Commentary

As professional investors, managing the risk of losing money is a responsibility we take very seriously. The traditional approach when managing a portfolio is to allocate money to different opportunities as if it were a pie being sliced, with each slice being measured by the amount of money invested. Limiting how big a slice of pie you eat is a good way of managing the risk of over-eating, but when it comes to investing, judging risk based on the size of an investment works less well.

The same amount of money invested in two different companies does not result in the same risk of loss. For example, the amount of debt a company uses will alter the chances of it exposing investors to future losses. It is for this reason that we spend time looking inside the pie (company!) to understand the threats to a company’s on-going health.

Our investment approach does not require us to be fully invested in stocks at all times, and the analysis below demonstrates how this helps us manage risk. We show the performance of a naïve value strategy, which each year selected the cheapest 10% of US companies based on their price/earnings ratio. This is compared to the performance of having invested equally in all US companies[1]. These results support the established academic result that a valuation-driven strategy can deliver superior long-term returns. As a simple measure of risk, we show the average return in down months[2], and on this basis the simple value strategy exposed investors to a greater risk of short-term loss than investing in all companies.

The value strategy also had long periods of time when it was subject to above-average levels of volatility as measured with the “beta” statistic (which quantifies the volatility of a stock, or group of stocks, relative to the average).  If we relax the need to invest entirely in stocks, we can attempt to make this risk more consistent through time. The “risk-controlled value” series in the charts takes the simple value strategy and attempts to control its relative volatility (or beta) to be 90% of the average. It did this by varying its allocation to the “value” stocks and investing the spare cash in US government bills. This combined approach of a value strategy coupled with risk control delivered simulated returns that were above average, whilst reducing the typical monthly losses.

This exercise is just an illustration and does not represent the actual way in which we select and weight companies in our portfolio. Instead, we wish to demonstrate that forcing yourself to be fully-invested in equities is like tying one hand behind your back when it comes to managing the risk of financial loss. It means that your risk of losing money is entirely determined by your choice of stocks, without any other way to make this risk stable through time. Being able to hold some money in the safe harbour of government debt can provide greater freedom to actively control this risk, whilst seeking the best long-term investment opportunities.

Using this flexibility to pursue more consistent risk management is part of our creed of “modern investment management”.

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[1] Datasets are courtesy of Kenneth French and details of calculation methodologies are available on his website.

[2] We define down months as being those months where our all-companies portfolio experienced a loss.

Successful active management comes from two components; investment selection and portfolio construction. Very crudely, the former is about maximising long-term returns and the latter is about ensuring there are no surprises on the way. Effective diversification requires identifying feasible scenarios that could impact a portfolio and determining portfolio weights that make it as resilient as possible.

The minimum number of securities required to achieve adequate diversification is a recurring question among investors and academics. It depends on an investor’s risk tolerance, and the scenarios most relevant to the securities in the portfolio. But one scenario that all portfolios are exposed to is that of idiosyncratic shocks in individual securities. Concern for exposure to single-name events drives investors to prefer larger portfolios to smaller ones, however the relevant risk is not usually well quantified, and the distribution of weights is as important as the portfolio size.

To explore this, we develop a metric that quantifies the single-name risk of a portfolio by establishing its effective size. While several metrics exist that quantify portfolio concentration, they generally lack interpretability in terms of risk[1]. Our metric is based on the chance of experiencing losses from single-name shocks, thus it goes straight to the heart of the matter[2].

We review some well-known indices in the table below and find their effective sizes to be much smaller than the headline number of assets[3]. This is a result of weight being unevenly distributed and concentrated in a relatively small number of holdings. In these examples, the effective size is well approximated by 2 x the number of assets covering 50% of the portfolio, which drives home the fact that it is the size of the largest positions that determines the exposure to single-name risk and not the number of assets in the portfolio.

Index	Number of assets	Effective size	Largest weight	Sum (number) of weights > 5%	Number covering 50%	Gini coefficient
FTSE100	100	25	11.3%	24.7% (3)	11	0.59
NASDAQ	100	22	9.7%	36.9% (4)	9	0.61
S&P500	500	99	3.6%	0% (0)	50	0.60

Rather than working with simulations, heuristics often form the basis of practical approaches to managing diversification. One well established rule is the 5/10/40 restriction placed on most UCITS funds which says that no single weight can be greater than 10%, and weights greater than 5% must total less than 40%. This equates to a minimum effective size of ~15-18[4]. It is interesting to note that these rules are relaxed specifically for UCITS schemes that replicate indices, and the FTSE100 and the NASDAQ are frequently at odds with them[5]. Therefore, products that track these indices can, and do, take positions that are prohibited for an active manager.

We conclude that it is important to look past the number of assets in a portfolio in order to assess risk. Equity funds that contain ~25 stocks will generally be referred to as ‘concentrated’ by the industry, but as we have seen here these portfolios may have lower risk levels than those with a much larger number of assets. Working with metrics that meaningfully quantify the risk you are concerned with is key to effective risk management.

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[1] For example, the Gini coefficient compares portfolio weights to those of an equally-weighted portfolio of the same size. This does not help to understand the risk associated with portfolios of different sizes, as seen in the table.

