Unconstrained investing

The right choice for active managers

History shows that it pays for a skilful fund manager to operate under an unconstrained mandate.

Most fund managers are benchmarked to an index against which their relative performance is judged. This has led to a proliferation of so-called ‘closet’ tracker funds, which command active fees but deliver passive-like returns.

The chances are that you own some of these in your own portfolio right now.

But there are managers out there that pride themselves on being different. These ‘unconstrained’ fund managers have the flexibility to invest across many different geographies, asset classes and security types. Their returns are often less correlated to the wider indices than their counterparts in the more heavily marketed funds space.

History shows that it pays for a skilful fund manager to operate under an unconstrained mandate. What follows is an explanation of what unconstrained investing really means – and an illustration of why being unconstrained is a major advantage in today’s volatile world.

Unconstrained funds = no-holds-barred investing

Most fund managers are given a mandate that requires them to construct a portfolio based off a benchmark index. The fund manager will underweight or overweight the benchmark’s constituents based on the manager’s biases and assessment of an individual security’s valuations and prospects.

While there is nothing wrong with this approach in principle, in practice it tends to lead to a performance not too dissimilar from the underlying index. Managers of heavily marketed funds often have a minimum number of holdings imposed upon them by regulators, which leads to a manager having to diversify a portfolio well beyond their ‘best ideas’.

There is also an element of game theory at play here. The managers of these funds will be compared with other managers operating under a similar mandate. It is therefore in the manager’s interest to run a portfolio that overlaps many of his peers’, as it is better from a career standpoint to fail conventionally than it is to fail unconventionally – after all, nobody ever got fired for buying Microsoft!

While the large investment houses focus on heavily marketed products that follow a benchmark, the smaller, ‘boutique’ managers must make a name for themselves by doing something different. An unconstrained investing mandate is therefore appealing, as it gives the fund manager the best possible opportunity for their investing skills to be put on display.

The world is your oyster

Aside from portfolio concentration, most funds have very clear boundaries in terms of where they can invest – in terms of asset class, so-called ESG characteristics and geography, for example. However, a fund manager who is truly unconstrained is free to capitalise on opportunities wherever he finds them.

A great example of how some fund managers have been hamstrung by the often-arbitrary parameters imposed the ESG lobby is the Damascene conversion regarding nuclear energy. Nuclear energy was once a no-go zone for ESG-focused investors due to the disapproval of the ‘green’ lobby. But in March 2022 the European Union announced that nuclear will join its green taxonomy in 2023. ESG-focused funds will now be turning up late to the party, as uranium miners in particular had been seeing strong share price performances in the run-up to this announcement. Unconstrained investors would have been free to invest as soon as it became clear that nuclear capacity was the obvious choice to plug the gap without abandoning CO2 emissions targets.

Active managers should have the flexibility to be agile in terms of their asset allocation – a point which is infinitely relevant in today’s rapidly changing and volatile world. A good example of this can be found during the Great Financial Crisis of 2008/09, when investment grade corporate debt was often way more attractive than the equity of the respective companies. There was a clear technical reason why this opportunity arose. Equity is what is known as a residual claim – i.e. the equity holder is only entitled to his share once the senior charge holders, usually bond holders and secured creditors, get their due. During these special circumstances, it was rational and the only right decision to exploit some opportunities through choosing a corporation’s bonds.

A good example of investor agility during a crisis can be observed from the Sage of Omaha himself, Warren Buffett, when he bought $5 billion of preferred stock in Goldman Sachs in 2008. Preferred stock, despite the label, is more akin to debt, and in this particular case entitled Buffett to a 10% annual dividend, as well as warrants enabling him to buy 43.5 million of Goldman’s common shares at $115 each (for a total investment of $5 billion) at any point in the following five years.

The deal, which secured Goldman’s short-term financial position at the height of the financial crisis, paid off handsomely for Buffett and Berkshire Hathaway shareholders, as it produced strong returns at a lower level of risk than would have been the case for common equity holders. The preference shares netted a total return of around 36% for Berkshire before they were redeemed by Goldman in 2011. As for the warrants, Goldman ended up renegotiating the prospective purchase before conversion to simplify the transaction. Instead, Berkshire was granted 13.1 million Goldman shares and $2 billion in cash in 2013. Of course, few market operators are able to secure the kind of deals available to Buffett, but the Goldman deal highlights the value of being able to adjust one’s investment strategy to suit the prevailing market conditions.

Geography can be just as important a determinant of returns in the short- to medium-term. The current pivot towards ‘value’ stocks favours the UK market, as its leading indices have a heavy component of traditional ‘old economy’ value stocks, while the British pound sterling has depreciated significantly versus the US dollar. This has made UK firms attractive to US predators, not least because UK markets are much more amenable to M&A activity when compared to continental European countries, which tend to intervene in foreign takeover situations from a protectionist standpoint. This has led to a flurry of takeovers of UK companies, which shows no signs of slowing down. A Europe ex-UK manager would have to sit by and watch from the side lines if their mandate prohibited investment in UK-quoted stocks, as many do.

Guernsey: the perfect home for unconstrained managers

Guernsey takes a different approach. Whilst its financial regulators adhere to the highest international standards and best practices, they also believe that the Guernsey financial services sector exists primarily to serve the best interests of its clients.

The GFSC (Guernsey Financial Services Commission) is prepared to work with firms to introduce products in areas it believes will help it to carve out a competitive niche internationally. It has demonstrated this time and again, in areas like the European high-yield bond market and, more recently, cryptocurrencies.

Sarnia Asset Management was established to capitalise on the opportunities afforded by Guernsey’s robust but pragmatic regulatory regime. If you’d like to discuss the themes addressed in this article in more detail, please don’t hesitate to contact us

Disclaimer: This blog is intended for informational purposes only. This blog is not intended to invite, induce or encourage any persons to engage in any investment activities and is not a solicitation or an offer to buy or sell any stock, investment product or other financial instruments. If in doubt, please seek financial advice from an independent financial adviser. Sarnia Asset Management is licensed by the Guernsey Financial Services Commission (GFSC). Past performance is not an indication of future returns. Investments carry risk, including the risk that you will not recover the sum that you invested.

By James Faulkner

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