Portfolio Manager Nathan Moser reflects on his approach at the Pax Small Cap Fund’s 10-year anniversary
The Pax Small Cap Fund crossed the 10-year mark in 2018. In recognition of this milestone, Portfolio Manager Nathan Moser, CFA®, reflects on managing the Fund since its inception in 2008.
Mr. Moser discusses his risk-focused investment approach, active versus passive investing in small cap, and implications of uptick in market volatility thus far in 2018. All Pax Small Cap Fund performance and risk information referenced in the interview relates to the institutional share class.
Q: What aspect of your investment approach has helped you succeed in managing the fund?
Mr. Moser: I’d say the emphasis on risk management is a point of differentiation, and, over longer periods, this discipline has helped the Fund versus peers. Our philosophy has always been focused on investing in the highest quality companies we can find, avoid over-paying for them and use active management to mitigate risk. We manage with a long-term perspective and seek to preserve investor’s capital during market declines as much as possible.
In my view, all too often investors chase short-term performance and fail to account for the level of risk in their portfolios. Our strategy was developed specifically to provide attractive risk-adjusted returns over the long term. Over the 10-year period, we’ve done just that, generating more alpha than the Russell 2000 Index and 86% of peers. This approach has helped the Fund rank better than 88% of small cap peers on standard deviation and better than 96% of peers on downside capture over the trailing 10 years period ending 3/31/18.1
Q: How did risk management become such an important part of your investment approach?
Mr. Moser: Over my career, which started at the peak of the technology bubble in 2000, I’ve seen two market declines of greater than 45% – with many investors losing significantly more. Boom and bust cycles are a normal part of financial markets, which may be fading from investors’ minds because of how unusually placid and long this bull market has been thus far.
While all investors know they need to focus on the long-term, even for those with the most fortitude, it’s very difficult when you’re watching markets fall sharply. We designed this strategy to mitigate the risk of the small cap asset class, with the goal of allowing clients to remain invested through the inevitable bumps in the road.
Q: What gives you confidence that you can continue to provide strong risk-adjusted results?
Mr. Moser: The small cap market is inefficient, which affords us the opportunity to outperform the market. I believe that to beat the index and your competition, you can’t look like the index or do the same things your peers do.
Another aspect of our process that is differentiated is the integration of environmental, social and governance (ESG) analysis into our research process. In our view, this helps us identify potential risks and opportunities that our competitors may overlook. When combined with disciplined financial research, we gain additional insights and we believe the result is a higher quality portfolio with less risk.
Q: Over the past ten years, passive investing has increased in popularity. What are your thoughts on the passive approach in the small cap asset class?
Mr. Moser: With respect to small cap stocks, passive investing exposes investors to meaningful risk as the benchmark contains many lower quality companies. In fact, approximately one-third of the companies in the Russell 2000 Index are unprofitable.2 In an up market, very few investors care to closely scrutinize the fundamental quality of the stocks they own. However, should the inflows to passive vehicles reverse to outflows, I expect we’ll see meaningful small cap index volatility.
The reason is because passive vehicles are largely mechanical – when money comes in, they put it to work. As companies in the index grow larger, passive funds buy more regardless of the underlying company’s fundamentals or valuation. Simply put, these vehicles buy more of what’s working – which is what momentum investors do. Passive vehicles now represent a very large part of the market and a shock to the system could cause investors to redeem en masse.
Q: Volatility has picked up in 2018, how are you positioning the fund?
Mr. Moser: We’ve seen some volatility this year as investors contemplate the impact of increased trade tensions and the Federal Reserve’s tightening of monetary policy. I think the Fed is the bigger risk as they normalize policy. Higher interest rates at the margin may slow growth and deter further multiple expansion. This puts an increased burden on earnings growth, which could lead to increased dispersion – allowing strong stock pickers a favorable backdrop to add alpha.
In addition, inflation appears to be picking up – which encourages the Fed to stay vigilant. We expect interest rates to increase and have positioned the Fund accordingly with an overweight to Financials and underweights to Utilities and Real Estate. Overall, we remain concerned with small cap valuations and remain defensively positioned. Should markets decline, we look forward to taking advantage of any potential opportunities.
Q: What are some of the things you’ve learned over the 10-year period of managing the fund?
Mr. Moser: I’ve learned many important lessons over the past ten years. I would highlight the importance of having an effective sell-discipline as one of the most critical. That is, having a plan on specific valuation levels or under what circumstances we exit a position. The sell discipline is a key element of our strategy and we see it as an important driver of strong risk-adjusted returns. Over the years the process has become better structured, more consistent and I am continually looking for ways to improve that facet of my decision making.
