Top strategies used a tactical approach for success over past year

Tactical allocation, small-cap and midcap funds emerged as the top performers among domestic equity strategies for the year ended March 31, according to the latest data from Morningstar Inc.'s separate account/collective investment trust database.

Of the top 10 strategies, four were categorized as tactical allocation strategies, which included the top two strategies, while three were categorized as midcap, two were small cap and one was large cap.

The diversified makeup of the top 10 strategies for the trailing year stood in stark contrast to a 2022 that had been dominated by energy and natural resources-based strategies. For the year ended Dec. 31, the top 10 strategies consisted of four natural resources-based strategies and two equity energy strategies, along with two midcap growth strategies, a large-cap value strategy and one tactical allocation strategy.

One particular surprise among the latest list of top 10 strategies was the presence of four growth strategies, said Tony Thomas, associate director of equity strategies for Morningstar Research Services LLC, a subsidiary of Morningstar, Inc., Chicago, in a phone interview.

The overall median return for domestic equities in the Morningstar separate account universe for the year ended March 31 was -6.7%, compared to -8.6% for the Russell 3000 index.

Among value strategies, the Morningstar universe median was -4.48% compared to the Russell 3000 Value index return of -6.4%. Growth strategies, meanwhile, had a median return of -10.06% in the Morningstar universe, while the Russell 3000 Growth index returned -10.9%.

"2022 was such a hard year for growth stocks. I'm just surprised to see any growth funds on this list," Mr. Thomas said. "There's a few of them, now I will say I'm also struck by how idiosyncratic some of the performers are here."

Mr. Thomas noted that a number of the top performers were concentrated strategies that were able to ride on the coattails of a single holding that had a particularly outstanding year. One such performer in the top 10, he noted, was Horizon Kinetics Asset Management LLC's small-cap institutional strategy. As of Dec. 31, over 40% of the strategy was invested in Texas Pacific Land Corp., which owns royalty rights in Texas for oil drilling.

While the presence of the growth strategies might seem like an outlier, Mr. Thomas did say, "There was a rebound in growth in the first quarter. As hard as 2022 was, that looks like it benefited some of these strategies. They bounded right back when some of their holdings bounced back."

For the quarter ended March 31, the Russell 3000 Growth index returned 13.8%, while the Russell 3000 Value index returned 0.9%.

"I was looking at some Morningstar sector indexes, and the three hardest hit ones in 2022 were tech, communications services and consumer cyclical, and those three sectors were the hottest sectors in the first quarter. Very much an immediate bounce after a rough sell-off," Mr. Thomas said.

Ranked first for the third straight quarter was Boston-based Model Capital Management LLC, with its tactical allocation strategy posting a gross return of 28.47% for the year ended March 31.

The strategy mixes broad market exchange-traded funds — such as the Vanguard Value ETF and the iShares Core S&P 500 ETF — with a bond portfolio.

Roman Chuyan, president and chief investment officer, said in a phone interview that in the second quarter of 2022, the firm's models were negative on U.S. equities and the stock market in general and shorted the market during the quarter.

"It probably accounted for about half the positive performance of this 12-month period," Mr. Chuyan said. "We capitalized on the downside of that quarter."

Around May 2022, the firm's models anticipated an upside in equities.

"Because the market became undervalued, that was a big reason for our model to go positive on stock," Mr. Chuyan said. "It wasn't universal throughout that nine-month period (ending March 31), but for the most part we went long on equities and that added to our gains."

Ranked second was Miami-based Potomac Fund Management Co.'s Navigrowth strategy, which returned a gross 19.99% for the year ended March 31.Dan Russo, portfolio manager, said in a phone interview that the firm's philosophy is "really win by losing less."

"Our core belief is that risk can actually be contained and even overcome through the thoughtful use of objective technical indicators," Mr. Russo said. The indicators help determine when "risk is not worth the reward, and then the strategy has the flexibility to go to cash."

"We just kind of believe in the math — probability over prediction — and the math behind that is if you can avoid catastrophic losses, it's that much easier to outperform over time because of just the way the math works," said Mr. Russo.

The strategy, which falls within Morningstar's tactical allocation category, allows the manager to determine when it makes sense to be in or out of equities.

Among the reasons for outperformance was the strategy increasing exposure to commodities and other sectors related to commodities such as metals and mining. The manager also "identified for the first time in a really long time that it made sense to start positioning outside the U.S. somewhat," Mr. Russo said. The strategy benefited from more exposure to Latin America, which also was very exposed to commodities and energy, he added.

"It is really just the flexibility to market time, and then when probabilities dictate, really paying attention to relative strength," Mr. Russo said.

Kayne Anderson Rudnick Investment Management LLC's small-cap quality select strategy was the third top performer for the year ended March 31, with a gross return of 19.26%.

The Los Angeles-based manager's small-cap core strategy also appears in the top 10, ranked eighth with a gross return of 9.71%.

Todd Beiley, portfolio manager and senior research analyst, said in a phone interview that the firm applies an overarching philosophy to its numerous strategies.

"We're trying to find business that we believe have a defensible, competitive position that will allow the business to generate an attractive profitability for a long period of time," Mr. Beiley said.

He said the small-cap core strategy began in 1993, and "the natural outcome of our approach is a return-risk profile where over time we will generate a higher average rate of return with lower risk, so our return doesn't come in explosive bull markets. It comes from holding up better in rough markets," Mr. Beiley said.

The small-cap core strategy is fairly concentrated and typically holds around 30 stock holdings, he said.

