The value of a fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested. The views expressed in this document should not be taken as a recommendation, advice or forecast.
A holistic and well-considered approach
For concentrated funds with a large investment universe but a relatively small number of positions, such as the M&G Global Sustain Paris Aligned Funds, we believe that the risk management framework must be holistic. The core of our framework is around the ‘real’ fundamental risks of companies – their business and financial risks, and the risks that may emerge when these companies are combined in a portfolio. We seek exposure to different business models, end-markets and structural trends. Good fundamental diversification is essential risk management when investing with a 10-year horizon.
The second step of our risk management process is to focus on stock price diversification. We do not believe models should be relied upon solely to dictate how portfolio risk is managed, but volatility numbers, tracking error and factor risk model outputs are useful indicators of whether the fund is well-diversified and behaving as we intend it to. They can confirm if the diversification is working, or sound warnings to investigate holdings or clusters of stocks further, and potentially act.
In the M&G Global Sustain Paris Aligned Fund, we invest in a diversified mix of companies from a variety of regions, sectors and industries. We also invest in companies operating with differing business models and end-markets.
Companies are categorised as:
- Stable growth – companies with a strong competitive edge and a proven track record of producing stable earnings at stable or increasing returns on capital
- Opportunities – which sit in corners of the market where business risk is considered higher, but stocks can offer significant upside potential
Balancing these parts of the strategy enables us to keep factor risk and volatility in check while still allowing us to stray significantly from the benchmark and pursue alpha. It has made the strategy resilient to deliver potential performance under different market regimes and more independently of market trends. Keeping the fund balanced has the added benefit of relieving the fund manager of having to predict market movements or macroeconomic changes. Possible changes in expectations are not ignored, but treated as risk management considerations.
Focusing on business risks
When analysing companies, we dedicate considerable resource to the analysis of business risks. These are any risks to the company’s operational, financial or competitive position. Business risks can include both operational and financial risks specifically, as well as, for example, the company’s competitive strength, degree of cyclicality and relative maturity.
With a concentrated portfolio of fewer stocks, and a low turnover rate, we can dedicate significant time and resource to the ongoing analysis of these company-specific risks. This differs to the risk management frameworks of many less-concentrated funds, where managers may be more preoccupied with numbers surrounding sector and geographical weights, and seek to optimise within these.
Importantly, while we will review volatility as an indicator of risk, importantly we do not equate volatility with company-specific business risks. We believe there are drawbacks to doing so, as changes in volatility can often be the result of natural market movements, which will revert in the near-term. For example, the fund may hold a position in a stable business, which suffers a short-term period of heightened volatility, with its share price falling in the wake of an earnings release. That could represent an opportunity to buy more, because the intrinsic value of the stock might not have deflated or increased the fundamental riskiness of investing in the business to the same degree, but an investor focusing solely on backward-looking volatility may be required to sell, not buy.
As investors, we are concerned with the prospects of our investee companies, and the risks to their long-term success, but also have a strong general focus on not losing money on specific investments. Making investments in a diverse group of resilient companies with a healthy margin of safety (intrinsic value minus market value) is a good starting point. Volatility can be used as an indicator in both fund and stock-level risk analysis, but should not force portfolio changes.
We aim to avoid clustering within the funds. This applies not only to companies with similar business models, but also those operating in different sectors, whose share prices nevertheless move in tandem, perhaps because they are of a similar size and operate in the same region.
If we hold clusters of stocks, we will make sure to be well-diversified within this group to mitigate correlation. For example, companies with different end-markets and drivers, but also a mix of business model maturities and stock characteristics.
How we consider position sizing
It is important to note that position sizes are primarily based on our assessment of risk, rather than on ‘conviction’ in the investee companies. Generally, we choose to hold larger positions in companies that we consider to be less risky.
In a typical high-conviction portfolio, we typically expect to see half of the fund’s total risk attributable to the five largest holdings. In the M&G Global Sustain Paris Aligned Fund, we aim to ‘flatten the curve’, taking relatively larger positions in companies which we deem to have less business and valuation risk. In practice, this means that a 5% position in a more stable company and a 2% position in a riskier high-growth company can provide equal contributions to overall risk. We typically expect around half the aggregated contribution to volatility to come from our top 10 holdings.
We also consider each holding’s contribution to overall diversification when reviewing position sizes. For example, rather than buying additional companies, a position size may be allowed to grow if we consider the stock to be a diversifier for a particular sector or region, which we would like to maintain or increase exposure to.
What is the output?
- Fund volatility broadly in line with benchmark volatility
- Stock-specific risk contributing more than 50% of relative risk
- Limited style risk
We expect for the output of this framework to be a fund exhibiting a similar level of relatively low volatility compared to the benchmark, despite its concentrated nature. Furthermore, we aim for the majority of overall portfolio risk to be attributable to stock-specific risk, with style, factor or country risk playing a limited part. We believe this high level of stock-specific risk is a good indication of diversification. We are generally more concerned about drift in style risk than country and sector risk.
We monitor these risk metrics and many others on a monthly basis, working closely with representatives of M&G’s Equity Risk team. As mentioned previously, these numbers can provide a helpful indication that we may need to review areas of the fund. However, the analysis of stock-specific business risks remains the core focus of our risk management framework.
Figure 1: Fund beta and volatility versus the benchmark
Source: Aladdin, 17 January 2024. The fund benchmark is the MSCI World Index. Volatility figures are calculated with an annualised ex-ante calculation, based on weekly returns, using data on a two-year look back basis with a 26-week decay factor (effectively weighting the latest 6 months with a higher emphasis).
