Why difficult markets demand a high-conviction approach
“Protect yourself at all times” is the most important instruction given to boxers. Investing is no different. It’s those managers who can protect their investments when the inevitable market corrections hit, who can perform over the long term. From an equity portfolio manager’s perspective Matt Benkendorf, CIO of the Vontobel Quality Growth boutique, and from a bond portfolio manager’s perspective Luc D’hooge, Head of Emerging Markets Bonds, provide their approach to risk management and what risks they see on the horizon in the near future.
“As a portfolio manager you need to know how much risk you can take and how much risk a client wants to take.”
Luc D’hooge: It’s very important when you manage a portfolio. At all times, you need to be comfortable with the risk that you take. You have to avoid being in a position where you need to reduce risk suddenly and heavily, and become a forced seller.
So, as a portfolio manager you need to know how much risk you can take and how much risk a client wants to take. This means being transparent towards your investors, explaining what kind of risks and how much of it you take and most importantly – you have to stick to that.
Matt Benkendorf: One of the ways that we’re very different from other asset managers is that we take a fundamental view of risk. We look for companies that can grow, but with low volatility in their earnings and share prices. These are typically companies that are dominant franchises that have attributes such as pricing power, strong balance sheets, steady demand, low leverage and transparent accounting.
We don't focus on traditional measures of risk, such as beta, standard deviation or volatility. That isn't risk to us. It's what you own as an investment and what the risks are in that underlying business. Then we reduce our overall portfolio risk by meaningfully diversifying the earnings streams of our holdings, as opposed to the classic approach where you measure risk via diversification across regional or sector categories.
In conventional methodology, a way to lower risk is to construct a portfolio that looks similar to the benchmark, because risk is traditionally defined as deviation from the benchmark. We don’t agree with that approach. In fact, we think that a portfolio that looks very different from the benchmark – for example, a portfolio that owns the best businesses and ignores many of the benchmark holdings, which can be lower-quality, inferior businesses – is the best way to reduce risk.
Luc D’hooge: We concentrate on credit risk. When it comes to emerging market hard-currency, sovereign risk is part of the credit risk and what matters for sovereign risk often relates to political changes. Interest rate risk also plays a role, which we have to manage, but there the information ratio is very limited. So we prefer not to take big bets on interest rates.
We want to avoid giving surprises to our end investors. They know what the duration of my benchmark is, and they know I move out of that duration +/- 2½ years, but most of the time I stay within one year. That's something we really want to respect. So the risk where we can make money and where the information ratio is higher is in credit risk.
Liquidity risk is also important for a portfolio manager. In fact, you promise liquidity to your end investors: that they can move in and out of the fund freely, so you need to have sufficiently liquid positions in sufficient amounts that you can easily absorb these flows without being pushed into an uncomfortable position.
Matt Benkendorf: Our mindset is that risks are generally the same and they’re omnipresent. It's just a question of whether investors are paying attention to them. So, the risks in the second half of this year aren't really any different than the risks we see today or saw a year ago. Quite frankly, today’s risks – an economic slowdown, protectionism, higher interest rates, and valuations in the marketplace – are always somewhat prevalent. The market just chooses to ignore them or not, which is why we don't focus on the market; we focus on businesses.
“Our mindset is that risks are generally the same and they’re omnipresent. It's just a question of whether investors are paying attention to them.”
However, if we think about where we expect to see volatility in the second half of this year, we’re closely watching emerging markets, where continued US dollar strength could prolong this already volatile period. I think that's fairly intuitive. And, in Brazil and Mexico, in particular, we expect the two important upcoming elections will bring about volatility.
Regardless of where we see volatility, the risks that matter the most for us are our in the businesses we own. We’re constantly questioning and researching our holdings: what’s their evolving competitive situation? their structural advantages? their growth prospects? These are all long term issues that can impact the types of businesses we invest in. Market-related risks over the course of shorter time periods tend to have less of an impact.
Luc D’hooge: Protectionism is on the rise - populism and protectionism are very much linked. That's not good for global trade, but developments haven't been dramatic; they’re moving slowly. I think on that front we will probably get an agreement where there won’t be too many changes to NAFTA, for example. So that's one point.
We see that there are interest rate risks to some extent. Currently, it’s all about the US Fed, and if they might be obliged to increase rates much faster than anticipated. This could create a correction on US Treasuries, but only if the Fed moves much quicker than anticipated. I don't think there's a big danger of that at the moment.
Political risks - there are always plenty of those. I think the clearest right now, are linked to elections, and I think the Mexican election is the most important there, where you have Lopez Obrador, who is a populist guy who has made comments that could be negative for markets if he follows up on them. He is leading in the polls by a wide margin and I expect him to win the elections. However, we don't expect his party to get a two-thirds majority, so it’s likely that he will have to govern with the other parties. Mexico has strong institutions, therefore, I don't think politics in Mexico will change dramatically.
Matt Benkendorf: Given our investment philosophy, we expect to be positioned for risk, which as I mentioned is embedded in our approach. We believe in buying high-quality, predictable, sustainable businesses because we believe those businesses are more durable. You can never predict, from a top-down perspective, when macroeconomic or political events will surface and you’ll never be able to consistently predict the market’s sentiment ahead of time. This is why we focus on fundamental business risks and hence we expect to be well-positioned for a different set of risks. In a nutshell, it comes down to owning better-quality businesses.
Luc D’hooge: We don’t avoid risks, we manage them. Investors in general don't like risk, which means that many of these assets where risks are present, are a little bit cheaper and more rewarding. So, for instance, Mexico - there is real political risk there, but it's one of our bigger overweights. We like those positions, because they’re cheap.
Another example is Argentina. Where, with the sudden increase of risk aversion in the markets, people started to sell their positions. We, as is often the case for us, take a contrarian view here. For me, Argentina is still an improving credit: Macri has a good team, they know what they’re doing, and I think Argentina has taken good measures and increased rates quite impressively. Of course, you can’t keep those rates at that level forever. They also took the brave decision of going to the IMF; brave because the Argentine electorate doesn't like the IMF. But I think it was necessary to get rid of the volatility and to get back on a good track.
However, it's important that you diversify your bets and you take several bets to diversify your risks. This way, most of the time you may make money; sometimes you’ll lose money, but when you diversify, the end result tends to be rather good.