According to S&P Dow Jones Indices, the “Magnificent Seven” – Apple, Microsoft, Nvidia, Amazon, Meta, Tesla and Alphabet – accounted for 60% of the S&P 500’s total return of 26.3%, indicating how top-heavy last year’s rally has been. In this piece, we will consider how our Old Mutual Global Managed Alpha Equity Fund’s dynamic approach to factor investing was able to cope with such return concentration – especially considering our stated intention to provide our investors with a core global equity strategy which is broadly diversified.
Underweight to six of the Magnificent Seven
Our benchmark, the MSCI All Country World Index (ACWI) has a far larger universe than the S&P 500, yet the 2023 return domination of the Magnificent Seven was still unprecedented – accounting for 42% of the index’s 22.2% total annual return. To put this into context – there are roughly 2 500 companies represented in the ACWI, across more than 40 countries.
Despite this scenario, our fund’s portfolio construction approach remained true to its objective, systematic methodology – creating a 390 stock portfolio that was ultimately underweight to six of the seven “Magnificent” counters – accounting for only 27.5% of the fund’s 23.5% annual gross return. Producing outperformance of 1.3% in this challenging environment was especially pleasing as it illustrated that the model’s forecasted return drivers created factor tilts which added significant value. Close to 70% of the share positions contributed positively to the fund’s alpha – with no material “chunky” outliers.
It is worth noting that maintaining a broadly diversified portfolio, essentially put the fund at a distinct disadvantage as an ‘at-weight’ position to the Magnificent Seven would have produced an extra absolute return for the year of 3.2% - which is significant in the context of the final 2023 return of 23%. What this means is that the remaining 383 shares in the fund made up this difference and then some, given that the outcome produced an excess return vs the ACWI benchmark.
The risk of active fundamental management for global portfolios in this top-heavy world
Fundamentally orientated global equity funds tend to have portfolios comprised of less than 100 shares – sometimes less than 50. In a world in which the benchmark return is being dominated by only seven counters, it would have been extremely tempting to have sought to avoid underperformance by increasing the weight to these technology-orientated stocks – thus taking an already concentrated portfolio and ‘upping the ante’.
For fundamental managers who succumbed to this “herd-mentality”, they have entered 2024 in a more precarious position – placing undue reliance on a handful of companies. The trend is your friend until it isn’t!On the other hand, given that our objective is to provide our investors with a long-term orientated global core equity building block, our systematic approach was able to avoid the “peer pressure” and has entered 2024 with a broadly diversified blend of counters which exhibit exposure to the factors the model predicts will drive future returns. The scatter plot demonstrates our commitment to risk management – each dot represents one of the 390 counters and illustrates that the fund’s tracking error to its ACWI benchmark is spread across a large array of holdings (the cluster in the middle) – producing risk diversification and potential alpha sources that can be derived from many small tilts.
By continually monitoring each share’s contribution to tracking error, we have been able to intentionally reduce the overall fund’s realised tracking error, as shown in the below chart. This means that the benchmark beating returns – consistently produced since the fund’s inception in December 2017 (see table below) – have been achieved with lower relative risk.
Recapping our investment process
Our proprietary systematic model evaluates six broad market drivers or factor buckets – value, growth, quality, momentum, size and volatility (risk). This process is style agnostic, meaning that the approach will tilt toward or away from these factors depending on the forecasted return drivers. By ‘tilt’, we mean an over- or underweight exposure to the factors relative to the MSCI All Country World Index (ACWI).
The ‘end product’ of these factor exposures will be an over- or underweight to the underlying shares, which ultimately results in over-or underweight exposure to countries and industry sectors. This is done within the tight risk parameters we have integrated into the portfolio construction process. Risk management is a deliberate part of the approach as our objective is to provide an outcome that produces incremental excess returns without taking on undue risk relative to the benchmark. We seek to achieve this by having a broadly diversified fund with relatively tight tracking error limits.