[2] We simulate 10⁶ 10y futures in which each asset in a portfolio has a 1% chance of experiencing complete loss in a single year. We quantify exposure to large losses with a weighted-count of 10y losses >15%. Effective size is defined as the size of an equally weighted portfolio with the same exposure to large losses, using the same methodology. Using like-for-like analysis makes the effective size metric robust to the underlying assumptions of the simulations.

[3] Index weights are as of 31/12/18, 15/02/19, and 14/02/19 for FTSE100, NASDAQ and S&P500 respectively. Multiple share classes for the same issuing body are combined.

[4] The higher of these considers that it is not practical to maintain weights exactly at the boundaries of what is permissible.

[5] For example, the FTSE100 largest position is currently 11.3%. Further, as of 16/11/2018, the NASDAQ had 41.0% of its weight in just 4 positions with the largest at 11.9%.

Nearly one year on, Jake Moeller returns to Havelock London to chat once again to CEO Matthew Beddall about the company’s progress and recently-launched fund, LF Havelock Global Select.

Listen below, or visit https://tmsnrt.rs/2Un9llU.

Who doesn’t love a sale bargain? If you are like me, knowledge that you paid less than others, is enough to leave you feeling quietly smug about a new purchase, irrespective of if you really needed it! Why then all the upset when the stock market decides to hold a sale?

The opportunity to buy a share of a business at a knock down price should be welcomed by investors, but any feeling of joy is normally overwhelmed by the sense of regret at having not sold what you already own. Any would-be bargain hunter can relate to this, when you discover that your beloved recent purchase is suddenly available for even less than you paid. For most of us it is unrealistic to think that we can have the foresight to accurately “time the market”, but we still succumb to the emotion of regret when stock prices fall.

Four months have now passed since the LF Havelock Global Select fund launched. It was not lost on us that this followed a long period of rising stock prices, with the valuations of many companies resting on brave assumptions for their continued growth. Whilst we do not attempt to time markets, we only invest at prices that do not require undue optimism about a company’s future. A bull market makes bargains harder to come by, but this optimism is never unilateral. With 55,000-or-so publicly listed companies would be shoppers have plenty of choice.

Since October the stock market has been holding an extended end of year sale, based on growing pessimism about the prospects of many companies. In this time the fund held some “dry powder” outside of the stock market, which together with a valuation driven approach, provided us with much comfort. Moving into 2019 the pessimism that has descended on markets gives would-be bargain hunters more choice at their disposal.

Our approach is to estimate what we think a company is worth, by using data about its underlying business. We want to understand how it generates its profits and then use our experience in forecasting to estimate what the future might reasonably hold. These forecasts consider a range of future outcomes, some of which are optimistic and some of which are pessimistic. A scientific approach helps us quantify the likelihood of such events and guard against our judgements being clouded by emotion. Furthermore, using data to understand uncertainty helps us look beyond the short-term. We go into 2019 excited by the opportunity that uncertainty in markets creates for our approach, and wish you a happy, and bargain filled, New Year!

Important information

Please ensure you have read this important information. The value of investments in LF Havelock Global Select may fall as well as rise. Investors may not get back the amount they originally invested. Investments will also be affected by currency fluctuations if made from a currency other than the fund’s base currency. Past performance is not a reliable indicator of future results. Potential investors should not use this website as the basis of an investment decision. Decisions to invest in LF Havelock Global Select should be informed only by the fund’s Key Investor Information Document (KIID) and prospectus. Potential investors should carefully consider the risks described in those documents and, if required, consult a financial adviser before deciding to invest. LF Havelock Global Select can invest more than 35% of its value in securities issued or guaranteed by an EEA state listed in the prospectus. The KIID and prospectus are available in English from this website and from Link Fund Solutions.

This website is not intended for any person in the United States. None of Havelock London’s services or related funds is registered under the US Investment Company Act of 1940 or the US Securities Act of 1933. This material is not an offer to sell or solicitation of offers to buy securities or investment services to or from any US person.

Like many investors, we worry about current equity market valuations looking historically high. Surely markets cannot continue to defy gravity? Although we believe that they are ultimately anchored to fundamentals, it pays to remember that we live in wealthy times.

This chart shows the wealth of the United Kingdom, expressed as a multiple of the country’s national income. Wealth in the UK, and elsewhere, has grown substantially since the end of the second world war, and the financial crisis of 2008 did little to slow this down.

Following the financial crisis, it is not only the stock market that has risen, but so too has a populist political movement. Arguably the rise of Trump and the Brexit vote are the product of discontent over how wealth is shared within society. Cuts in public spending and low wage growth, coupled with rising asset prices, have clearly served to increase the divide between the haves and have-nots. It is not our place to take a view on the correct divide of wealth within a society, but we recognise that the debate forms one of the major components of the economic climate that we operate within.

Has this growth in wealth, coupled with low interest rates, created increased demand for owning stocks? Does this mean that markets are not heading for an imminent fall? Or has the bull-market seen valuations become too high? Are investors not fully recognising the realities of the current political climate?

Our approach to investing is to not rely on any one narrative being correct. We attempt to understand the intrinsic value of an investment in a range of different scenarios in the belief that this will help us be robust to an uncertain future. We want to be part owners of companies that are not highly leveraged, purchased at prices that do not require undue optimism about the future. Furthermore, our preference is to currently hold some “dry powder” outside of the stock market. This forms the major part of our “proceed with caution” approach to the place in which we find ourselves as investors.