What’s The Biggest Risk You’re Taking?

If you’re a portfolio manager and you don’t know this, you probably should…

What’s the biggest risk you’re currently taking? This is a question I often ask prospective fund managers. It’s meant to refer to risks in their fund, but if I get the odd tale about cliff diving in Brazil then that’s no bad thing. What I really mean is: if there’s one thing that could derail your current portfolio, what is it?

This can be revealing in different ways. Firstly, do they have an answer? Many don’t. You can split this mob into two groups, neither of which are good: Some will resort to waffle, suggesting they haven’t thought about their portfolio in enough depth.

The second claim their fund is so well positioned that it doesn’t face any significant risks. This also suggests they haven’t thought about their portfolio enough and, more worryingly, that they’re delusional.

The second way it’s revealing is whether the manager identifies a relative risk (i.e. it might mean underperforming the market, even if it makes money), or an absolute risk (one that might lose money - full stop).

One isn’t better than the other, but it does help in understanding what that manager is trying to do. Counterintuitively, it doesn’t necessarily follow that a manager who highlights a risk relative to a particular benchmark is more concerned about relative returns: Sometimes it can mean the exact opposite; that in trying to reduce an absolute risk (i.e. losing actual money) they have taken a position that puts them at serious risk of underperforming their benchmark.

This is the kind of manager I overwhelmingly favour. My portfolio is crammed full of them, because this is exactly how I think investing should be done; by backing intelligent, diligent investors who have carefully picked a diverse selection of good investments. This sounds obvious, and I’m sure lay people assume that’s what most fund managers are doing. But, in my experience, they’re not.

Not exclusively, anyway. I’d say most have an eye on career risk. This is the same thing as relative risk, but highlights how that risk is personal to the manager, as they could be sacked if their performance is too far behind a benchmark. To reduce this risk, some managers will forgo holding a great investment in favour of one they like less, purely because it forms a large part of their benchmark.

How widespread this is within any sector can depend on the yardstick its managers are gauged against. Some managers are tyrannised by benchmarks that contain massive, outsized companies or sectors.

Latin America, back towards the end of the “commodity supercycle” theme in 2011, was a good example: a couple of Brazilian companies — Vale and Petrobras — each madeup more than the 10% of their index.

I remember interviewing Latin American fund managers at the time. Most felt they had to hold these stocks — often as their biggest holdings — even though they didn’t think they were good investments. They were petrified of what might happen if they continued to outperform, as they’d drive their benchmark higher while their portfolio stood still.

In other words, they had chosen to raise the risk of losing clients’ money in order to reduce the risk of losing their job. From the perspective of the fund manager, this may be understandable, but as a fund buyer I steer well clear. My experience last decade when the commodity supercycle theme collapsed, dragging down the Latin American index — and its huggers — demonstrated the benefits of this.

This brings us to today where conditions echo those of Latin America last decade, but this time on a global scale. The global market is now more concentrated in its top-five holdings than it’s been at any time in our investing lifetimes. And if that wasn’t enough, those top-five holdings are all concentrated on the same theme: technology. And on the same country: the US.

This is the backdrop to my own answer to that question: what’s the biggest risk you’re taking? My fund picks are diversified in many ways, but united in their willingness to risk their careers in the name of high absolute returns. If they don’t like an investment, they won’t invest in it. And they have been increasingly unwilling to invest in technology names, as even my more growth-oriented managers are put off by their valuations.

Taken together, this adds up to a notable underweight in tech and other expensive-looking growth names. And sure enough, just as my chosen fund managers have underperformed in this year’s tech-only markets (with one or two even losing their jobs), we have too.

Yes, I could try to compensate for that underweight by buying tech-heavy funds, or even market trackers (which are increasingly concentrated in tech). But that misses the point of hiring a group of exceptional fund managers: If they are collectively telling us to invest less in technology stocks, then we should heed that warning.

So this is, for now, my ‘defining’ risk: my portfolio won’t outperform this tech-led rally. I’ll just have to hope my career outlasts it.

This was adapted from a piece I wrote that appeared in Professional Adviser in November 2020 (it’s eery just how much of this still applies — more so, in fact). My career has just about survived this market episode (so far), although it’s in a very different place now (this turned out to be the last article I wrote in my previous job).