Portfolio construction isn’t just about compiling a collection of ‘best ideas’. And as active investors, we know that risk can’t be avoided. Thus, understanding the risks inherent within these best ideas is the key to successful investment outcomes.
At the heart of understanding portfolio risk management lies the investment philosophy, which sets out the aims or goals of the investor and consequently changes indiscriminate investing into a systematic and repeatable risk-taking exercise.
We believe that the market often under-appreciates the impact of companies’ extra-financial factors, thereby creating exploitable inefficiencies – and we understand the importance of taking risks consistent with this belief. These are the risks that we want in our portfolios and expect to be rewarded for (‘intended risks’ or ‘stock-specific risks’). Conversely, unintended risks are incidental to the investment philosophy and have an unknown expected return.
Intended risk and return: the perfect match
As investors who think like long-term business owners and consider all forms of a company’s capital, not just those displayed in traditional financial reporting, we look at what is unique about a business, such as the launch of an innovative product or a positive change in management.
We use ESG as a tool to focus on the idiosyncratic aspects of a business that no other company shares. This helps us to identify intended sources of risk, which is the type of risk that we desire, as bottom-up stock pickers. Frequently these risk sources are poorly priced by the market.
If we ensure that our portfolios’ risk profiles are dominated by these stock-specific risks, we should expect to deliver attractive, risk-adjusted returns.
It’s a risky business
Managing residual exposures to unintended risk sources, such as interest rate, currency or country risk, is also key.
Risk models can be used to shed a light on hidden biases within portfolios; biases that have the potential to give investors unwelcome surprises. Such risks lie outside our investment thesis and have the potential to add volatility with outcomes determined by chance. They must therefore be controlled, reduced and diversified.
For example, it’s easy to be drawn to a particular company based on its brand and technology but to be unconcerned about the country in which it is listed. However, should that country be affected by a risk event, portfolio returns may be compromised.
Unfortunately, the investment environment is complex and ‘events’ are not uncommon. There are many such sources of unintended incidental risk. Such risks may be mitigated through diversification. Investor skill lies in managing the trade-off between having fewer holdings to preserve conviction and adding additional holdings to diversify incidental risks. This is one of the challenges of efficient portfolio construction.
A balancing act
Assuming we have the skill to select stock-specific risks, then a portfolio that focuses on these intended risk sources should deliver the best risk-adjusted returns. Common risks that are shared by multiple companies become unintended by-products. Examples of these could be the country of incorporation, the type of industry, the company’s size or the sort of raw materials it buys.
Although one cannot buy stock-specific alpha without it coming with some systematic factor exposures (‘betas’), in practice their impact on portfolio returns can be minimised through diversification. And the more sources of unintended risk there are, the smaller the portfolio’s exposure to each unintended risk source, and the less likely that their return will be significant.
Stock-specific alpha is potentially very valuable, not only because it can be incremental to returns, but also as a diversifier of sources of returns. The uncorrelated nature of alphas offers potentially valuable diversification benefits to investors seeking to combine risk premia and produce an efficient portfolio that maximises returns for an acceptable level of risk.
Conclusion
Regardless of the market conditions that lie ahead, we believe in the persistence of returns from stock-specific risks associated with great businesses at attractive valuations.
In practice, this means long-term relative performance is determined by the companies owned, not by unintended risk exposures – in other words, it is determined by stock picking-led outperformance. A great management team – a unique characteristic of a business – will be able to steward that business responsibly, and can also bring ingenuity and resilience. In the face of uncertainty, those two key characteristics are especially valued by investors.
The investment landscape will continue to evolve, but in our view, the focus of active risk on great businesses that are able to successfully harness the opportunities of change will continue to provide the potential for resilient value creation over time.
For more information, please contact us.