Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
SMIDs pierce the gap in mega-cap armour
SMIDs have cumulatively outperformed large caps to the tune of some 200 per cent over the last 20 years. The last six years have been more challenging; the rise of the FAANG mega-caps has “dominated everybody”. But you don’t need a weatherman to know which way the wind blows, and the future will likely be wildly different.
“Starting points matter,” says Nicholas Paul, institutional portfolio manager and investment officer at MFS. “And the starting point today relative to ten years ago is obviously very different – whether it’s the interest rate environment, whether it’s the inflationary environment, whether it’s the appetite for central banks to continue to pump liquidity into the market.”
“You’re starting to see some gaps in the armour of these mega-caps, whether it’s Meta or Netflix or even Amazon more recently. That’s not to say they’re not great businesses and they’re not going to continue to have dominant share, but they’re now – in a lot of cases – trillion-dollar businesses. How much bigger are they going to get?”
Returns are going to be “harder to come by – period”. Investors will likely subsist on mid-single digits; a set and forget environment where they basically had to pick geography and sector could soon give way to one where the fundamental, bottom-up approach that plenty of long-suffering SMID managers pride themselves on is king again.
Eric Braz, one of four portfolio managers for MFS’ New Discovery Fund, has been using the recent spate of volatility to re-up on names he likes on a “better the devil you know” basis. The portfolio consists of around 110 stocks – with position sizes of between 50 and 200 basis points – and efforts are being made to trim it to 100.
Very concentrated strategies are great in an up market, Braz says, but the team believes that the universe is large enough (7500 stocks) that they don’t need to run a concentrated portfolio in order to have high conviction about the stocks within it. SMIDs generally receive less research coverage than their larger peers, but the team believes MFS’ global research capabilities are a key differentiator for the strategy; about 70 per cent of the index is assigned to an analyst across its nine offices.
They mainly look for “companies in good industries, strong management teams, pricing power” and at the end of the day believe (perhaps controversially, given what the market has thrown its weight behind in recent years) that “earnings and cash flow drive stock performance”. While the bar for IPOs is higher now than in the past – the valuations are “too crazy” – the team participated in the listing of US software company Avalara, which is currently producing tax management software but has the potential to be a platform for capital management and payroll.
“To be fair, the stock hasn’t been great, because it was a higher-multiple stock,” Braz says. “But if we take a three to five year time horizon we think it could be quite good, and we’ve added to it – not aggressively, but we’ve added to it through some of the drawdown.”
Paul believes that the dominance of the mega-caps has now left investors with a hole in their portfolio that small caps alone won’t fill, and MFS has established a local unit trust to meet demand Down Under.
“(Mega-caps) have become such big parts of global benchmarks – whether it’s the ACWI or the MSCI World – that what you’ve seen is that those basis points have come out of SMIDs where below $30 billion in market cap a decade ago was almost half the benchmark,” Paul said. “Today it’s basically been cut in half.”
“I’m not sure the benchmark providers had the clairvoyance to understand what trillion-dollar companies would do in terms of sourcing basis points from a cap-weighted perspective – I’m not sure anybody did – but you’re nonetheless left with this big gap in investor’s portfolio of $30 billion and below.”
