On a curated tour of the distillery recently, I observed the traditional methods employed to produce the unique aromas of this whisky. The quality and quantity of yeast, malt, water; the size and specific wood used to make the barrels; the drying techniques; the copper pot stills, and the cast iron cooling tubs, all needed to come together in perfect proportions, technique and craftsmanship, and be aged for a minimum of 12 years to produce this exquisite spirit.
The staff at the distillery explained that consistency across batches was an ongoing challenge. Each batch could have more fruity, less woody, lighter or heavier flavours. External factors such as weather and humidity, and internal factors such raw materials could cause inconsistencies. For example, no two oak casks were identical because of differences in previous usage, grain and maturity of oak. Distillers hedged the risk of a poor batch by ageing casks under different conditions, be it weather, wood, heat, humidity, or raw materials.
A toast to alpha
In this sense, managing a portfolio of stocks that strives to beat its benchmark over the long term isn’t too different from producing consistent, high-quality batches of whisky at Glenkinchie. Actively managed stock portfolios can outperform benchmarks and generate significant alpha over several years, but they can also underperform the index, sometimes by a large margin.
Alpha is excess performance over the appropriate benchmark, adjusted for risk. It is not possible to generate alpha using a portfolio that is identical to its benchmark. The very process of active stock management necessitates that the portfolio deviate from the benchmark to generate alpha. The extent of this deviation is called the ‘active position’.
There are four main ways to achieve active positions.
- Include stocks in the portfolio that are absent from the benchmark.
- Remove stocks that are present in the benchmark.
- Hold more of certain stocks than their weight in the benchmark.
- Hold less of certain stocks than their weight in the benchmark.
Active positions, when clubbed together, are commonly known as factors. Factors are broad, measurable characteristics or strategies that drive return and risk in securities. Every such strategy or factor is fundamental and unique to the way a fund is managed. Often, when stocks in the portfolio deviate from their core philosophy, the fund manager eliminates them, even if they are performing well in the current market environment. Some common factors or styles are momentum, value and quality.
Momentum investing predominantly tracks stock price movements. It involves picking stocks that have had a strong run-up recently and are expected to continue rising, and eliminates those that may dip in the near term.
Value investing typically involves taking a contrarian view on stocks. Value investors pick stocks with strong fundamentals that for some reason are trading at a discount. The fund manager typically buys such stocks and holds them until the price matches their fundamental or intrinsic value.
Quality investing typically disregards whether a stock price is undervalued or overvalued. If a stock’s fundamentals are sound (strong management, high earnings growth, clean balance sheet, robust order book, high return on equity), the fund manager will buy or hold on to it as she expects it to perform well over the long term, even though short-term performance may or may not be strong.
Diversify across factors
Investors cannot expect all three strategies to do well simultaneously. Just as it is important to diversify across asset classes such as equity, debt, commodities, currency, real estate, and across market capitalisation, it is also crucial to diversify across factors such as momentum, value and quality.
Factors tend to have a low correlation with each other. Each has a unique purpose in the portfolio, and hence a blend of strategies help investors navigate market cycles and build more resilient portfolios. Dissimilar strategies perform well at different points in time and across market cycles. If a contra fund in your portfolio is currently underperforming, it’s not a good idea to exit it and invest in a momentum or quality fund because that specific style is driving returns today. Investors must hold on to such a fund, provided it is performing well compared to its peers.
There has never been a 12-year rolling period in the Sensex’s history that has produced a negative nominal return. However, investors can certainly have negative returns over such a period because of behavioural biases. Ultimately, how investors respond to changes in market cycles has a big effect on their returns.
Imagine if investors treated their portfolios like a Scottish distillery treats its whisky – with conviction in their strategy, patience through market cycles, and trust in the investment process. Like a finely aged 12-year Glenkinchie, investors would have a richer, smoother and more consistent investing experience.
Cheers to that!
Priya Sunder is director and co-founder, PeakAlpha Investments.
About the Author