A broader lesson I’ve learned over my career is that as markets evolve, investors have to as well. One of the outcomes of the shift to passive investing is an increase in the persistence of stock trends, both up and down. To the extent that stocks are moving lower on deteriorating fundamentals, we feel it’s more important now than ever to exit.
Q: Anything else that you would like to share?
Mr. Moser: While milestones are a good time to pause and reflect, we remain committed to our approach and passionate about the opportunity that lies ahead. As we embark on the next ten years, I would like to thank all our investors for their confidence and continued support.
For information about the Pax Small Cap Fund, visit the Fund page here.
Equity investments are subject to market fluctuations, the fund’s share price can fall because of weakness in the broad market, a particular industry, or specific holdings. Funds that emphasize investments in smaller companies generally will experience greater price volatility.
Performance data quoted represent past performance, which does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. For most recent month-end performance information visit paxworld.com
1 Rankings in other time periods may be lower. Comparison based on the Lipper Small Cap Core Classification. The Fund’s Institutional Class Alpha for the 10 year period ranked 69 out of 513 (14th percentile) and was 0.12 compared to the Russell 2000 Index Alpha of 0.00. The Fund’s Institutional Class Standard Deviation for the 10 year period ranked 447 out of 513 (88th percentile). The Fund’s Institutional Class Downside Capture for the 10 year period ranked 489 out of 513 (96th percentile). The Fund’s Institutional Class Alpha for the 5 year period ranked 32 out of 698 (5th percentile). The Fund’s Institutional Class Standard Deviation for the 5 year period ranked 691 out of 698 (99th percentile). The Fund’s Institutional Class Downside Capture for the 5 year period ranked 696 out of 698 (99th percentile). The Fund’s Institutional Class Alpha for the 3 year period ranked 474 out of 813 (59th percentile). The Fund’s Institutional Class Standard Deviation for the 3 year period ranked 805 out of 813 (99th percentile). The Fund’s Institutional Class Downside Capture for the 3 year period ranked 782 out of 813 (97th percentile). The Fund’s Institutional Class Alpha for the 1 year period ranked 571 out of 991 (58th percentile). The Fund’s Institutional Class Standard Deviation for the 1 year period ranked 882 out of 991 (89th percentile). The Fund’s Institutional Class Downside Capture for the 1 year period ranked 783 out of 991 (79th percentile). The Fund’s Individual Class Alpha for the 10 year period ranked 89 out of 513 (18th percentile) and was 0.10 compared to the Russell 2000 Index Alpha of 0.00. The Fund’s Individual Class Standard Deviation for the 10 year period ranked 446 out of 513 (87th percentile). The Fund’s Individual Class Downside Capture for the 10 year period ranked 486 out of 513 (95th percentile). The Fund’s Individual Class Alpha for the 5 year period ranked 46 out of 698 (7th percentile). The Fund’s Individual Class Standard Deviation for the 5 year period ranked 692 out of 698 (99th percentile). The Fund’s Individual Class Downside Capture for the 5 year period ranked 695 out of 698 (99th percentile). The Fund’s Individual Class Alpha for the 3 year period ranked 517 out of 813 (64th percentile). The Fund’s Individual Class Standard Deviation for the 3 year period ranked 806 out of 813 (99th percentile). The Fund’s Individual Class Downside Capture for the 3 year period ranked 776 out of 813 (96th percentile). The Fund’s Individual Class Alpha for the 1 year period ranked 587 out of 991 (60th percentile). The Fund’s Individual Class Standard Deviation for the 1 year period ranked 886 out of 991 (90th percentile). The Fund’s Individual Class Downside Capture for the 1 year period ranked 779 out of 991 (79th percentile). A higher percentile for Alpha indicates a higher peer ranking. A lower percentile for Standard Deviation and Downside Capture risk measurements indicates a higher peer ranking.
2 Source: Bloomberg as of 4/17/2018
Alpha is a coefficient measuring risk-adjusted performance, considering the risk due to the specific security, rather than the overall market. A positive alpha reflects relative risk-adjusted performance of the Fund versus its benchmark.
Standard Deviation measures a Fund’s variation around its mean performance; a high standard deviation implies greater volatility.
Downside capture measures an investment manager’s overall performance in down-markets and is used to evaluate how well or poorly an investment manager performed relative to an index during periods when that index has dropped. A downside capture ratio less than 100 indicates that the investment manager has outperformed its index during down-markets, while downside capture ratio greater than 100 indicates that the investment manager has underperformed its index during down-markets.