An unconstrained view of the world
Written by Lynn Strongin Dodds
Nov / Dec 2009
Now that stock markets have reversed their down-ward trend, un-constrained equity investing is back on the radar screen. Simply put, unconstrained investing means not adhering to a benchmark. In a global context, fund managers can hold stocks of any size and within any sector, across the geographical spectrum. Nick Evans, associate partner in KPMG's investment advisory team, says: "If you look at equity investing, whether passive or active, the investor is already taking the risk by being in equities. The question is whether you have time to monitor active equity managers or not. In an unconstrained global fund, the manager does not just have to invest in a stock because it is part in the index. He has the freedom to put together a portfolio of the best of breed of companies across the world, take a long-term view and have sensible allocations to give meaningful diversification."
Jeff Molitor, head of international institutional asset management at Vanguard in the US, argues that in the broad sense we are going
back to the future. "A few years ago, managers viewed themselves as relatively unconstrained but then institutions put them in boxes in terms of growth, value, small and large cap stocks because they wanted greater predictability and understanding of their exposures. What we are seeing now is that they have a core of passive global investments and then look for a manager who can add value."
The problem with unconstrained, he warns, is that there are very few managers who are capable of doing it. "Investors need an extra layer
of governance, patience and pers-pective because these managers needs to be evaluated on a three to five year time horizon."
Debbie Clarke, global business and investment leader for Mercer's equity boutique group, is seeing a move towards unconstrained investing whereby investors are buying cheap beta and using unconstrained investing to generate higher alpha. However, she adds, from a governance perspective clients have to ask if they have the depth and breadth of resources to identify unconstrained managers, whose investing approach is often quite
different and which requires a much more detailed analysis and a longer time horizon. "Investors should focus on explaining their methodology, fundamental or quantitative, and whether they have the skills to choose the right stocks, including new, growth stocks before they become part of the index."
Proponents of unconstrained investing believe this is a good way for investors to tap into the emerging markets growth story. The uncoupling theory may not have quite worked in practice in the immediate aftermath of the financial crisis, but over the longer term emerging markets have weathered the storm better than their developed counterparts.
The average exposure for pension funds in emerging markets, however, is only 3%-8% of their total equity portfolios, according to estimates from consultants. Depending on individual funds' risk/return targets, the general consensus is that they should at least be doubling those exposures over the next five years.
Some fund managers running unconstrained funds believe a global equity fund and not a dedicated emerging market fund should be the preferred route as it provides investors with the best of both worlds. Mark Tinker, global portfolio manager at AXA Framlington, says: "If you are in a global portfolio practicing unconstrained investing you do not just have to buy emerging market shares to play the emerging market story. There are many mature companies in Australia, US and Europe, for example, that are benefiting from their exposure to emerging markets."
As for the methodology, Tinker says, "I am benchmark aware and we have a loose target to outperform the MSCI World by 3% over three years but it does not drive our decision making process. We have a thematic approach that looks to invest in companies who are benefiting from the economic tailwinds and avoid those that are exposed to the headwinds."
Alistair Wilson, head of institutional business at Neptune Investment Management, adds that an unconstrained global fund widens the opportunity set and enables a fund manager to choose the best of breed of companies. "Our fund has over a 30% exposure to emerging markets because that is where we believe there are the greatest opportunities for growth. We look at global sectors and then choose the leaders in those sectors regardless of their country or origin. We run concentrated portfolios because we believe in holding only the very best stocks and not diluting performance by over diversifying."
JPMorgan Asset Management also adopts a thematic approach. John Stainsby from the firm says: "What we are finding is that many institutions are investing less in equities but they want to make the equities they are holding work harder. We have a broad range of different types of funds but with our unconstrained global funds we do not use a benchmark as a prop or neutral position. We focus on major themes in world business and
identify the leading companies benefiting from those themes who will generate better returns. For example, we are looking at companies who will benefit from changes in consumer spending and the demand for natural resources. These companies can be quoted either in emerging markets or developed markets. The lines between emerging and developed are blurring and that we are operating in a truly integrated and global business world."
Origin Asset Management, on the other hand, focuses on four specific characteristics, according to Michael Rimmer, a partner at the firm: "We look for companies that are well-managed, undervalued, demonstrate improving operating performance and already have a rising share price relative to the market. We measure these four criteria objectively using publicly available financial data, earnings forecasts and historic share price information. We operate a monthly investment cycle, ranking 4000 stocks quantitatively before isolating the most promising 350 plus all existing holdings for fundamental due diligence by our global team of five managers.
"We then have a final audited ranking of stocks in order of attractiveness which drives the monthly changes to the portfolio."
Some fund managers though believe that investing in emerging markets sometimes requires a specialist touch. Benjamin Segal, portfolio manager for Neuberger Berman's institutional and mutual fund global equity team, says, "I do not think a global manager can necessarily identify the best opportunities in the small to mid cap space. You will need a dedicated emerging market specialist who has more in-depth knowledge about the specific markets and knows the local themes and nuances."
Written by Lynn Strongin Dodds, a freelance writer