Due Diligence Report on DCI
DCI is a San Francisco–based, corporate credit–focused investment firm that manages systematic quantitative-driven portfolios of long-only, long-short, and net-short credit strategies. The firm was founded in 2004 by Stephen Kealhofer, David Solo, Mac McQuown, Tim Kasta, and Richard Donick. The group has a long history of innovation in finance, including the creation of the first equity index fund at Wells Fargo in 1971 (McQuown), and the cofounding of Dimensional Fund Advisors in 1981 (McQuown) and KMV in 1989 (Kealhofer, McQuown). After selling KMV to Moody’s, they founded DCI in 2004 to create a corporate credit asset management business. The firm has managed various long-only investment-grade credit, long-short credit, and, more recently, long-only high-yield strategies since 2004, while continuing to refine the investment process and expand their offerings.
We have been familiar with DCI for several years and increased our research focus on a potential sub-advisory relationship over the last 12–18 months. Our research involved many hours of phone calls and in-person meetings with the senior members of the firm’s research, portfolio management, risk management, and executive teams. Most of our time was focused on understanding the nature of the firm’s fundamental credit risk and valuation models, how they translate a variety of disparate information into a portfolio construct, and the evolution of the investment and portfolio management processes.
The firm’s investment philosophy is based on two core characteristics of the credit markets.
- Credit markets contain exploitable information gaps: DCI believes equity and credit markets react to information differently. Credit markets tend to be very sensitive to capital structure changes while equity markets tend to focus more on future corporate profitability. As a consequence, equity markets tend to lead credit markets with respect to information on the firm’s value and the volatility of that value.
- Credit markets are poorly diversified and inefficient: A small number of firms issue a disproportionate amount of total debt, and firms that are rated too highly relative to their fundamentals by ratings agencies are able to (and frequently do) issue too much debt, and vice versa. Conventional approaches to credit investing are built around issuance-weighted credit indexes, which are further concentrated into positions in firms with poor return-to-risk profiles; this tends to create excessive idiosyncratic risk for investors and perpetuate potential mispricing in the market.
Over the course of 20-plus years, DCI’s principals built and refined a systematic investment approach that takes advantage of these credit market inefficiencies. At KMV (1989–2002), they built a credit default probability model that considers equity and other market information to enhance the timeliness and accuracy of credit assessment. Subsequently, at DCI, they have enhanced the default probability model and added a portfolio construction model that sizes positions to generate superior risk-adjusted returns.
DCI believes its investment edge is the combination of the default probability model (which is unique in its ability to capture real-time equity, credit, and other market information that is not widely used in traditional credit analysis), the translation and mapping of credit risk to valuation, and its systematic portfolio construction process. Further, the failure of conventional credit approaches to consider equity and other information systematically, and the tendency to build portfolios with sub-optimal weightings (tracking or at least influenced by issuance weightings in an index) are features that create persistent inefficiencies. While informational efficiencies are likely to develop as credit markets mature and evolve, DCI expects that as long as conventional credit investors and indexes dominate the market, exploitable inefficiencies should persist.
At the core of all DCI strategies is a model that uses publicly available information from credit, equity, and options markets to calculate default probabilities for hundreds of corporate debt issuers and then translates the default probability into a corresponding “fair value” credit spread. DCI then compares their model-generated credit spreads to the actual credit spreads in the market and buys the most undervalued credits and shorts the most overvalued credits.
The elements of DCI’s systematic process can be summarized by the following:
The principal driver of all DCI strategies is the proprietary default probability model. The model incorporates fundamental balance sheet information, real-time equity and options markets information, and a robust database of historical defaults.
The valuation model takes into account the model-generated default probability, along with the estimates of the risk premia that should be associated with other security characteristics (e.g., size, sector). Using this information, it produces a “fair value” model credit spread.
The portfolio construction model balances perceived security mispricing, default probability, and diversification to create a portfolio where no single issuer contributes a disproportionate amount of risk. DCI monitors portfolio weightings across a number of metrics (e.g., credit beta, sector, geography) to ensure the portfolio remains relatively balanced, which should result in idiosyncratic credit movements driving the majority of performance.
DCI Long/Short Credit Strategy Implementation for the Litman Gregory Masters Alternative Strategies Fund
The strategy’s portfolio will consist of two components:
- A long-short, market neutral portfolio made up entirely of single-name corporate credit default swaps (CDS). This sleeve will contain 70–100 positions on each side of the book, and will be approximately 100% long and 100% short on a notional basis. Returns are expected to come from both longs and shorts as the market credit spreads converge toward DCI’s fair value modeled spreads. Because the portfolio is balanced across different risk factors (e.g., sector, geography), the returns should be almost exclusively driven by credit selection.
- A portfolio of approximately 70–100 high-yield cash bonds hedged with CDX (the high-yield CDS index) and Treasury futures to reduce credit beta and interest rate risk, respectively. The hedging should largely isolate idiosyncratic credit risk as the main driver of performance.
These two components have historically demonstrated low correlation to one another, which we believe provides a superior strategy in combination than either one in isolation.
Litman Gregory Opinion
There are a number of factors that contribute to our enthusiasm for adding DCI as a sub-advisor to our Alternative Strategies Fund. They include the following:
- Distinctive investment process. DCI systematically assesses and integrates a variety of fundamental inputs from different markets (credit, equity, options) in a way we believe is very rare among credit managers.
- Team with a strong pedigree and long history of innovation in systematic investing. As mentioned previously, some of the founders of DCI have been involved in major investment innovations including equity indexing and factor-based investing. The culture of research and development seems to be fully intact and should help DCI continue to improve the investment process and implementation in the future. DCI has also made several meaningful hires to the research team over the past couple of years.
- Performance tends to be resilient to periods of market stress/higher volatility. When market volatility increases, there is a greater absolute spread that can be captured by the long-short CDS component of the strategy and there is typically faster convergence to fair value. (The long-short sleeve actually has a moderately strong positive correlation to the level of the VIX.) We expect DCI to be a strong performer among the fund’s sub-advisors during high-volatility periods.
- Key drivers of return are insensitive to interest rates. Despite using bonds in part of the portfolio, we believe the strategy should perform about equally well in a rising or falling rate environment (in terms of excess returns over cash) due to the hedging of interest rate exposure in the cash bond component of the portfolio.
- Attractive risk-adjusted returns with low/no correlation to equity or credit markets. The strategy has historically demonstrated effectively zero correlation to the equity market, and very low correlations to high-yield, investment-grade, and Treasury bonds.
- Very low correlation to other sub-advisors. We believe the addition of DCI’s strategy should benefit the fund by potentially increasing the fund’s long-term expected returns, while decreasing the fund’s risk.
We are confident DCI’s strategy on its own has the potential to generate attractive risk-adjusted returns across a variety of market environments with low volatility and low risk of significant drawdowns. Specifically, we believe the strategy should be able to produce attractive, positive annualized returns relatively consistently, given its diversification and lack of reliance on credit market beta or interest rate movements to drive returns. Additionally, because of its low correlation to existing strategies, it is a very attractive complement and should contribute to achieving the fund’s overall risk, return, and diversification objectives