What one investor sees as risk might not be the same for another, writes Joseph Mariathasan. It all depends on the objective of the individual investor
Everyone agrees that risk management within the management of equity portfolios is an integral component of portfolio construction. But what is often not discussed is what the objective should be. Moreover, as Nathan Gelber, the chief investment officer at Stamford Associates, an independent consultancy, points out, it is important to understand that what constitutes risk for one investor may not necessarily constitute risk for another.
The great majority of institutional investors define risk as the volatility of the pricing of the underlying assets. But, as Gelber argues, volatility is just a statistical measure that does not define risk in the way any retail or institutional investor understands the concept. Risk for them is the permanent impairment of capital. Whether asset prices vary over time is not really a risk for long-term investors who are able to sit through periods when the variability, particularly the downside, is pronounced. What is difficult to recover from is the permanent impairment of capital.
Asset owners might worry about losing their capital, but for their agents, the fund managers, that is not their own biggest risk. For them, it is the business risk of the loss of a fund management contract through underperformance against a benchmark index. The incentive for fund managers is, therefore, to minimise business risk through minimising tracking error against the benchmark. Such closet indexing has been a staple of much of the fund management industry for decades.
Gelber argues that benchmarks should not be used as a guide to risk. They are merely a measure to look at long-term returns and to give a clue as to whether over the long term the manager has been able to do a good job.
Consultants are much more wary of closet-indexing approaches. Redington tries to screen them out using metrics such as tracking error and active share, says Nick Samuels, head of manager research at the consultancy. It means that Redington actively seeks managers with high tracking errors – the opposite of the behaviour of asset owners when they seek to constrain managers by imposing limits of tracking errors.
Should managers therefore only include stocks that they have strong convictions on within portfolios? That is, should they ignore ‘risk’ in the form of tracking error against a benchmark index if that implies buying stocks they do not like? For fundamental active managers, consultants such as Gelber and Samuels favour such an approach. Indeed, the real problem such managers face is that they have a limited bandwidth to spend on analysing stocks. “Spending limited resources on monitoring stocks in the portfolio purely for risk management purposes is a waste of their time,” says Samuels.
Gelber prefers managers to focus on risk within the stock selection itself. Stamford prefers managers that bring an absolute-return mindset to the investment analysis. “As such, they think long and hard of how much money they could lose with any given investment,” says Gelber.
When valuations are high, though, Gelber argues that price/earnings (p/e) contraction is a great hazard to the protection of capital, so Stamford is not keen on high p/e ratios within its portfolios. “At the moment, if you look at the so-called bond proxy sector of the equity market, the p/e ratios have been bid up because of investors’ insatiable appetite for income. p/e ratios have been driven to stratospheric levels and these are due for a correction. This could result in permanent impairment of capital, for all you know.”
If managers are only focusing on high-conviction bets within their portfolios, it does drastically reduce the number that can be reasonably included. Samuels argues that a team of three or four managers would be hard pressed to cover more than 70-80 stocks in-depth and they would be competing with managers who may be having only 15-20 within a portfolio. Fewer than 20 stocks, though, would be seen as unusual, while they prefer managers with no more than 50 stocks within global portfolios.
Stamford has a similar philosophy. “Anyone who has more than 40 stocks does not have high conviction. It is a question of bandwidth. How many stocks can one individual have real knowledge about? The human bandwidth is limited,” says Gelber.
With such concentrated portfolios, should risk controls be imposed on a manager? Gelber argues not. Stamford sees risk control as employing skilful talented managers who know what they are doing. “We think if they are talented, they should be able to put the highest convictions in their portfolios with no constraints. The moment you put constraints on, you do start undermining the accountability issue.”
Mark Beveridge, global head at AXA IM Framlington Equities, an evangelist for active management, acknowledges that there has to be some risk control. At a minimum it should ensure managers do not lose their contracts through severe underperformance. Today, however, his global portfolio has 52 stocks compared with the 100 he was managing 30 years ago.
The reduction in stocks has arisen, he says, through the greatly increased analytical capabilities now available to fund managers on their own desktops. In the past, the only way of ensuring sufficient diversification for risk management was through having a large number of stocks. The ability to analyse factor risks within an analytical framework enables the number of stocks to be reduced. “There are 80 stocks I like equally. I only have 52 because I can produce a sufficiently diversified portfolio with that number using today’s analytics. I would rather have fewer stocks I can analyse more deeply than adding more for increased diversification.”
High-conviction concentrated portfolios are the best approach for fundamental active managers if they wish to compete over the long term. But for systematic quantitatively managed strategies, ranking a whole universe of stocks in order of preference, the problem is that the confidence associated with any single stock analysis is low.
In between pure index funds and active quant lie the so-called ‘smart beta’ approaches which are based on tilting indices to emphasise exposures to specific factors. Such enhanced indexing blurs the line between active and passive and even the definition of what a specific bet may be. Even with what is clearly ‘active quant’, the number of stocks within a portfolio can be large. RAM Active Investments, says Emmanuel Hauptmann, senior equity fund manager and founding partner, has 400-500 names in its model portfolio. Its live portfolios may have double that number.
Quant strategies have as their strength the ability to systematically cover the whole universe of stocks. However, the information that is analysed can only be numeric data from financial statements and market data in terms of prices. Any quant process therefore has a low confidence level in any one bet but having the ability to systematically cover the universe can give an edge over the benchmark index. Risk control is therefore a much more important and integral part of any quant process of this type, even with tracking errors as high as the 5% target that RAM’s strategies aim at.