Managing risk in the M&G Global Sustain Paris Aligned Fund

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.

Fundamental diversification

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.

Avoid clustering

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?

1. Fund volatility broadly in line with benchmark volatility
2. Stock-specific risk contributing more than 50% of relative risk
3. 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