The power of portfolio flexibility

Many investment managers apply strict portfolio constraints under the guise of risk management best practices. These often include limits in sector over-/under-weightings, geographic concentrations, minimum levels of portfolio holdings and/or market capitalization requirements. The challenge around these types of curbs is that while they are designed to reduce potential return variance, typically in relation to a particular benchmark, they also can considerably constrain excess return potential.
 
Overly restricting a potential investment universe can work against active managers’ ability to fully exploit research and market mispricing opportunities. To help illustrate this, think of constraints from the perspective of retail consumers.
 
A consumer who is free to purchase from any retailer without restriction can make more informed choices – and likely better purchases in terms of price, quality and overall value – than consumers who must spread purchases across at least 50 different retailers, restrict purchases from retailers headquartered in certain countries and/or only make purchases from retailers with a minimum of $1 billion in annual sales. Applying the same logic to investment management suggests that greater selection choice combined with effective security research can offer a more favourable position to potentially generate excess returns.

The illusion of risk mitigation

Additionally, we believe conventional constraints frequently provide only an illusion of risk mitigation, without necessarily reducing actual risk exposures. For example, country constraints usually categorize companies based on the location of their senior managements or the exchanges on which they are listed. However, where a business derives its underlying revenue is much more indicative of its risk profile.

AB InBev, the world’s largest brewer, is classified as a Belgian company. Yet, only an extremely small percentage of the company’s current revenues come from Belgium – about 57% are generated in emerging markets, with a significant portion coming from the U.S. and Brazil¹.
 
Such situations are far more common than investors may realize, due to the many global businesses headquartered and listed in smaller countries.
 
Similarly, sector limitations can also be problematic given the somewhat blurred nature of industry classifications. Beyond energy, materials and financials, few businesses fit neatly into a sector where constituents are consistently more highly correlated within than outside the segment. Moreover, the industrials sector often serves as a catchall for niche businesses that are challenging to classify.
 
Or consider when S&P and MSCI decided to shift several prominent companies from the technology sector to the newly renamed communications services (formerly telecommunications services). Are Netflix, Facebook, TripAdvisor and Google more closely correlated with traditional communication stalwarts like AT&T and Verizon? Truly understanding how a company generates revenues and its underlying business prospects are much more insightful into risk exposures then what may be an arbitrary, and at times even potentially misleading, classification.

Independent thought to drive alpha potential

Our deep conviction to unconstrained portfolio management is backed by a disciplined commitment to in-depth proprietary research. Through a combination of high turnover and excessive diversification, many active managers simply lack sufficient time and/or internal resources to conduct adequate research on companies through source documentation and direct management meetings. Consequently, it can be common to utilize broker-generated research to supplement their internal research capabilities and permit them to rapidly gather filtered information and recommendations as to what they should be buying and selling.
 
In contrast, our approach is to conduct extremely detailed research on a select group of companies by combing through publicly available source documentation and publications covering competitors, customers, suppliers and other pertinent industry participants. This is supplemented by frequent company management meetings, allowing us to largely avoid mass-distributed – and often short-term-oriented – industry research.
 
Our focus on independent research allows us to draw different conclusions than the broader market, which has historically been instrumental in our ability to generate repeatable, long-term alpha across our portfolios.

The pursuit of consistent excess returns over the long term

We believe avoiding common risk constraints can enable skilled active managers to arrive at a more optimal combination of investment ideas and therefore generate long-term excess returns.

Without the burden of excessive constraints, we are often able to buy into investment ideas at earlier stages and at more reasonable valuations, while passive vehicles and investors reliant on broker research and/or operating under constraints may be forced to buy at much higher valuations and at a later stage in the growth trajectory. Ultimately, we believe our approach can generate potential returns and provide you with confidence as we continue our efforts to grow your capital over time.