Managing risk in concentrated global equity portfolios – a novel approach

While concentrated portfolios have the potential to produce higher returns^{1, 2, 3}, they also present unique risk management challenges. Traditional tools such as quantitative models and sector and regional limitations may be insufficient to fully understand risk in portfolios that are highly differentiated from their benchmarks.

The Franklin Global Growth team utilises an alternative risk management process that incorporates a granular “bottom-up” focus when constructing diversified portfolios. This methodology seeks holdings that:

• exhibit a low degree of earnings correlation
• avoid direct competition
• have limited overlapping economic exposures.

This “bottom-up” risk management strategy can result in concentrated, yet diversified equity portfolios designed to deliver attractive levels of alpha over a full market cycle.

The limitations of using sector and regional constraints

Setting limitations on sector and/or country weightings relative to a benchmark is a commonly employed approach to risk management of global equity portfolios. We find that these restrictions can provide a false sense of security that a portfolio’s performance will not deviate too widely from the benchmark.

This is because the sector/country framework assumes a high level of commonality and correlation between securities in each sector or country/region. While such correlations may become more elevated over short periods when macro events drive markets, they tend to be volatile over time given the breadth of sector composition. Sectors themselves are broad groupings of companies, often with little in common. The industrials sector, for example, is home to data and analytics companies as well as capital goods firms.

Managing concentrated global equity portfolio risk from the bottom-up

Modern portfolio theory—the theoretical basis for controlling risk through diversification—suggests that successful diversification requires the ownership of assets with uncorrelated price movements. And over the long run, stock prices theoretically should follow earnings and cash flow.

It is through diversification, specifically selecting companies whose earnings streams are not highly correlated, that we believe risk can be effectively managed in a concentrated portfolio that crosses regions and sectors.

In practice, this approach means building portfolios with companies that do not share revenue and expense drivers, and do not compete directly. A highly integrated forward-looking research process built on fundamental in-depth research is crucial to successfully implementing this approach.

Assessing underlying economic overlap between companies

When reviewing a security, our analysts identify a company’s fundamental drivers and economic exposures to determine whether that company might have an economic overlap with other portfolio holdings. This analysis must also look beyond standard industry classifications or country listings to consider factors driving a company’s earnings streams.

To drive this evaluation, analysts and portfolio managers research a company's revenue drivers, customers, and competitors, and consider their similarities to those of other holdings. Expense drivers are subject to the same review.

For example, if an industrials stock relies on petrochemicals as an input, one would need to examine whether other holdings in the portfolio have similar exposure to underlying oil prices—and to what degree.

This approach would call out, for example, overlapping revenue exposure to the automotive industry, whether from OEMs or from suppliers that could be in the consumer, industrial, materials or technology sectors.  Conversely, the approach can highlight opportunities to hold multiple exposures in some sectors, such as healthcare, where companies’ products or therapeutic specialization drives little to no actual economic overlap.

Other factors included in the analysis are a company’s competitive landscape and prospects for merger and acquisition activity. A detailed understanding of such factors is crucial to ensuring that the resulting portfolio ultimately holds companies that do not compete head-to-head, and do not share identical economic drivers. By limiting overlapping economic exposures, the resulting portfolio could be naturally diversified across industry groups, and its holdings could show lower correlation of returns over time.

Benefits of fundamentals-driven risk management

Limits Impact of Macro Factors

By employing a risk management approach based on company fundamentals and limiting overlap among underlying economic drivers, one can limit the impact of macro factors affecting individual industries or verticals, and individual economies.

Limits exposure to country-specific risk based on revenue sources

Deep fundamental analysis at a geographical level provides transparency into the locations where a company’s revenues and earnings are derived, helping limit economic overlap and potential country-specific macro events.

The approach is forward looking

Companies are dynamic. Understanding how they are evolving helps us recognize when a company initially focused on one industry begins to have greater exposure to a new growth opportunity that may overlap with an existing portfolio holding.

A novel approach to managing risk in concentrated portfolios

This risk management approach, tailored to concentrated, global and non-US equity portfolios, makes use of the concepts that underly risk management—namely diversification and correlation—while helping to overcome the limitations of standard risk models. 

By seeking to construct portfolios with companies that should exhibit a low degree of earnings correlation and that avoid direct competition, resulting in limited overlap of economic exposures among holdings, a concentrated portfolio can be appropriately diversified while enhancing the portfolio's potential to deliver alpha over a full market cycle.