There is an argument to be made for not seeing the investible world in terms of whether or not a country is ‘developed’ or still ‘emerging’, but the global financial crisis seems to have cemented the difference given how each has reacted to it.
Right now, we are on the cusp of greater market volatility – witness the circuit breakers kicking in to China’s stock market twice in the first week of this year – as markets decide where to go next given how they have rallied since the depths of the crisis.
As they stand, the larger developed markets are providing investors with less volatility but do not come cheap, while it is some of the less expensive emerging markets that are bringing with them greater volatility.
Equity volatility and risk
The nature of equity investing implies a degree of risk and volatility. As interest rates are starting to rise, with an associated uncertain impact on the wider economy, this risk is coming more into focus for equity investors.
A benchmark-driven, benchmark- constrained equity investment strategy will still leave investors open to equity market risk, but in a way that may prevent managers from backing their highest conviction ideas, forcing them to tie up investors’ capital in benchmark ‘ballast’. An equity benchmark is not risk free.
Taking a truly unconstrained approach enables this risk budget to be spent only on stocks where there is genuine difference from consensus and, therefore, the most compelling opportunity.
This kind of unconstrained approach gives investors the freedom to perform, the freedom to invest across the market to back the best ideas.
Some fear it is simply a cover for managers to do as they please, holding whatever stocks they feel like, lured into the trap of an unintended style or market- cap bias, having unnecessarily large – and costly – turnover levels and massive liquidity constraints.
In fact, an unconstrained approach, combined with appropriate risk analytics and oversight, with diversified portfolio construction, enables managers to combine the best of both worlds: high conviction and diversification, using an investor’s risk budget to back the most compelling stock-specific ideas.
Unintended exposures
First, a benchmark reflects the consensus pricing of all stocks within that index, when stockpickers should be challenging consensus to avoid following the herd; second, by definition, benchmark- related portfolios take far less exposure to stock-specific risk and this can be compounded by other unintended exposures.
With significant resources invested in large, benchmark-weighted stocks this kind of strategy often ends up doing little more than mimicking the index, giving it higher exposure to uncontrollable market risk rather than to the underlying stock-specific risks many investors expect.
In fact, rather than viewing them as risky, unconstrained investment strategies should be seen for what they are – highly risk aware and benefiting from manageable risk. Focusing on the ‘right’ stock-specific risks ensures that investors are exposed to the best ideas of the managers and their teams.
The key focus is therefore not ‘risk versus no risk’, but rather taking the right risks in the right proportion for the return available.
Improving outcomes
Fees are slightly higher, yet the long-term alpha generation potential when compared with mainstream active investment strategies should more than compensate.
Unconstrained strategies are unlikely to be the only solution for investors, but this kind of differentiated approach with a stockpicking focus can be highly valuable as diversifier, allowing investors to benefit from genuinely active equity investment and superior return potential.
In fact, for those investors seeking to de-risk their portfolios and optimise the cost of the investment solution, an unconstrained approach represents an efficient way to spend their remaining equity risk budget and active management-fee budget.
Consequently, the debate appears to be less about whether such strategies are suitable at all but more about how they can best be incorporated into client portfolios in the right proportions to capitalise on their attractions and improve overall client outcomes.
SLI range – active share
