Managing Unintended Risks—Avoiding Leaky Bucket Syndrome

Executive Summary

Avoiding Leaky Bucket Syndrome in Equity Investing

Why does the active management industry often struggle to generate excess returns? Many investment teams focus heavily on their stock selection process. However, returns created from good stock picking may be eroded when unintended risks enter a portfolio—a challenge we refer to as "leaky bucket syndrome."

This article discusses how recognizing and neutralizing undesirable exposures may help reduce the erosion of returns generated through stock selection.

Neutralizing Unintended Equity Risks

The risk profile for investors is evolving. Ongoing changes in global monetary policy, political bipartisanship, and geopolitical tensions introduce additional variables. Relying solely on owning great companies at good prices may no longer be sufficient for effective risk management. Unintended risks can potentially impact a portfolio’s excess returns.

Concentration risk remains a particularly pressing concern for large-cap portfolios. The recent outperformance by a small handful of stocks presents both opportunities and challenges. While it can contribute to returns, it may also introduce significant concentration and unintended style factor risks.

Trimming top-performing positions may address single-stock risk, but how that capital is redeployed is also important. Reallocating across the rest of the portfolio without careful consideration could introduce new vulnerabilities. A strategic, informed approach to rebalancing may help investment teams address the potential factor exposures that each decision can introduce.

Strategic Portfolio Construction for Volatile Markets

A robust approach to portfolio construction may help reduce the erosion of returns generated through stock selection. Investment teams often monitor how style, country, and currency exposures influence active risk. Understanding the correlation across stocks can allow managers to intentionally neutralize undesirable risks.

Consider how interest rates can influence equity investing. Managing interest rate risk is complex because exposures may reside within individual securities, sectors, and style factors. For example, industries like utilities and real estate often exhibit negative correlations to the direction of rates.

If fundamental analysis indicates that most utilities do not meet strict cash flow standards, an active manager may underweight them. To help offset this and manage interest rate exposure, managers might overweight fundamentally strong sectors with similar rate correlations, such as housing and building products. This approach can reduce undesired bets on the direction of interest rates.

Isolating Alpha in Active Equity Investing

When portfolio managers intentionally seek to minimize the impact of any single macro event, security selection becomes a primary driver of portfolio outcomes. Maintaining strict discipline and a thorough understanding of these exposures may help reduce the erosion of returns generated through stock selection. Without such awareness, unintended risks can quickly diminish potential outperformance.

The Special Global Equity team employs an accounting-based approach to identify companies with a durable asset base, flexible balance sheets, and strong free cash flow. By sourcing active risk primarily from security selection, the portfolio is constructed to look different from its index, with the goal of maintaining a high active share, lower tracking error, and style purity.

We view volatility in equity prices as a potential advantage when tracking error contributions are closely monitored. As volatility shifts from geopolitics to inflation to interest rates, it is important for equity investors to remain vigilant. Pursuing risk-neutral portfolio positioning may help reduce unintended macro exposures. By sourcing active risk from security selection, investment teams can seek to construct resilient portfolios that strive for consistency over the long term.

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All investing involves risks, including the possible loss of principal. There can be no assurance that any investment strategy will be successful. Investments fluctuate with changes in market and economic conditions and in different environments due to numerous factors, some of which may be unpredictable. Each asset class has its own risk and return characteristics.

This material is provided for informational purposes only and is intended for professional/institutional investor and qualified client use only. Not for retail public use.

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