Figure 2: Fund tracking error and tracking error composition
Source: Aladdin, 19 January 2024, Long Term 60 Months Equally Weighted. Past performance is not a guide to future performance.
The fund aims to provide a combination of capital growth and income, net of the Ongoing Charge Figure, that is higher than the MSCI World Index over any five-year period and to invest in companies that contribute towards the Paris Agreement climate change goal of keeping a global temperature rise this century well below two degrees Celsius above pre-industrial levels. At least 80% of the fund is invested in the shares of sustainable companies from across the world. The fund is concentrated and usually holds fewer than 40 companies. Sustainability considerations are fully integrated into the investment process. Companies that are assessed to be in breach of the United Nations Global Compact principles on human rights, labour, environment and anti-corruption are excluded from the investment universe. Industries such as tobacco and controversial weapons are also excluded. The fund manager makes long-term investments in companies with sustainable business models, where short-term issues have created buying opportunities for the fund.
The fund’s benchmark is the MSCI World Index. The benchmark is the target for the fund’s financial objective and is used to measure the fund’s financial performance. The index has been chosen as the fund’s benchmark as it best reflects the financial aspects of the fund’s investment policy. The benchmark is also used to define what a Low Carbon Intensity company is. The fund manager considers the fund’s weighted average carbon intensity against the benchmark when constructing the portfolio, but the benchmark does not otherwise constrain portfolio construction. The fund is actively managed and within given constraints, the fund manager has freedom in choosing which investments to buy, hold and sell in the fund. The fund’s holdings may deviate significantly from the benchmark’s constituents, and as a result performance may deviate materially from the benchmark. For unhedged and hedged share classes, the benchmark is shown in the share class currency.
Key fund risks
The main risks that could affect the fund are:
- The value and income from the fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise. There is no guarantee that the fund will achieve its objective and you may get back less than you originally invested.
- The fund holds a small number of investments, and therefore a fall in the value of a single investment may have a greater impact than if it held a larger number of investments.
- The fund can be exposed to different currencies. Movements in currency exchange rates may adversely affect the value of your investment.
- Investing in emerging markets involves a greater risk of loss due to greater political, tax, economic, foreign exchange, liquidity and regulatory risks, among other factors. There may be difficulties in buying, selling, safekeeping or valuing investments in such countries.
- In exceptional circumstances where assets cannot be fairly valued, or have to be sold at a large discount to raise cash, we may temporarily suspend the fund in the best interest of all investors.
- The fund could lose money if a counterparty with which it does business becomes unwilling or unable to repay money owed to the fund.
- Operational risks arising from errors in transactions, valuation, accounting, and financial reporting, among other things, may also affect the value of your investments.
Further details of the risks that apply to the funds can be found in the funds’ Prospectus.
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Risk Management Framework:
- The article emphasizes the importance of a holistic risk management framework for concentrated funds, specifically citing the example of the M&G Global Sustain Paris Aligned Funds.
- The core of the risk management framework focuses on the 'real' fundamental risks of companies, including business and financial risks, and the risks associated with combining these companies in a portfolio.
- The fund employs a strategy of fundamental diversification, investing in a mix of companies from various regions, sectors, and industries. This strategy includes exposure to different business models, end-markets, and structural trends.
- The article highlights the significance of good fundamental diversification as an essential risk management measure, especially when investing with a long-term horizon.
Stock Price Diversification:
- The second step of the risk management process involves focusing on stock price diversification. While not solely relying on models, the fund uses indicators like volatility numbers, tracking error, and factor risk model outputs to assess the effectiveness of diversification.
- Volatility is not equated with company-specific business risks, as the fund acknowledges that changes in volatility can often result from natural market movements.
Business Risk Analysis:
- The article emphasizes dedicating considerable resources to the analysis of business risks when evaluating companies. Business risks include operational, financial, and competitive factors, as well as considerations like the company’s competitive strength, degree of cyclicality, and relative maturity.
- The fund's concentrated portfolio allows for in-depth analysis of company-specific risks, distinguishing it from less-concentrated funds.
Position Sizing and Risk Assessment:
- Position sizes are primarily based on the assessment of risk rather than mere conviction in investee companies. Larger positions are held in companies considered less risky.
- The fund aims for a diversified portfolio with a relatively low turnover rate, and position sizes are reviewed based on risk assessment, not just conviction.
- The fund aims to avoid clustering, not just within companies with similar business models but also within different sectors. Clusters of stocks are well-diversified to mitigate correlation.
Output and Performance Metrics:
- The expected output of the risk management framework is a fund with relatively low volatility compared to the benchmark. The majority of portfolio risk is expected to be attributable to stock-specific risk, with limited style, factor, or country risk.
- Figures and metrics, such as fund beta, volatility, tracking error, and their comparison with the benchmark, are provided to illustrate the expected performance of the fund.
Fund Description and Benchmark:
- The fund aims to provide capital growth and income while aligning with the Paris Agreement climate change goal. Sustainability considerations are fully integrated into the investment process.
- The MSCI World Index serves as the benchmark, reflecting the fund's financial aspects and defining what a Low Carbon Intensity company is.
Key Fund Risks:
- The article concludes with a list of key fund risks, including the value and income fluctuation, exposure to different currencies, potential losses in emerging markets, counterparty risks, and operational risks.
In summary, the article provides a comprehensive overview of the risk management strategies employed by the M&G Global Sustain Paris Aligned Fund, with a focus on fundamental diversification, business risk analysis, and careful consideration of position sizing. The inclusion of performance metrics and the alignment with sustainable investing principles further enhance the transparency of the fund's approach.