"Because we're concentrated, we can be very different from the index, and we can really cherry-pick the best businesses," said Mr. Beiley.

The small-cap quality select strategy began in 2006 so the firm can have "a more focused, opportunistic approach that can invest in anything, whether it's value or growth so-called, and a little but more flexibility in terms of the market cap," he said. That strategy typically holds between six and 12 names.

He cited Primerica Inc. as a primary driver of outperformance in both strategies. The firm has a large independent contract sales force that sells term life insurance policies to the middle market in the U.S.

Kayne Anderson owned the stock since 2014 and the company has benefited from keeping costs down through its independent sales force and is able to find its own niche in the insurance market, while higher-profile insurance companies with high-cost full-time sales force have traditionally targeted the wealthiest customers and ignore the middle market.

Ranked fourth was Private Capital Management LLC, Naples, Fla., which posted a gross return of 15.29% for the year ended March 31.

Jeffrey Fortier, managing director, said in an email that the firm identifies companies trading at discounts of 50% vs. their true economic worth.

"Situations that cause companies to fall out of favor with public market investors can often be rectified when we find management teams that possess a proven track record coupled with significant management ownership in the company," Mr. Fortier said.

The value focus strategy holds between 25 and 30 names, he said, "which highlights our belief that portfolio concentration can be an enormous driver of excess returns and that the fears surrounding the risks associated with concentrated investing are often overblown."

Key performers included Target Hospitality, which provides temporary housing in Texas.

"When oil companies couldn't give their product away in 2020 and 2021 due to the pandemic, short-sighted investors failed to see the longer-term value in Target shares," Mr. Fortier said. "Anyone willing to do the work could see that management was making strides to diversify the business, while there was simultaneously an 'inevitability' to a recovery in WTI (West Texas Intermediate oil) prices if we simply assumed that the U.S. would eventually reopen."

Ranked fifth was Marshfield Associates Inc., Washington, with its core value equity strategy returning a gross 13.67% for the year ended March 31.

Elise Hoffmann, principal, said in a phone interview that the firm's philosophy is to be "as different as possible in ways that make rational investing sense from a risk-adjusted return perspective."

Its core value strategy has always had somewhere between 15 and 20 stocks, and Ms. Hoffmann said what also makes the firm different is that "we are content to hold cash."

"We are extremely selective with respect with what we put in our portfolios," Mrs. Hoffmann said. Our main job is to keep things out of our portfolios, so while we're waiting for new holdings and make a decision to pull the trigger and buy those, we can have upwards of 20% in cash and that's when the market is roaring."

The portfolio actually had around 30% in cash at the end of 2021 and the firm put "about half of that" to work, said Christopher Niemczewski, managing principal, in the same interview.

"We don't care about sectors or industries or anything like that to align with the index," said Ms. Hoffmann. "We do care about industries in terms of their dynamics and their underlying economics. We're not trying to match the index in any way."

The firm's team of four principals work collaboratively and it's only with unanimous agreement a stock is added to the portfolio, Ms. Hoffman said.

AutoZone Inc. and Arch Capital Group Ltd. are two standout holdings for the portfolio, Mr. Niemczewski said. What both have in common, he said, is weather.

Arch Capital is a property casualty company whose cycles are "reasonably independent" of the overall economy and more dependent on the number of storms that create claims, he said.

Regarding AutoZone, an auto parts retailer, Mr. Niemczewski noted that the average age of a car in the U.S. is getting to be about 12 years. The stock fell a number of years ago when "in the 12 months from summer 2016 to summer 2017, the weather across the country was relatively benign."

"The stock leveled off, and analysts assumed that was Amazon taking over the business, and it wasn't. It was the weather," said Mr. Niemczewski. Old cars and bad weather means more visits to the mechanic, and AutoZone promises deliveries to their mechanic customers in 30 minutes.

"It's very hard for an Amazon to match that," he said.

For the five years ended March 31, growth strategies accounted for seven of the top 10 overall performers, split among four large-cap strategies and three small-cap strategies. Two small-cap blend strategies and one equity energy strategy rounded up the top 10.

The overall median annualized return for domestic equities in the Morningstar separate account universe for the five years ended March 31 was 8.96%, compared to 10.4% for the Russell 3000 index.

For the same period, the Russell 3000 Growth index returned an annualized 13%, compared to the Russell 3000 Value index returning 7.3%.

For the five years ended March 31, the top performer was once again Minneapolis-based Next Century Growth Investors LLC with its microcap growth strategy posting an annualized gross return of 25.44%.

Within the collective investment trust universe for the year ended March 31, five of the top 10 trusts were value strategies. There were also two small-cap blend trusts, one midcap growth trust, one energy trust and one trust that fell within Morningstar's health category.

The top performer among CITs fell within Morningstar's equity energy category. For the year ended March 31, Boston-based Wellington Management Co. LLP's CIF research energy trust, which reported a net return of 10.02%.

The median return of domestic equity collective investment trusts in Morningstar's universe for the year ended June 30 was -8.53%.

For the five years ended March 31, nine of the top 10 trusts were large-cap growth trusts, with one midcap growth trust rounding out the top 10.

The top performer was State Street Global Advisors' Nasdaq 100 index trust with an annualized net return of 15.98% for the five years ended March 31.

The median annualized return of domestic equity collective investment trusts for the five years ended March 31 was 7.94%.

All data for Pensions & Investments' top-performing managers report are provided from Morningstar's global separate account/collective investment trust database. The data for the separate account and CIT rankings on which this story is based were pulled May 5.