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These Terms of Use ("Terms of Use") are made between the undersigned user ("you") and Lord, Abbett & Co. ("we" or "us"). They become effective on the date that you electronically execute these Terms of Use ("Effective Date").

A. You are a successful financial consultant that markets securities, including the Lord Abbett Family of Funds;

B. We have developed the Lord Abbett Intelligence System (the "Intelligence System"), a state of the art information resource that we make available to a limited community of broker/dealers through the Internet at a secure Web site (the "LAIS Site"); and

C. We wish to provide access to the Intelligence System to you as an information tool responsive to the demands of your successful business pursuant to these Terms of Use. Accordingly, you and we, intending to be legally bound, hereby agree as follows:]

1. Overview. · Scope. These Terms of Use (which we may amend from time to time) govern your use of the Intelligence System. · Revisions; Changes. We may amend these Terms of Use at any time by posting amended Terms of Use ("Amended Terms of Use") on the LAIS Site. Any Amended Terms of Use will become effective immediately upon posting. Your use of the Intelligence System after any Amended Terms of Use become effective will be deemed to constitute your acceptance of those Amended Terms of Use.We may modify or discontinue the Intelligence System at any time, temporarily or permanently, with or without notice to you. Purpose of the Intelligence System. The Intelligence System is intended to be an information resource that you may use to contribute to your business research. The Intelligence System is for broker/dealer use only; it is not to be used with the public in oral, written or electronic form. The information on the Intelligence System and LAIS Site is for your information only and is neither the tax, legal or investment advice of Lord Abbett or its third-party sources nor their recommendation to purchase or sell any security.

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Equity Perspectives

True diversification is forward-looking and addresses emerging risks. Here’s how this approach has aided Lord Abbett’s security selection process.

One of the basic tenets of Modern Portfolio Theory (MPT) is that higher expected returns require taking on greater risk. But MPT also proposes that by owning a variety of assets, investors may earn higher returns—without taking on more risk. That’s because if asset prices are not perfectly correlated, price increases in one asset often are offset by price declines in another. This makes diversification “the only free lunch,” according to Harry Markowitz, originator of Modern Portfolio Theory and winner of the 1989 Nobel Prize in economics.

For decades, diversification was largely guesswork, measured by a simple rule of thumb: A fund with at least 100 stocks was considered diversified, while one with 50, for example, was not. The Investment Company Act of 1940, in fact, still defines “diversified” mutual funds in terms of the number of stocks held and the limits on the sizes of those holdings.

But that rule of thumb has become obsolete. Today, models from Barra, Axioma, and other providers help managers assess their exposures to well-known factor risks such as sectors, leverage, growth, and value as well as momentum. This means that even a 50-stock portfolio can be adequately hedged. In fact, even macroeconomic risks—oil prices and interest rates, for example—can be modeled as long as enough of the right historical data are available. 

A Scenario That “Rhymes”
But useful as they may be, these off-the-shelf models cannot address the full range of dangers to portfolio performance. Managers must also be on the alert for emerging risks, according to Alec Crawford, Lord Abbett Partner and Chief Risk Officer, Equity Investments. These risks may be unprecedented, and, therefore, little, if any, historical data may exist to provide a guide. The outbreak of the Ebola virus in 2014, for example, had never happened before on such a large scale, making it difficult to model.  

Instances such as this require some imagination, and to model them, Crawford and his team typically look for historical events that are analogous. “When there’s an existing historical scenario, obviously we’ll consider that. When there isn’t such a scenario, we look for one that ‘rhymes,’” Crawford said. “To model the Ebola outbreak, we looked at the impact of the SARS [severe acute respiratory syndrome] outbreak that occurred in Asia in 2002–03.”

Although the SARS outbreak was different in many ways, it was similar enough to be instructive. The Ebola outbreak mimicked SARS in that both threatened to shut down transportation around the world, so it was likely that the Ebola outbreak would harm airline stocks, for example, as SARS did. Likewise, pharmaceutical stocks benefited in both instances, though the effects were quite company-specific.

A Team Approach
These analyses sometimes require more than the usual resources. In many cases, data must be collected that are not readily available from the standard providers. In fact, sometimes it may only be available from a knowledgeable team of research analysts. Yet not all asset managers have this capability. Only those with extensive research departments that facilitate the collection of the necessary data have the resources to carry out these analyses.

For example, another threat on the horizon is the possibility of a concerted crackdown by countries in the Organisation for Economic Cooperation and Development on companies that don’t appear to be paying enough in taxes. This issue occasionally makes news headlines, as it did in 2014, when some companies were engaged in “tax inversions”—that is, acquisitions that were designed to minimize their global tax burdens. “We’re not predicting that governments are going to crack down in the immediate future, but it’s reasonable to expect that at some time in the next few years, they will coordinate their efforts and try to close loopholes,” said Crawford.

To model the possible effects of this scenario, Crawford and his team screened for companies paying an overall tax rate of less than 10% worldwide. Eliminating those that had lost money over the previous five years still left a large pool of companies. From there, Crawford relied on the analyst team’s intimate knowledge of the remaining companies to reduce the list to those that could be possible targets for a government crackdown.

One of these was a United Kingdom-based pharmaceutical company. Its stock nosedived when U.K. officials, in cooperation with the U.S. government, refused to provide tax benefits connected to a merger that the company had agreed to with a U.S. drug company, late in 2014. “So our analysis had a concrete result in that it enabled [our] portfolio managers to understand this risk and allowed them to avoid that stock,” Crawford said.

 

Chart 1. Some Investors Were Hurt by the Cancelled Acquisition of a U.K. Drug Company
Stock price of U.K. drug company (in U.S. dollars)

Source: Bloomberg.
For illustrative purposes only. 

 

In this case, having a large research group was “a huge advantage for us; without them, we would not have been able to tackle this kind of analysis at the same level of granularity,” said Crawford.

Other Benefits
The obvious benefit of this approach to risk management is the possibility of avoiding the negative effects of significant downturns in certain market segments or themes. This can result in improved information ratios, which can take a beating if an unforeseen risk is allowed to wreak havoc on returns. “What we’re trying to do is catch problems early,” said Crawford, “and then get out of them or hedge them before they negatively impact our investors.”

For portfolio managers, this approach provides a more comprehensive understanding of the risks they’re taking. “Fund managers are very knowledgeable about the companies in their portfolios,” Crawford said. “Where risk management helps is in keeping them informed about the top-down or macro risks, including hidden risks. We represent ‘risk understanding’ as much as ‘risk management.’”

For investors, diversification is still the only “free lunch.” By holding a variety of uncorrelated assets, investors could have the opportunity to improve their expected returns while reducing their risk. But today, asset managers with enough resources and the correct tools may achieve true diversification--without the guesswork. 

 

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