Benchmark blues

A notable trend in the UK fund management industry in recent years has been the emergence and increasing popularity of “alternative” funds. These funds sport a range of exotic sounding names – for example, “unconstrained”, “absolute return”, “opportunities” etc. – and they can have very different processes and objectives. From the outside it can sometimes be tricky to know what the overall investment philosophy is.

A key objective of this blog is to explain clearly what we mean when we talk about “unconstrained” investing. Since there is no generally accepted industry standard or definition for unconstrained, we have created our own. Over a series of short articles, I want to explain the key tenets of our philosophy, focussing particularly on how it differs from many other approaches to equity investing. This introductory article will outline the basics of what we are doing and why.

When most people think of the stock market, the first thing that comes to mind is the benchmarks – for example the FTSE 100 in the UK or the Dow Jones in the US. Most of the fund management industry measures success in reference to these benchmarks. As a result, many fund managers prioritise their stock picking based on the importance of stocks within the benchmark. A common consequence is portfolios that end up looking rather similar to the index, allowing the fund manager to control his or her “risk” relative to the benchmark. An “overweight” in one sector or stock is offset by an “underweight” elsewhere.

The problem with this approach is that the benchmarks have themselves been partly responsible for the volatile (and not particularly impressive) absolute returns from equities over the past fifteen years. The benchmarks have an annoying tendency to concentrate into certain bubble sectors that have then subsequently delivered very poor returns (e.g. telecommunications and technology in 1999 and 2000 or financials and real estate in 2007). This can cause poor absolute returns even if the relative outcome is better than the benchmark. Our unconstrained philosophy avoids this problem by being willing and able to avoid entirely areas of the stock market where absolute risk factors are very high. Over time this can lead to steadier absolute returns and lower draw-downs during periods of market stress.

Of course, our unconstrained approach still aims to outperform the benchmarks, but the idea is to achieve this by ignoring them, focussing instead on the individual merits of an investment. We do this through a stock selection and portfolio construction approach that prioritises absolute over relative factors. The aim is to produce a relatively concentrated portfolio in which every stock is held for a positive reason, where the absolute upside is much greater than the downside, and where position sizes reflect the degree of downside rather than just the upside.

This means that the portfolio can look very different to both the equity benchmarks and most other funds. Sectors or stocks that are large in the benchmark may not appear at all in the fund, while small companies may at times be amongst the largest holdings. It all depends on where and when the most attractive investment opportunities arise.

Does this make unconstrained more “risky” than the benchmark or most other funds? The answer depends on how you view risk. If risk is defined as the probability of underperforming the benchmark then unconstrained can be more risky because performance, at least over short time periods such as a year or less, can be very different to the benchmarks. If, as we do, you define risk in absolute terms – the probability of permanent impairment of capital – then unconstrained can in fact be less risky than the benchmark. I believe this is a very important distinction, which I intend to cover in more detail in future posts. The table below provides a summary.

Absolute and relative investing compared

In the next post on unconstrained investing, I will explain the concept of investment edge, and how it helps us to find potentially undervalued stocks.

Matthew Tillett

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Author - Matthew Tillett

Matthew Tillett

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