A New Approach to Risk Management

COMMENTARY

Market Insight

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A NEWAPPROACH TO RISK MANAGEMENT

Investors seeking to dampen the impact of market volatility on their portfolios frequently overweight defensive sectors or industries, such as Real Estate, Telecommunications and Consumer Staples. We believe this practice can potentially lead to underperformance during certain periods of market declines as well as during longer time periods. In this paper, we discuss this observation and propose an alternative for managing risk. The Nuts and Bolts of Defensive Sectors Defensive sectors and companies are called non-cyclical because they provide products that are essential throughout economic cycles. • Businesses require offices and other buildings and consumers require housing, which can support the performance of the Real Estate sector when the economy slows. • The Telecommunications industry experiences steady demand for telephone communications and networks for transmitting data. • Consumer Staples are also non-cyclical with demand for food and household items persisting throughout economic cycles. Defensive sectors often provide consistent earnings rather than potential for strong revenue growth and accelerating profits. Some investors believe the steady results of non-cyclical companies can be appealing during market dips or when the economy weakens. Downside capture ratios illustrate this perceived appeal. A downside ratio simply measures the decline in a stock’s price relative to the decline in the market—a ratio of 0.80 implies a stock’s price decline has been 80% of the decline of the market. Upside ratios measure the percentage of market gains that a stock captures. Certain stocks with low downside capture ratios can potentially outperform when markets decline, but not always. In some instances, stocks of companies that are benefiting from secular growth, such as the rapid adoption of software, can outperform sectors with low downside capture ratios as illustrated by Figure 1.

Matt Weatherbie, CFA CH I E F E X ECU T I V E O F F I C E R CO - CH I E F I NV E S TMEN T O F F I C E R WE AT H E RB I E CA P I TA L , L LC

H. George Dai, Ph.D. S EN I OR MANAG I NG D I R ECTOR CO - CH I E F I NV E S TMEN T O F F I C E R WE AT H E RB I E CA P I TA L , L LC

Joshua D. Bennett, CFA S EN I OR MANAG I NG D I R ECTOR D I R ECTOR O F R E S E A RCH WE AT H E RB I E CA P I TA L , L LC

Figure 1: Performance During Bear Market (3 years ended 12/31/2009)

-20% 0% 20% 40% 60% 80% 100% 120%

● Annual Return ■ Downside Capture

2% 3% 4% 5% 6%

Downside Capture

-2% -1% 0% 1%

Source: FactSet.The figures presented are provided for illustrative purposes.They include examples of the performance of two industries with downside captures above and below 100%, respectively. Please note that using dierent industries or dierent time periods might have materially dierent results than those shown above. Annual Return The performance data quoted represents past performance, which is not an indication or a guarantee of future results. Telecom Software

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By capturing market share, innovative companies, including those with high downside capture ratios, can potentially benefit from secular growth that may occur even during periods of economic weakness.

Even though the downside capture ratio of the Software industry was substantially higher than that of Telecommunications, Software’s high upside capture ratio resulted in strong gains on days when markets rallied during the bear market referenced in Figure 1. Those gains resulted in Software outperforming. A Better Approach to Risk Management? We believe investors should seek companies that have potential for generating earnings acceleration and revenue growth. In many instances, these companies use innovation to develop products or services that disrupt their respective industries. By capturing market share, innovative companies, including those with high downside capture ratios, can potentially benefit from secular growth that may occur even during periods of economic weakness (See Figure 2). EATHERBIE CAPITAL

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Figure 2: Innovation Prevails

130% 140% ■ U.S. Internet Ad Revenue ■ U.S. E-Commerce ■ U.S. Total Retail Sales

120%

+30% Growth

110%

100%

90%

80%

2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11

Source: Bureau of Economic Analysis, PwC, Census Bureau. *See Alger’s white paper“The Enduring Force of Innovation.”

The most innovative companies as determined by the percentage of revenues invested in research and development have transcended market volatility associated with the Great Recession and have outperformed (See Figure 3).

Figure 3: Innovative Companies Outperformed During the Great Recession (From December 2007 to June 2009)

Cumulative Excess Returns

Most Innovative

+6.3%

S&P 1500 Index

-11.5%

Least Innovative

The performance data quoted represents past performance, which is not an indication or a guarantee of future results. Source: Factset. Most/least innovative stocks excess performance is derived from highest and lowest S&P 1500 quintiles based on R&D as % of sales, normalized for market value, using one-month returns for period from 2008 to June of 2009.

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HEICO Corporation, which provides aircraft parts, is benefiting from an increase in air travel, but we believe the company’s strong commitment to research and development has positioned it to continue its sales and earnings growth momentum throughout economic cycles.

Innovation Is Transforming Health Care Insulet Corporation has developed Omnipod, a tubeless insulin system for treating diabetes. It is a wearable and waterproof pod that delivers insulin for up to 72 hours. Insulet is also expanding the types of drugs that can be administered with Omnipod. For diabetes patients, Omnipod is a more convenient option than administering insulin with syringes, which can require keeping the medication on hand around the clock. The device can also deliver more accurate dosages at a steady rate, which improves treatment efficacy. These attributes, we believe, can potentially support growing demand for Omnipod throughout economic cycles. Public Safety Gets a Boost from Digitization Government agencies and employers need to respond promptly to weather emergencies, infrastructure failures, civil unrest, health threats and other events. To that end, Everbridge, Inc. offers cloud-based technology for disseminating alerts via text messages, emails, telephone voice messages and the web, including social media. Its technology also helps governments and employers better manage crises, including deploying and coordinating first responders. By providing innovative products that help governments and employers better respond to events, we believe Everbridge has potential to continue increasing its sales and produce earnings expansion. Research and Development Thrives in Aviation HEICO Corporation, which provides aircraft parts, is benefiting from an increase in air travel, but we believe the company’s strong commitment to research and development has positioned it to continue its sales and earnings growth momentum throughout economic cycles. The company specializes in private manufacturer authorization parts that replace original equipment manufacturer parts. It sells parts at substantially lower prices than original manufacturers. It has considerable resources such as engineers and testing equipment for developing replacement parts that meet strict Federal Aviation Administration requirements. Conclusion Identifying smaller high-quality companies that are leaders in secular growth trends requires in-depth fundamental research. Such a process, we believe, can potentially identify companies that will generate attractive returns for investors throughout economic cycles. At the same time, having an in-depth knowledge of portfolio holdings and unique characteristics that can allow each company to grow its earnings is crucial to managing portfolio risk.

