Factor InVe(nn)stigator: Brown Capital Management International Small Company Fund

Overview

For the third edition of the Factor InVe(nn)stigator, we will be interpreting the factor analysis results of an international small-cap manager’s fund, Brown Capital Management’s International Small Company Fund (ticker BCSFX) (the “Fund”), using the Two Sigma Factor Lens. 

We picked this particular Fund because we felt it demonstrated how factor analysis can both confirm what you believe about a Fund’s strategy as well as point out interesting observations that can help you understand the Fund better.

Outline

• We’ll start by translating the Fund’s stated approach to expected factor exposures. As you’ll see most of our factor predictions appear correct, but there were some surprises. 
• Relative-to-benchmark analysis follows, in which we analyze the Fund’s notable outperformance versus its benchmark by attributing its excess returns to factors and residual. 
• Stay tuned for the final section where we discover an interesting trend in the Fund’s excess returns recently.

Setting Expectations

According to the Fund’s stated approach in its March 31, 2020 factsheet: “The Fund invests at least 80% of its total assets in the equity securities of non-U.S. based companies with total operating revenues of $500 million or less at the time of the initial investment, (‘small companies’). The Fund typically invests in common stocks. The Fund’s advisor seeks to build a portfolio of exceptional international small companies with the wherewithal to become exceptional large companies. The Fund typically holds a portfolio of between 40 to 65 securities that the Fund’s advisor believes have the potential for growth.”

Let’s break these statements down to see what they may mean in terms of factor exposures:

• We would expect the Fund to have high, positive exposure to the Equity factor, since this is a long-only, stock-focused fund. 
• It’s international, so we wouldn’t expect any positive Local Equity exposure, but there could be some Foreign Currency sensitivity, especially if the Fund doesn’t hedge the currency risk. 
• We think that small companies with “operating revenues of $500 million or less” could indicate a positive exposure to the Small Cap factor, which is measured by market capitalization.
• A portfolio of only 40-65 securities could mean that the Fund carries a meaningful residual component -- perhaps because more risk and/or return may be coming from idiosyncratic stock decisions than would be expected for a more diversified manager or an equity index.
• Per the above, the Fund typically holds securities that “have the potential for growth.” Since we see growth typically defined as the opposite of value, we think there may be a negative Value exposure.

Factor Analysis Results

The factor exposure expectations set above largely held true, according to Venn. The Fund exhibited high, positive exposure to Equity, positive exposures to Foreign Currency and Small Cap, and a negative exposure to Value (see Exhibit 1).

Exhibit 1: Factor Exposures of the Fund and the Benchmark (MSCI ACWI ex U.S. Small Cap Gross Total Return USD Index)

Source: Venn (January 26, 2020). Time period: October 1, 2015 - January 22, 2020. 
Click here to view the updated factor exposures in Venn.

The risk not attributed to the factors in the Two Sigma Factor Lens, or “residual” risk, is approximately 22% (see Exhibit 2). 

Exhibit 2: Factor Contributions to Risk of the Fund 

Source: Venn (January 26, 2020). Time period: October 1, 2015 - January 22, 2020.

Click here to view the updated factor risk contributions in Venn.

Generally, it seems that the manager has rewarded investors for taking that idiosyncratic risk because the return not explained by the Two Sigma Factor Lens, or what some would call “alpha,” was approximately 4.4% per year (see Exhibit 3).

Exhibit 3: Factor Contributions to Return of the Fund 

Source: Venn (January 26, 2020). Time period: October 1, 2015 - January 22, 2020.

Click here to view the updated factor return contributions in Venn.

Despite most of our expectations playing out in the factor analysis results, there were a few unexpected exposures that are worth noting:

• The Fund exhibited less than 1.0 Equity beta, which would imply to us that it’s relatively defensive compared to the global equity market. However, the benchmark (we used the same benchmark as stated on the Fund’s March 31, 2020 factsheet) exhibited the same Equity beta as the Fund (see Exhibit 1) so this might not have been an active decision.
• There was a strong negative Local Equity exposure shown, which we believe reflects that the Fund is international and therefore underweight U.S. equity (relative to its global market cap weight).
• There was one interesting equity style factor exposure -- positive Momentum (see Exhibit 1). This exposure indicates that the stocks the Fund invested in have exhibited positive momentum, in addition to growth potential. 

Relative-to-Benchmark Factor Analysis

According to Venn, the Fund has meaningfully outperformed its benchmark, posting 7.4% excess returns annually. However, the Fund has also apparently taken on quite a bit of tracking error -- 8.5%, resulting in an Information Ratio (excess returns over tracking error) of 0.8. 

Exhibit 4: Relative to Benchmark Performance Statistics

Source: Venn (February 4, 2020). Time period: October 1, 2015 - January 22, 2020.

Click here to view the updated statistics in Venn.

Where could that tracking error be coming from? The active, or relative-to-benchmark, factor exposures were shown as follows (see Exhibit 5):

• As discussed earlier, the Fund has shown a positive Foreign Currency exposure. However, it has shown less exposure than the benchmark, meaning perhaps that the Fund had relatively more exposure to the USD than the benchmark. 
• The Fund’s positive tilt to Momentum and negative tilt to Value, each as described above, also show as having contributed to its tracking error (see Exhibit 6). Both of these tilts appeared to contribute positively to excess returns (see Exhibit 7).
• Roughly 65% of the tracking error was unexplained by the factors in the Two Sigma Factor Lens (see Exhibit 6), and most of the excess return was shown as due to residual (i.e., return not explained by the factors in the Two Sigma Factor Lens) (see Exhibit 7).

Exhibit 5: Active Factor Exposures of the Fund Relative to the Benchmark (MSCI ACWI ex U.S. Small Cap Gross Total Return USD Index)

Source: Venn (January 26, 2020). Time period: October 1, 2015 - January 22, 2020.

Click here to view the updated active factor exposures in Venn.

Exhibit 6: Factor Contributions to Tracking Error 

Source: Venn (January 26, 2020). Time period: October 1, 2015 - January 22, 2020.

Click here to view the updated factor tracking error contributions in Venn.

Exhibit 7: Factor Contributions to Excess Returns

Source: Venn (January 26, 2020). Time period: October 1, 2015 - January 22, 2020.

Click here to view the updated factor excess return contributions in Venn.

While the Fund’s residual excess return appeared very positive overall, Venn’s trend view analyzes its movement over time (see Exhibit 8). The Fund is shown as having some well performing years in 2017 and 2018, with a positive residual excess return, perhaps from good stock bets or tilting towards certain regions or countries that performed well. More recently though, the residual excess return shows as trending negative; in fact, over the 6 months ending in December 2019 the residual excess return showed as -12%. This deviates from the Fund's generally positive performance over its life and therefore could be something to clarify with the manager in due diligence.

Exhibit 8: Rolling 6 Month Factor Contributions to Excess Returns 

Source: Venn (February 3, 2020). Time period: October 1, 2015 - January 22, 2020.

Click here to view the updated rolling factor excess return contributions in Venn.

Conclusion

While we felt that the factor analysis results overall for the Fund were intuitive and lined up with the Fund’s stated approach, the relative-to-benchmark output was more interesting. The active returns are shown as largely driven by the residual component (which appeared strongly positive overall, but degraded recently), followed by negative and positive tilts to Value and Momentum respectively.

If you have candidate investments for the next Factor InVe(nn)stigator, please send them to invennstigator@venn.twosigma.com.

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