Q: What is the history of the company and the fund?

Although Frost Investment Advisors was launched in 2007, Frost Bank, our parent, was founded in 1868 and received its trust charter in 1919, almost 100 years ago. Our company has been in the investment management business for a very long time. The mutual fund company currently has $3.1 billion in assets under management. 

Prior to March 2014, the fund was called Frost Strategic Balance and was a world allocation fund with a flexible global investment strategy. On April 1, 2014 Frost rolled out a lineup of asset allocation funds and the fund became Frost Moderate Allocation, one of the three diversified asset allocation funds available to investors. 

A key differentiator is that we use other investment company funds and ETFs, so the fund has more of an open architecture than many of our peers offer. This is a fund of funds with assets under management of $25 million. 

Over the past 25 years, we have had a research-driven process, which uses optimization and asset-class analysis to design the portfolios. That has evolved into the resampling process for optimization analysis that we currently use.

Q: How would you describe your investment philosophy?

The fund is designed for the moderate risk investor and is typically used by retirement investors, or investors looking for a single-fund solution with moderate risk profile. That’s why diversification is part of our core process and one of our deeply held beliefs.

Part of our culture is to manage money with a long-term focus. We are aware of the short-term moves, but they really don’t drive our decisions. We believe that well-constructed and diversified portfolios smooth out the highs and the lows of market movements without unduly sacrificing long-term performance. 

One of the ways to define a moderate type of allocation is by looking at the volatility of the fund, which is between 8% and 10% on a standard deviation basis. We stay within that range by monitoring the volatility of the fund and by having defined ranges for the equity and fixed income exposures. 

Q: What is your investment strategy and process?

Part of our philosophy and process is to monitor and analyze about 10 to 12 different asset classes. We look at the market based inputs, but we also integrate our own forecast of returns. So, we would reconsider the returns and the risk of the different asset classes, if we have a different belief than the market-based inputs. 

One of our differentiators is the optimization scenario that we run based on the inputs, which help us to determine the strategic allocations. 

We divide fixed income into low duration, a core intermediate piece, high yield, global aggregate, domestic equities, which we subdivide into large cap, mid cap, and small cap. We also incorporate developed markets, emerging markets, and REITs. Right now we are analyzing commodities, although we do not have an allocation in that asset class yet.

On the foreign exchange side, we typically select the managers and give them a leeway to manage the FX exposure as part of the allocation, because we are not an international shop.

Q: How do you select the funds you invest in?

We use both qualitative and quantitative metrics to select the funds. On the qualitative side, we look for a high-quality management team with a consistent process. We want to see a demonstrated ability to deliver favorable risk characteristics. We also look at specific metrics, including the up down capture ratios, beta, Sharpe ratios, semi-variance, etc. 

Our team performs due diligence, visits the managers that we select, and monitors them based on the metrics I mentioned. 

The fund consists of 14 funds. About two thirds are allocated to managers and about one third is in ETFs. 

Q: Could you give us some examples of the 14 funds you hold?

Frost Total Return Bond is one of our internally managed funds. It is an actively managed total return fund, whose manager is a very active alpha seeker. For instance, manager is shorter on duration right now, but more exposed to credit risk that the overall bond market. That is a strategy that has worked well in the long run and we maintain our conviction and allocation.

For our real estate allocation, we use Cohen & Steers, which is an excellent REIT manager that can add value in that space. We have a little over 4% allocation to that particular manager. Over long periods of time, Cohen & Steers has proven to be an excellent REIT manager, so we like both the space and the manager. 

Q: What would prompt you to add or drop a fund?

We do not make changes very often, because we look for sustainability and durability in the long run. We don’t focus on quarterly performance. In fact, we may be tolerant of short-term underperformance, because we monitor our managers, we know their thinking process and their positioning. If we agree with their outlook and conviction, we wouldn’t make a short-term change just because of a quarterly variance. 

However, if the management has drifted away from its process, we may sell the fund. Sometimes an asset base becomes elevated and difficult to be managed efficiently, so that would be another reason to sell. Also, there are times when a fund fails to show signs of improvement during favorable periods and that’s certainly a flag that we monitor. 

Sometimes there might be qualitative reasons to make changes. For instance, in the past we sold a fund when there was nothing wrong with the management team, but the parent company had regulatory issues. We just were not comfortable with that holding because the issues could create a distraction for the management team. So there are a variety of reasons to sell.

Buying is a process of analyzing the management teams. We wouldn’t necessarily select a top high-flying performer, because we know through experience that the markets go through rotations, and being at the top can very quickly work against a particular style or a concentrated position. Instead, we look for sustainability and durability in the long run. 

Q: How do you set your strategic allocation? Could you provide some examples of your process?

