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Steady as She Goes With This Pairs-Trading Fund

Pairs-trade strategies can be tricky, but this American Century fund has provided a smooth ride.

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In every issue of Morningstar magazine, Undiscovered Manager profiles a manager on the Morningstar Manager Prospects list, which is compiled by Morningstar's manager research group.

Old-fashioned stock-picking isn't what often comes to mind when investors think about market-neutral funds. That's especially the case as increasingly these strategies are driven by complex, black-box computer programs.

But at American Century, the same stock-by-stock, bottom-up analysis that fuels the firm's plain-vanilla value funds is at the core of AC Alternatives Market Neutral Value (ACVVX).

The team behind the fund is led by Phil Davidson, the chief investment officer for U.S. value equity strategies at American Century. The group starts with the same research employed on long-only funds, such as  American Century Equity Income (TWEIX),  American Century Value (TWVLX), and  American Century Mid Cap Value (ACMVX)--each of which carries a Morningstar Analyst Rating of Silver.

The difference is that with the market-neutral fund, the team's stock research is taken one step further. The managers don't just use it to buy stocks they think are undervalued; they use a "pairs-trade" strategy, in which those shares are paired against short positions in similar companies, exchange-traded funds, or share classes they think are overvalued.

While shorting stocks is often perceived as a strategy that aims for stocks that will crater in value, the goal of the American Century pairs-trade strategy is to build a portfolio that grinds out steady-as-she-goes returns 3 or 4 percentage points above Treasury bill returns.

Over the trailing three years through June 30, the fund's total return is 3.6%. That compares with a 0.06% gain on the Barclays U.S. Treasury Bill 1-3 Month Index. It's accomplished those returns with some of the lowest volatility statistics in the category.

"The fund has chugged along steadily toward its objective," says Gretchen Rupp, who follows the fund for Morningstar. The fund was added to Morningstar's Prospects list in the first quarter.

This solid performance, however, has attracted a rush of investor attention. The fund, launched in late 2011, has recently seen a surge in flows. Now with over $670 million in assets, the fund more than doubled in size. That led American Century to impose a "soft close" on the portfolio, narrowing the window for new investments.

Back to Basics
When it comes to the approach for the fund, it isn't that American Century has anything against new-fangled computer-driven funds. Back in 2005, the Kansas City-based firm launched the quantitatively driven AC Alternatives Equity Market Neutral (ALHIX), which screens stocks based on quality, valuation, growth, and sentiment.

But the firm wanted to broaden its lineup of alternative offerings in a different way.

"When we started this in 2011, the idea was to leverage or extend the work we have on the long-only side," says Davidson, who has been with American Century since 1993 and has worked in the investment industry since 1980. "We wanted to provide a product that could have noncorrelated absolute returns that would be a function of our securities ranking we use on long-only funds."

A pairs-trade strategy "is easier said than done and there weren't a lot of funds that do it in the space," he says. "But we worked on it and talked about it for several years. We felt like we had a good team and process in place that wasn't dependent on where the market was."

The value team's stock-picking process screens through stocks with a market capitalization of more than $500 million. It looks for high-quality names based on returns on capital, low financial leverage, and high levels of "franchise sustainability" such as high barriers to entry.

As part of the process, the team of five portfolio managers and nine analysts determines fair value estimates and calculates what they see as the upside potential for a stock and downside risk and its risk/reward ratio.

"It's not, 'what are five companies that are bankrupt and go to zero,'" Davidson says. "If we run across a very impaired company, it might be paired up with a long, but that's not what drives this."

From there comes the process of matching up the pairs of long and short positions in order to reduce risk and correlation to the broader stock market. "It's the real differentiation of what we do," Davidson says.

"If we simply bought the 50 most attractive stocks we follow and went out and shorted the least attractive, all the long weighting could be energy and all the shorts could be in tech," he says.

The portfolio generally holds 90 to 120 pairs, each of which are "dollar neutral," meaning the long and the short positions are the same size. Within the portfolio, lower-risk trades are given higher weightings than riskier stakes.

At any given time, 40% to 70% of the portfolio is composed of pairs trades with stocks in both the long and short slots.

Playing Defense
The process could be seen in a defense-industry pairs trade put in place in mid-2014 with Exelis, a military electronics firm, and  Lockheed Martin (LMT).

