How unconstrained investing can help your clients

Standard Life Investments’ head of UK wholesale, Jacquie Kerr, explains how deviating from the benchmark indices can pay off.

Recent years have seen increased appetite for investment portfolios that target enhanced levels of index outperformance. These deploy a wide range of investment strategies and portfolio construction techniques, under a wide array of different labels, including focus funds, high alpha funds and unconstrained offerings.

The common objective is to give investment managers the flexibility to deploy their alpha generation skills to the fullest effect. A key feature of many approaches is that investment managers are granted a flexible, less benchmark-driven approach to stock selection.

Benchmarked approach

Stock market indices were originally established to measure the performance of selected stocks listed within a particular country or wider geographic region. Over time, many were adopted as benchmarks against which to measure the performance of investment portfolios, notably mutual funds. Active investment managers aim to outperform these benchmark indices as a result of their investment skills – the process known as generating alpha.

Active managers who are constrained by tight tracking error limits (in other words, restrictions on their capacity to deviate from benchmark returns) may need to replicate benchmark weightings of specific stocks, sectors and, indeed geographies, within their portfolios. They may be required to hold lower conviction stock ideas that form a material weighting of an index to meet the risk parameters set out in their particular fund’s investment objective.

Unconstrained investing

Investment managers running unconstrained mandates can build portfolios that may look very different from investible indices, like the FTSE All Share for example, increasing the probability they will generate returns that differ markedly from those of the index. They can broadly invest in any shares they favour within the designated market and need not reference an index when selecting and weighting shares.

Since they need not hold particular stocks, sectors, styles or market capitalisation ranges, investment managers with unconstrained mandates have the freedom to hold only their very best investment ideas, without any unwanted ‘ballast’.

Many run relatively concentrated portfolios, ensuring they can fully back those stocks in which they have highest conviction. Consequently, some describe their unconstrained portfolios as pure plays on their investment judgement, and hence their investment philosophies and processes. Some also point out that their portfolios are free from the unintentional biases that may have crept into benchmark indices over time.

Style agnostic

The most commonly used benchmark indices are weighted by the market capitalisation of their constituent companies. This can produce index performance that can end up being dominated by a mere handful of ‘mega caps’. In the UK, for example, the ten largest companies make up about 40% of the FTSE All Share Index. Unconstrained mandates need not hold allocations to these super-sized companies and will often have the flexibility to exploit the whole market capitalisation spectrum.

Unconstrained approaches are often described as being ‘style agnostic’; their ability to invest across market capitalisations is mirrored by their ability to invest across investment styles (i.e. growth or value-oriented opportunities), which further reinforces their flexibility and capacity to adapt to changing market and/or economic conditions.