Our asset allocation team, which is part of our investment committee, does the asset allocation research. We run our optimization analysis to set the strategic allocations and we revisit our assumptions several times per year. Although we don’t take huge tactical bets, many of our moves are based on our quantitative analysis.

Recently, based on our analysis, we felt that the correlations for emerging markets and for small caps were starting to look better than for developed markets. So we ran our re-sampling optimization engine, did our analysis, and we started to allocate more out of developed markets and towards emerging markets and small caps. We are currently using ETFs in those two spaces, although we are preparing to reallocate into the active managers. 

In terms of rebalancing, the market performance skews portfolio allocations over time and we would rebalance them. We always consider rebalancing as cash comes in and out of the account, but we also rebalance to reflect our selected target allocations over time. 

Right now we are running a 10-year analysis on the market to develop the market-based inputs. For instance, we don’t agree that just the fixed income component in itself provides high return and low volatility, so we work with our fixed income team to develop a forecast of the fixed income markets and its different segments. Then we integrate that forecast into our optimization engine. We use the resampling methodologies of Dr. Richard Michaud to run our resampling process and the inputs produce the output of a risk level that we allocate towards. 

Currently, we are muting the fixed income returns and that, of course, changes our allocations. In the long run, we generally prefer diversified equity portfolios versus fixed income portfolios, and I believe our allocations reflect that. 

Q: What is your portfolio construction process?

Ultimately, we seek to build an efficient portfolio, with risk/reward characteristics that are consistent with our outlook through diversification. 

Since we are a moderate fund with caps on our equity and fixed income exposure, we stay within the defined ranges. Our equity exposure is 40% to 70%, while the fixed income exposure is in the 30% to 60% range. 

Currently, the volatility is 8.8% and we would be comfortable with volatility slightly below 9% right now. In asset classes, the fund is 34% fixed income, 63% equity, and 3% cash.

We monitor the volatility of the fund and we make changes to keep it in the desired range and below the upper boundary for the moderate category. If we feel that volatility is going to increase, or started to increase with more than a transitory effect, then we would allocate away from the higher volatility assets and towards the lower volatility assets. 

We typically keep our cash low, below the category average. We don’t really use cash as an asset to avoid a drawdown. Instead, if we believe that volatility is going to increase, we would increase our allocations to lower volatility assets, not cash. 

We don’t have any specific position limits but when we run our optimizations, we would diversify our allocation to large caps, for example, in more than one position. We would use an ETF and maybe a couple of alpha seekers. 

Q: Why would it not be enough to use traditional asset allocation between stocks and bonds? For example, a portfolio invested 50% in large caps and 50% in high yield?

It is not part of our philosophy to invest only in two asset classes. We manage through a cycle. The scenario that you describe would probably be a strong performer year to date, but rotations can come very quickly. 

Moreover, such a portfolio would have higher volatility than our target range. The large-cap volatility is about 15%, while the high-yield volatility is in the double digits, probably 11% or 12%. High yield would probably have a 70% correlation to equities, so the described portfolio is out of the boundaries of a moderate fund. 

Our composite benchmark per prospectus is Blended 45/15/34/6 of S&P 500 Index/MSCI ACWI ex-U.S. Index/Barclays U.S. Aggregate Bond Index/Barclays Global ex-U.S. 

For us it is very normal to be invested in more asset classes and we wouldn’t go down to just two of them.

Q: How do you define and manage risk?

There are different types of manageable risks. We are an allocation fund and it is our job to be fully deployed for our investors. The primary risk is the asset allocation risk, or being overly allocated to an underperforming part of an asset class with increased downside volatility. We aim to minimize the downside risk through asset allocation and setting specific ranges, while remaining fully deployed. 

There is also the fund selection risk of an underlying fund to underperform and not achieve its investment objective, so we monitor our managers closely. 

We are also very cognizant of the style risk, because there has been big movement between growth and value within our equity allocations. It has been quite volatile year to date, compared with the previous years. Through allocation, we try to avoid a style that would underperform the alternative. 

Additionally, even within a style, some managers may have a bias that could make them drift away and we are cognizant of such trends. We would start allocating away and have an open discussion with the manager on his strategy that will drive our decision. 

On the fixed income side, there is interest rate risk. Right now duration is driving a lot of the market. One of our alpha seekers, Frost Total Return Fund, is a little bit shorter on duration, but is taking more credit risk. Until recently that would be a positive feature, but duration has underperformed. We still like the fund in the long run and are willing to understand the short-term variance, but it is still a risk that we are aware of.

Since we are a fully deployed allocation fund, if equities go through a bear market and we cannot go below a 30% to 40% allocation, we won’t be able to protect from the fund from going down because of this equity exposure. At the same time, however, we can allocate to negatively correlated assets or lower-volatility assets and try to neutralize that effect. That’s what we do for investors with the appropriate risk profile for this fund.