Investors often ask how it's possible to allocate capital to European stocks given the political risks that abound. We think the answer is to combine disciplined stock picking with risk-management tools that look for unintended threats to a portfolio.
Managing Risk in Stock Selection
Risk can mean many different things to different investors. For some it's just another word for volatility. For others it's all about how a portfolio looks versus a benchmark.
We believe managing risk is about ensuring that a portfolio's returns are driven primarily by the business strengths of its holdings. That means making sure performance isn't knocked off course—or even boosted unexpectedly—by events or exposures that aren't related to the businesses.
Thorough company-level and industry research is essential, for example, to determine how sensitive company earnings are to changes in the macroeconomic environment and to identify environmental, social or governance risks that could damage performance.
However, even the best company analysts may have blind spots, so challenging our own perspectives is important. In some cases, this can be done by engaging with short sellers, typically working at hedge funds. Since short sellers are trying to profit from a stock price falling, they have a negative opinion on the company's prospects. By talking with them, long investors can identify potential holes in a thesis. This can lead us to revisit key assumptions or to revise our return forecasts to compensate for risks that we may not originally have spotted.
Innovation In Understanding Portfolio-Level Risk
Equity fund managers typically rely on a range of quantitative risk models from external providers to test a portfolio's resilience to various hazards. Models that analyse a portfolio's likely response to different scenarios can help control exposures, though ultimately, they aren't a substitute for experience and judgement.
Managers may also rely on risk models that test a portfolio's exposure to known country, industry and factor risks. These can gauge how cheap or expensive, or how large or small, the portfolio companies are relative to their broad investment universe. Risks that don't fit into these buckets are then categorized as stock-specific risk.
But these traditional risk models might need some help. While it's important to understand and control factor exposures, which can have a big impact on performance, this approach on its own may be too static and simplistic. Many other risks aren't stock-specific but don't necessarily fit easily into standard risk categories. And the way different stocks are exposed to these risks can vary significantly over time.
Cluster Analysis Fills The Gaps
Cluster analysis is an artificial intelligence technique that segments stocks into groups whose returns have been moving closely together over the past few months, therefore helping to identify less obvious, correlated, sources of risk that other quantitative risk models or analysts may miss. It can help separate groups of stocks within an industry or subindustry that will benefit in a risk-on trade, when markets reward riskier assets, and others that might be more aligned with a risk-off environment.
The findings can defy conventional wisdom. For example, while industrials are generally seen as risk-on stocks, some companies in the sector have business models that make them more defensive. In contrast, healthcare is often seen as a defensive sector, but some drug-makers with a small number of products or imminent patent expiries, might be much less defensive than perceived.
Discovering Surprising Correlations
Cluster analysis can reveal surprising patterns, the reasons for which are not always obvious, however identifying the correlation can help a portfolio manager avoid too much exposure to an unidentified risk.
For example, last year, we found a curious change in the trading patterns of a UK water utility. In the past, this stock behaved in-line with its utility peers, which are typically considered defensive. At some point, it started trading in-line with UK retailers, which are much more cyclical. The shift might have been related to the rise of the Labour Party in UK polls, as the party has a stated policy of nationalising assets like water utilities. This potential disruption could greatly widen the range of possible outcomes for the stock. Whatever the actual reason was, the utility's risk profile had changed significantly, which should prompt a rethink of its role as defensive ballast for a portfolio.
Finding new ways to detect unintended risks before the warning lights flash is paramount. Systematic cluster analysis as well as engaging with short sellers can sharpen fundamental research. Adding these techniques to more traditional risk models help investors construct a portfolio with truly idiosyncratic return streams, that are unlikely to be knocked off course by adverse political or macroeconomic developments.
The ES AllianceBernstein Europe (ex UK) Equity Fund entails certain risks:
- Equity securities risk: The value of equity investments may fall as well as rise, over short or long periods, and you may get back less than you originally invested.
- Focused portfolio risk: Investing in a limited number of issuers, industries, sectors or countries may subject the portfolio to greater volatility than a portfolio which is invested in a larger, more diverse array of securities.
- Derivatives risk: The Portfolio may use financial derivative instruments which may results in increased gains or losses.
- Other risks include: Concentration risk, counterparty and custody risk, country risk, currency risk, derivatives risk, hedging risk, liquidity risk, management risk, small & mid cap stock risk, illiquid or restricted securities risk and investment in collective investment schemes risk.
- These and other risks are described in the Portfolio's prospectus.
For Investment Professional use only and not for retail. Before making an investment, investors should review the fund's full prospectus, together with the relevant Key Investor Information Document (KIID). Copies of these documents may be obtained free of charge from the AllianceBernstein website or in printed form from Equity Trustees Fund Services.
Note to All Readers: The information contained here reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realised. The views expressed here may change at any time after the date of distribution. For informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor's personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information is issued by AllianceBernstein Limited, 50 Berkeley Street, London W1J 8HA, it is for marketing purposes. Registered in England, No. 2551144. AllianceBernstein Limited is authorised and regulated in the UK by the Financial Conduct Authority (FCA).
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