time.
JOHN: The performance in the Affinity Small Cap Strategy has been extraordinary over the 1 year, 3-year, 5-year, and 10-year. In playing devil’s advocate, some could argue that if you are going up that quickly, you could go down just as quickly. Are you taking undue risk to get to that point?
GREG: The performance has been consistent with our expectations over a long period of time, so we are not taking undue risk. We follow our process and stay true to our investment thesis. However, I think it would be more reasonable to say that there would be a time that we don’t pick the right stocks, which is not impossible. For example, when value is out of favor, and we are picking value stocks, some will perceive that we are not picking the right stocks. That is exactly what happened in 2008. During that period, people looked at their active managers and said, “this manager underperformed the benchmark; he must be picking the wrong stocks,” at least as it compared to the indices at that time. This is a somewhat unfair statement. The indices had something special about them, during a short, but very special period of time, which allowed them to do better than average, which we have seen, as we look back over the last six years.
JOHN: How can investors access the Small Cap strategy at Affinity Investment Advisors?
GREG: The Small Cap strategy, along will all of our other equity and international equity strategies are available in Separately Managed Accounts on a number of platforms and broker dealers.
JOHN: I understand that there are plans for a 40-Act mutual fund, as well?
GREG: We believe that there will continue to be great demand for mutual funds in the future. We plan to take our strategies deeper into the retail space. So, yes, be on the lookout, we do have a Small Cap mutual fund registered to file that will be available in the coming months.
Gregory R. Lai, CFA
Greg is a Principal and Lead Portfolio Manager for Affinity Investment Advisors, LLC. He works to maximize the investment team’s decades of experience to the benefit of all clients, having developed Affinity’s quantitative stock selection, risk management, and portfolio construction models. Greg’s leadership is an important aspect in Affinity’s commitment to performance and service.
Greg’s founding role with Affinity spans its history since launching in 1992. The firm was acquired in 2007 by Morgan Stanley Investment Management. The team joined Invesco in June 2010 when Invesco purchased Morgan Stanley and Van Kampen’s asset management business. Greg and the team chose to re-enter the market at the end of 2010 as an independent firm to capitalize on the increasing investor interest in boutique management firms.
Greg brings 28 years of experience working for a variety of firms, handling a wide range of clients, and building a well-earned reputation for his pragmatic quantitative approach to investments. Greg credits his experience as well as that of his other team members, who have worked through recent and past economic cycles, as a primary benefit to clients today.
Greg’s industry experience includes Senior Portfolio Manager and Managing Director at Morgan Stanley Investment Management, Van Kampen and Invesco, Ltd. leading the U.S. Active Equity team, and Quantitative Specialist and Co-portfolio manager at Pacific Investment Management Company (PIMCO).
Greg earned his M.B.A from the Paul Merage School at the University of California, Irvine and a bachelor’s degree in Chemistry from UCLA. He holds the Chartered Financial Analyst designation.