Assessing what constitutes appropriate and inappropriate risk
Risk is often always viewed as undesirable. But without risk, active fund management can never generate the necessary superior performance to justify its existence: no traditional long only manager could beat the market; no absolute return manager could beat cash. Diversifying away all risk is therefore never appropriate for an active fund manager: without risk, we are condemned to perpetual mediocrity. If every active fund manager needs to take risk, management of risk should be about isolating and diversifying away only inappropriate risk. This means that we must define what constitutes desirable or appropriate risk. Since every active fund manager should have an investment philosophy which explains, in their opinion, what moves share prices and therefore what they always look for as desirable characteristics in stocks, diversification away from this style bias is also never appropriate: the value manager should always invest in cheapness, the growth manager in quality and the earnings surprise manager in stocks with superior earnings surprise potential. As such, it is always appropriate that volatility emanating from a fund manager’s style bias is diversified at the fund selection level rather than through an individual manager’s style drift.
We should also note that style drift is most likely to occur when the manager is unable to attain immediate reward for their investors. In order to avoid style drift it is better that the manager sets expectations at realistic levels. Although we believe (although others may not) that our investment religion - earnings surprise - is a superior and more consistent investment philosophy than its obvious peers, value and growth, and this is what both distinguishes us from and diversifies our returns from our peers, this does not mean we expect to be permanently rewarded: in fact, we accept that through taking risk, it is not possible for any active fund manager, unless engaging in a fraud, to never suffer periods of underperformance or drawdowns; though clearly we would expect these to be more than offset by times when our funds are delivering out-performance and attractive positive returns. We have high conviction in our ability to generate performance for our unit-holders, but this is very different from a belief that we will do this all of the time. Even when their style of management is out of favour, the professional investor is - somewhat ironically - managing risk appropriately by always adhering to it: in their opinion, it should always give the best chance, though not a guarantee, of future outperformance.
It is however always appropriate to diversify away inappropriate risk and as such the biggest undesirable risk in our portfolios - given our style bias - is always the failure to correctly identify earnings revision trends, either through faulty analysis of individual companies or of wider macro-economic factors. As a result our biggest concern is always whether our views on particular stocks are legitimate. Given human imperfection it is impossible that we will ever perfectly execute our process: to construct a concentrated but diversified portfolio of companies that will over the near future subsequently uniformly see superior earnings surprise. We will also make mistakes believing in potential in stocks that transpires not to exist. As such it is always appropriate to diversify our investment risk across industries, countries and stocks, but only to the extent that superior earnings surprise can still be identified in all of our investments.
Diversification for its own sake is never desirable. By contrast, conviction in earnings surprise potential in an individual stock in a sector or industry where the catalysts are stock specific is always more valuable. However, although we will invest in any industry we can understand and identify potential, it is a fact of life that earnings surprise potential is unlikely to be equally spread at all times across industries, countries and stocks. As such indirect biases to sectors and countries are always a risk that can be managed, without ever being fully diversified away.
We also believe that running concentrated portfolios with stock specific risk is usually a desirable risk. The identification of earnings surprise is not easy: it involves significant labour intensive research and often contrary thinking. We want to be able to focus our research efforts on our “best ideas”. When we find these opportunities we want these stocks to have a meaningful impact on the portfolios and not be diluted by inferior opportunities.
Some of our funds have different objectives: this is important in assessing what constitutes appropriate and inappropriate risk. Most obviously, our traditional long-only Alpha fund will nearly always be fully invested with an aim of beating the market, whilst our long/short Absolute Return product has an explicit mandate to manage the risk profile of its return and will therefore always have a more modest market exposure.
But far from being a uniquely undesirable characteristic, risk – where taken appropriately in accordance with a coherent and proven investment process - is in fact the raison d’etre of the active fund management industry. Risk management involves exposing the fund to desirable risk characteristics and diversifying away undesirable risk according to the underlying investment process. It does not guarantee or promise permanent reward but it should always maximise the chances of future success.