When managing assets, understanding risks and having the ability to adapt equity positions quickly in a portfolio is crucial to minimising losses and improving profit opportunities, according to Franco Pretorius, Head of Equity Research at PSG Wealth.
At the same time, it’s crucial to trade the positions at fair prices without high transaction costs. Being forced to change equity positions too quickly could result in paying too much for a purchase order or receiving too little for a sell order.
“The central factor is managing the liquidity of the fund,” says Pretorius. “The ability to adapt equity positions quickly also means that managers can act faster on new information.”
To monitor liquidity risk, consider four analytical views: the total days to liquidate, the average days to liquidate, the liquidity profile, and the liquidity horizon.
The less liquid the market is (slow ability to adapt equity positions), the higher the transaction costs will be. “This will negatively impact the ability to adapt equity positions because the more expensive it is to trade, the less incentive there is to make changes to equity positions,” Pretorius says.
“In other words, the margin of safety would need to be great enough to warrant changes in positions.”
Why you should understand risk
It is vital that an equity team understands the risks, as they manage other people’s money. Moreover, the team will have mandates to which they are contractually obliged to comply; failure can lead to employment termination and, in severe cases, criminal prosecution.
“When equity teams fail to understand and interpret risk correctly, it can lead to incorrect investment advice, the loss of money and, more importantly, the loss of clients,” says Pretorius. In extreme cases, this could cause fund managers to go out of business.
Hence, it is essential that equity teams understand and interpret risk accurately to manage it correctly and understand the impact that over- or underweight positions have on the alpha of the portfolio.
Use a margin of safety to reduce risks
The difference between the current market price and the intrinsic value is the margin of safety. “At PSG Wealth we make use of three different intrinsic value prices: the bull-, base- and bear-case scenarios,” says Pretorius.
“The closer the market price is to the bull-case price, the higher the perceived risk will be and therefore, the higher the risk of realising drawdowns,” Pretorius says. “The margin of safety will be the greatest for companies where the market price is less than the bear-case price.”
For example, if Naspers Ltd shares (NPN SJ) were to increase by 20% in price/value, then the decision to have an active underweight position in NPN could cause the alpha of the portfolio to decline by about 0.90%. If there is enough ability to adapt equity positions, the underweight position could be reduced or even changed to overweight. This could reduce the negative impact on the alpha of the portfolio.
“Taking a large active position in a stock which has a zero weighting in the benchmark can have huge implications if the stock price were to decline without there being liquidity to sell out of that position quickly,” says Pretorius.
“It is imperative to understand the potential consequences of actively taking under- or overweight positions relative to the benchmark, and the impact this can have on the alpha of the portfolio.”
Only by comprehending the need for quick equity position changes and risk in full, can equity portfolio managers manage it correctly.