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Before the financial crisis of 2008–09, few people outside of finance knew what the job of a chief risk officer was. Now, my 16-year-old daughter can explain it to her friends. In the following column, I hope to communicate our approach to risk management as it applies to equities and to explain how our investment professionals—portfolio managers, research teams and the risk team—work together to address investment risk and opportunity.
Our Approach to Risk Management
Our aim is to reduce risks that could disrupt the long-term performance of an investment strategy. Those risks include such things as a large position in a single stock or exposure to a macro event, such as a jump in the price of oil. By using historical information and quantitative-modeling techniques, we can evaluate the probability of these risks and their impact on performance. High-likelihood/high-impact risks quickly capture our attention.
Identifying these risks is facilitated by a corporate culture that fosters a risk management mindset. At Lord Abbett, risk management is the responsibility of not only the risk team but also the portfolio managers and analysts. A few decades ago, equity investing was like tennis, with a single portfolio manager picking stocks while remaining mindful of exposures. Today, it is more like soccer. It's a team effort involving portfolio managers and equity research analysts, but risk management guards the net.
To facilitate this team approach, the risk team sits in on investment meetings. This helps us better understand the individual stock selections, but, more importantly, it also allows us to discover and examine new themes or risks as they develop. Constant engagement and our own customized risk systems give us a competitive edge that would not be available to us if we relied on less-flexible third-party systems and standardized reports.
Three Types of Risks
Investing involves a multitude of risks, and almost all asset managers track the basics, but there are different types of risk, some of which are harder to track and control. Table 1 shows some examples of what we consider basic risks, style factor risks, and thematic risks. Most investment managers have guard rails around the most basic of risks. For example, at Lord Abbett, we restrict sector weights within certain bands, though portfolio managers are allowed latitude in some circumstances, after consultations with our chief investment officer and chief risk officer. These guard rails are not aimed only at reducing risk versus the index. In fact, at Lord Abbett we encourage a certain amount of tracking error.1 This allows for higher active share2 and a heavier weighting of high-conviction stock positions.
Source: Lord Abbett.
The second type of risk involves style factors, such as growth, value, size, and volatility. Econometric models can explain a portfolio's historical performance not just in terms of stock or sector performance but also in relation to these style factors. For example, a portfolio may have performed well because it owned more value stocks than its benchmark as opposed to growth stocks. Many firms put measures in place to manage exposure to these style factor risks. Lord Abbett manages these risks in the context of each fund's benchmark.
Only a handful of firms go further still and address what we call thematic risks. These include a broad array of political and economic macro events, such as a rise in oil prices or interest rates. To manage thematic risks, Lord Abbett uses a variety of tools that can tell us how a strategy is likely to perform, given a particular event. How, for example, would a portfolio react to a 10% rise in the price of oil? There may not be formal limits for these risks, but a significant exposure would trigger a conversation between risk management and the portfolio manager.
Table 2 shows the exposures, or betas, of various companies to the daily price of crude oil as well as the related t-statistic, a measure of statistical significance. As one might expect, Nabors, an energy equipment and services company, has the highest exposure. A beta of 1.25 implies that if oil jumps by 10%, the price of Nabors stock will rise 12.5%, everything else being equal. A t-statistic of 7.3 means that this relationship is statistically robust historically.
Source: Lord Abbett. Data as of September 27, 2013. Calculated using two years of history.
For illustrative purposes only and does not reflect any Lord Abbett product or any specific investment.
Beta is a measure of the tendency of a security to move in concert with another factor, such as the market as a whole or oil prices.
A t-statistic is a statistical test used to indicate the likelihood that a difference between two groups is due to chance.
A number larger than 2.0 typically indicates that a difference is statistically significant, that is, not due to chance.
On the other hand, US Airways historically has been negatively exposed to oil. The low t-statistic, however, means this is not statistically significant. (Typically, a value of less than 2.0 means a result is not significant.) Nevertheless, the negative exposure is intuitive given that a significant percentage of airlines' operating costs consist of fuel, some of which is probably not hedged.
This exercise has the potential to uncover exposures that might not be obvious. Kellogg Co., for example, may have a slight positive exposure to oil prices, though this analysis indicates it is not statistically significant. Even without an overweight in energy stocks, it is possible for a portfolio to be positively exposed to oil through secondary effects. We will know the direction and degree of the portfolio's exposure currently and at any time in its history.
A portfolio manager is likely to have some notion of his or her portfolio's exposure to a particular factor, but these tools provide precision in gauging that exposure and the portfolio's likely performance versus the benchmark. Using this type of information and "what if" tools, portfolio managers can model trades to alter exposure to any theme or factor, enabling them to manage exposures more carefully. Knowing their exposures more precisely also allows portfolio managers more latitude in picking stocks, and frees them from the worry that a hidden risk might negatively impact the portfolio.
Thematic risks, however, are not static. They can emerge, fade over time, and, perhaps after a long period, reemerge. At Lord Abbett, we think about these risks extensively. By monitoring these themes and constantly evaluating new ideas, we believe we give the investment team an advantage.
Recently, for example, the Organization for Economic Co-operation and Development proposed a plan that would close tax loopholes for multinational corporations. To address this possibility, the Lord Abbett risk team, in collaboration with our research analysts, flagged companies whose profitability could be affected by this development. This metric, along with many others, allows the risk team to better monitor such idiosyncratic risk in a systematic way, which we believe provides another unique advantage to the investment team.
By fostering a risk management culture and helping portfolio managers better understand and monitor the risks in their portfolios, we strive to magnify the strengths of the investment team. We believe that, over time, this should balance risk and opportunity, improve consistency, and help contribute to the performance of our equity portfolios.
Risks to Consider:
The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. Value investing involves the risk that the market may not recognize that securities are undervalued, and they may not appreciate as anticipated. No investing strategy can overcome all market volatility or guarantee future results.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor before making an investment decision.