Portfolio manager Dan Gruemmer, who had been an aerospace engineer at  Boeing (BA) before joining American Century in 2009, says their work suggested Exelis was trading about 18% below the company's intrinsic value. Meanwhile, many other defense stocks had enjoyed rallies at the time and were starting to look frothy. Among them was Lockheed Martin, which the American Century team thought was trading at about a 19% premium to its intrinsic value.

When it came to the match-up of the two companies from a business perspective, Gruemmer says it was virtually a "one-to-one pair." Then, looking at other the risks to the trade, they thought Lockheed was unlikely to be acquired, and both companies had revenue very closely tied to defense spending. If anything, they believed Lockheed had a major downside risk to its share price from its troubled F-35 fighter-plane program, which, of course, would be good news from a short-sellers perspective.

The trade was "close to the epitome of what we look for in company-to-company pair trade," Gruemmer says.

It turned out to be a winning hand. In early 2015, Harris (HRS), a company that specializes in communications equipment, announced it was acquiring Exelis. That deal earned the portfolio a net return of about 25% on the trade.

Looking at Other Opportunities
In addition to company pairs, the market-neutral fund will also match stocks against ETFs. The team uses this approach when they have a stock they believe is attractively priced, but options on the short side are limited, especially by risks of takeover. Trades involving ETFs generally comprise about 20% to 40% of the portfolio, and it's been a common approach for pair trades involving utilities and semiconductor stocks.

A third category of pairs trades is capital-structure plays, such as owning one share class of a stock and shorting another share class in a bet that a difference in value between the two will narrow. "The good thing with capital-structure pairs is they trade very tightly, so it's very low volatility and low risk," Gruemmer says.

One such trade that paid off involved electrical equipment manufacturer Hubbell (HUBB), where the fund was long the firm's Class A shares and short the Class B shares. The potential with these trades is that in companies with multiple share classes, there is often a valuation difference between the classes owing to liquidity or voting rights. Hubbell's A shares, Gruemmer says, were trading anywhere from a 6% to 12% discount to the B shares during the time they had on the trade. When Hubbell announced in August that it would create a single share class, the gap effectively went to zero.

Performance Matters
All this has come together in the fund to produce returns that land it in the top of Morningstar's market-neutral category. The fund's 3.6% gain over the trailing three years puts it ahead of more than 90% of its class.

Morningstar's Rupp says that what really differentiates the fund's track record is its stability. "The market-neutral category has quite a few funds that look fantastic over a specific time period but then flame out unexpectedly," Rupp says.

Since its launch, the fund has the lowest maximum drawdown--peak-to-trough decline--of all market-neutral funds at 1.13%. That drop was confined to July 2015. By way of contrast, the median maximum drawdown for the funds in the category is a 6.9% decline and the median drawdown period is 14 months.

At the same time, the fund's standard deviation is 2.10 over the trailing three years, compared with 4.0% for the market neutral category.

The fund's returns have also come with essentially zero correlation to those of the S&P 500 and Barclays U.S. Aggregate Bond indexes.

Flows Come Fast
This performance has attracted investor attention. At the end of 2014, the fund had assets of $75 million. In 2015, the fund took in $138 million and $254 million during the first quarter of 2016.

The rush of money led American Century to limit access to the fund through a soft close. New investors can still purchase shares through American Century but now only through a limited list of brokerage firms and advisors.

The decision, the firm says, was made to create a better balance of cash flows in and out of the fund and preserve its strategy.

"We consider it a good stewardship practice when managers do close their funds earlier," says Josh Charlson, direct of manager research for alternative strategies at Morningstar. "I applaud American Century for that."

With alternative strategy funds, "capacity is often an issue," Charlson says. "The shorting aspect is one of the big limiting factors."

American Century's Gruemmer says the challenge comes in the nature of managing pair trades. "We build them in tandem and reduce the weights in tandem," he says. "The liquidity is a function of the lowest common denominator. You need them both to be liquid."

On the cost side of the equation for investors, like many alternative strategies, the fund charges much higher fees than its long-only brethren at American Century. Expenses on this fund are 1.6% after a fee waiver.

But compared with other market-neutral funds, the American Century offering is below the fee-level comparison group median of 1.7%.

"I think we have delivered on a goal of 3% to 4% types of noncorrelated return, and that's appreciated by our clients," he says.

This article originally appeared in the June/July 2016 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.

Tom Lauricella does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.