It is important to source ideas from the broadest possible opportunity set without style factors or other constraints.
1 minute read
Fund managers are expected to construct reasonably concentrated portfolios from thousands of stocks listed across the world. Confronted with this seemingly overwhelming choice, most global investors seek to reduce the complexity by resorting to some sort of screen. Typically, these take financial data and rank the stocks in their benchmark for their relative attractiveness based on a selection of measures, such as a low price-earnings multiple or a high return-on-capital figure. Often there is some explicit piece of academic research backing up the criteria, such as ‘value’ or ‘quality’ being ‘factors’ which outperform over the long run. The list is thus abbreviated to a more manageable length for further analysis.
Nobody goes there anymore. It’s too crowded
This appears to be a sensible way to go about business, as it directs the research effort to the seemingly most promising areas. After all, don’t we all want to invest in businesses with high returns offered to us in the market at low price-earnings ratios?
There are several problems with this process.
The first is that it is easily replicable and hence cannot be a source of investment edge. Data sourced from third-party providers such as Bloomberg, Capital IQ, or Factset is not proprietary unless it has been manipulated at significant time and expense, which defeats the purpose of an effort-saving screen.
The second is the issue of what to do when a particular factor stops working. Is it just temporarily out of favour, or has the factor become crowded, decayed permanently, and the screen needs to be adapted? It is impossible to tell. Diligent investors learn about mispricing from academic publications but they all read the same material, meaning they struggle to gain a relative advantage over each other.
The third is that using screens introduces constrains to the investment universe by restricting it unnecessarily. By definition, constraints can only serve to lower theoretical returns, and never enhance them ex ante.
Our approach is very different. Rather than beginning with the benchmark, we start from the entire universe of publicly-traded stocks. The sole screen we apply is one of liquidity as we are only interested in stocks that we can actually buy in material amounts. This defines our investment universe. From here, we keep an open mind and let good investment ideas come to us.