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Matt Weatherbie, CFA Chief Executive Officer Co-Chief Investment Officer

Joshua D. Bennett, CFA Senior Managing Director Director of Research

H. George Dai, Ph.D. Senior Managing Director Co-Chief Investment Officer

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The views expressed are the views of Fred Alger Management, Inc. and Alger Management Ltd. (together with their affiliated entities “Alger”) as of September 2019. Alger has used sources of information which it believes to be reliable; however, this publication is not intended to be and does not constitute investment advice. These views are subject to change at any time and they do not guarantee the future performance of the markets, any security, or any funds managed by Alger. Risk Disclosures: Investing in the stock market involves certain risks, and may not be suitable for all investors. Growth stocks tend to be more volatile than other stocks as their prices tend to be higher in relation to their companies’ earnings and may be more sensitive to market, political, and economic developments. Technology and healthcare companies may be significantly affected by competition, innovation, regulation, and product obsolescence, and may be more volatile than the securities of other companies. Investing in companies of small and medium capitalizations involve the risk that such issuers may have limited product lines or financial resources, lack management depth, or have limited liquidity. Assets may be focused in a small number of holdings, making them susceptible to risks associated with a single economic, political or regulatory event than a more diversified portfolio. Foreign securities involve special risks including currency risk and risks related to political, social, or economic conditions. Past performance is not indicative of future performance. Investors whose reference currency differs from that in which the underlying assets are invested may be subject to exchange rate movements that alter the value of their investments. Important Information for US Investors: This material must be accompanied by the most recent fund fact sheet(s) if used in connection with the sale of mutual fund shares. Fred Alger & Company, Incorporated serves as distributor of the Alger mutual funds. Important Information for UK Investors: The distribution of this material in the United Kingdom is restricted by law. Accordingly, this material is provided only for and is directed only at persons in the United Kingdom reasonably believed to be of a kind to whom such promotions may be communicated by an unauthorized person pursuant to an exemption under the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (the “FPO”). Such persons include: (a) persons having professional experience in matters relating to investments and (b) high net worth bodies corporate, partnerships, unincorporated associations, trusts, etc. falling within Article 49 of the FPO. Most of the rules made under the FSMA for the protection of retail clients do not apply, and compensation under the United Kingdom Financial Services Compensation Scheme will not be available. Important Information for UK and EU Investors: This material is directed at investment professionals and qualified investors (as defined by MiFID/FCA regulations). It is for information purposes only and has been prepared and is made available for the benefit investors. This material does not constitute an offer or solicitation to any person in any jurisdiction in which it is not authorised or permitted, or to anyone who would be an unlawful recipient, and is only intended for use by original recipients and addressees. The original recipient is solely responsible for any actions in further distributing this material and should be satisfied in doing so that there is no breach of local legislation or regulation. Certain products may be subject to restrictions with regard to certain persons or in certain countries under national regulations applicable to such persons or countries. Alger Management, Ltd. (company house number 8634056, domiciled at 78 Brook Street, London W1K 5EF, UK) is authorised and regulated by the Financial Conduct Authority, for the distribution of regulated financial products and services. FAM and/or Weatherbie Capital, LLC, U.S. registered investment advisors, serve as sub-portfo- lio manager to financial products distributed by Alger Management, Ltd. Fred Alger & Company, Incorporated is not an authorized person for the purposes of the Financial Services and Markets Act 2000 of the United Kingdom (“FSMA”) and this material has not been approved by an authorized person for the purposes of Section 21(2)(b) of the FSMA. The Russell 2500® Growth Index measures the performance of the small to mid-cap growth segment of the U.S. equity universe. It includes those Russell 2500 compa- nies with higher growth earning potential as defined by Russell’s leading style methodology. The Russell 2500 Growth Index is constructed to provide a comprehensive and unbiased barometer of the small to mid-cap growth market. S&P Composite 1500 is an unmanaged index that covers approximately 90% of the U.S. market capitalization. Investors cannot invest directly in any index. Index performance does not reflect deductions for fees, expenses or taxes. Performance data quoted represents past performance. Past performance is not a guarantee of future results. The following positions represented the noted percentages of Alger assets under management as of 6/30/2019: Insulet Corporation, 0.8%; Everbridge, Inc., 0.7%; and HEICO Corp., 0.4%. All information regarding firm history, biographies, and Fred Alger Management, Inc. (“FAM”) and Weatherbie Capital, LLC performance are maintained by FAM. Alger uses The Global Industry Classification Standard (GICS®) for categorizing companies into sectors and industries. GICS is designed to meet the needs of the investment community for a classification system that reflects a company’s primary business model as determined by its financial performance. FactSet is an independent source, which Alger believes to be a reliable source. FAM, however, makes no representation that it is complete or accurate.

Fred Alger Management, Inc. 360 Park Avenue South, New York, NY 10010 / 800.223.3810 / www.alger.com

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