Getting more out of equity portfolios
Loosening the constraints How do some equity fund managers make more money than others? The essential principle is easy to understand: buy the right stocks at the right time and you should generate outperformance. But how do managers structure these multiple stock bets to create equity portfolios with the ability to access the highest potential returns? Traditionally the approach has been to take fewer bigger bets, constructing a more concentrated portfolio. This means a fund with just the stocks the fund manager really likes – their high conviction ideas with the strongest upside potential. However, the concentrated nature of these portfolios also means that they experience high levels of volatility due to the increased level of risk. Is there an alternative which can be offered to meet the demand for strong fund performance but with potentially less risk exposure? Can’t high returns be created from a more diversified portfolio?
Making money from negative views Until now, equity managers have had to create concentrated higher risk portfolios as they have been unable to make the most of all the opportunities and tools available to them. If they really like a stock, they could always take an overweight position (i.e. hold a higher percentage of the stock in their portfolio than its benchmark weight), but if they don’t like a stock, they have not been able to fully express their view. At best, they can decide not to own the stock, but they are not allowed to express negative views by ‘shorting’ relative to the benchmark. (Shorting is a financial technique to profit from a fall in an asset’s price.) This penalises – constrains – managers from fully implementing their negative views. It’s effectively like throwing away half your best ideas. This seems counter-intuitive. If your objective is higher portfolio returns, why not allow your manager to exploit market inefficiencies by deploying their skills to the optimum – expressing and implementing both short views in stocks they don’t like as well as long views in stocks they like? Of course, this applies only to managers with the skills to identify unattractive stocks. Optimum performance with less volatility While this approach allows the manager to implement both positive and negative views, the final portfolio can still have 100 per cent exposure to the market, similar to a conventional long-only equity portfolio. This means introducing less volatility to your portfolio than you would with only a limited number of stock positions, but maintaining the upside potential. In fact, even potentially exceeding it since the long positions can be amplified through the same instruments used to express the short views. What about risk? There are risks involved with expressing negative views. With careful portfolio construction and monitoring, along with strong operational support, experienced managers can manage these risks effectively and often have been doing in non-retail strategies for many years. Moreover, risk can be further managed by constructing a highly diversified portfolio – with a large number of small positions. Accordingly, no single position will represent an overly large proportion of the total risk. An extra gear to equity investing In summary, a less constrained equity approach frees the manager to express their investment ideas more effectively, without changing the underlying philosophy or reducing the portfolio’s broad market exposure. These kinds of funds offer an attractive alternative method to maximise the potential returns from equities. In essence, equity investing has moved up an extra gear.
