Many investment managers apply strict portfolio constraints as part of their risk management process. These often include limits in sector over-/under-weightings, geographic concentrations, minimum levels of portfolio holdings and/or market capitalization requirements. The challenge around these types of curbs is that while they are designed to reduce potential return variance, typically in relation to a particular benchmark, they also can considerably constrain excess return potential.
The portfolio managers of Invesco International Select Equity Fund believe that overly restricting a potential investment universe can work against active managers’ ability to fully exploit research and market mispricing opportunities. To help illustrate this, think of constraints from the perspective of retail consumers.
A consumer who is free to purchase from any retailer without restriction can make more informed choices – and likely better purchases in terms of price, quality, and overall value – than consumers who must spread purchases across at least 50 different retailers, restrict purchases from retailers headquartered in certain countries, and/or only make purchases from retailers with a minimum of $1 billion in annual sales. Applying the same logic to investment management suggests that greater selection choice combined with effective security research may offer a more favorable position to generate excess returns.
The illusion of risk mitigation
Additionally, we believe conventional constraints frequently provide only an illusion of risk mitigation, without necessarily reducing actual risk exposures. For example, country constraints usually categorize companies based on the location of their senior managements or the exchanges on which they are listed. However, where a business derives its underlying revenue is much more indicative of its risk profile. AB InBev1 (NYSE:BUD) (3.78% of Invesco International Select Equity Fund, as of Dec. 31, 2019), the world’s largest brewer2, is classified as a Belgian company. Yet, only an extremely small percentage of the company’s current revenues come from Belgium – about 57% are generated in emerging markets, with a significant portion coming from the US and Brazil.3
Such situations are far more common than investors may realize, due to the many global businesses headquartered and listed in smaller countries.
Similarly, sector limitations can also be problematic given the somewhat blurred nature of industry classifications. Beyond energy, materials, and financials, few businesses fit neatly into a sector where constituents are consistently more highly correlated within than outside the segment. Moreover, the industrials sector often serves as a catch-all for niche businesses that are challenging to classify.
Or consider when S&P and MSCI decided to shift several prominent companies from the technology sector to the newly renamed communications services (formerly telecommunications services). Are Netflix (NASDAQ:NFLX), Facebook (NASDAQ:FB), TripAdvisor (NASDAQ:TRIP) and Google (NASDAQ:GOOG) (NASDAQ:GOOGL) more closely correlated with traditional communication stalwarts like AT&T (NYSE:T) and Verizon (NYSE:VZ)? (None are holdings of Invesco International Select Equity Fund, as of Dec. 31, 2019.) In our view, truly understanding how a company generates revenues and its underlying business prospects is much more insightful into risk exposures than what may be an arbitrary, and at times even potentially misleading, classification.
Independent thought to drive alpha potential
Our deep conviction to unconstrained portfolio management is backed by a disciplined commitment to in-depth proprietary research. Through a combination of high turnover and excessive diversification, many active managers simply lack sufficient time and/or internal resources to conduct adequate research on companies through source documentation and direct management meetings. Consequently, it can be common to utilize broker-generated research to supplement their internal research capabilities and permit them to rapidly gather filtered information and recommendations as to what they should be buying and selling.
In contrast, our approach is to conduct extremely detailed research on a select group of companies by combing through publicly available source documentation and publications covering competitors, customers, suppliers, and other pertinent industry participants. This is supplemented by frequent company management meetings, allowing us to largely avoid mass-distributed – and often short-term-oriented – industry research.
Our focus on independent research allows us to draw different conclusions than the broader market, which has historically been instrumental in our pursuit of repeatable, long-term alpha across our portfolios.
Current case study: A growing emphasis on small-cap securities
To see how our unconstrained, high-conviction approach can translate into active portfolio positioning, consider market capitalization exposure in the Invesco International Select Equity Fund. This portfolio operates with only one real constraint, limiting emerging market content to 30%. If eliminated, the portfolio could, at times, become an emerging markets mandate, which we already offer investors in the Invesco Emerging Markets Select Equity Fund.
The absence of constraints invariably produces meaningful portfolio shifts in sector, country, and market capitalization exposures over time, based on where our research uncovers greater relative business and underlying growth value. With this in mind, a notable market capitalization shift has occurred in the Invesco International Select Equity Fund over the past 24 months. Small-cap exposure has doubled from 19% at the end of the third quarter 2017 to 39.3% at the end of the fourth quarter 2019.4 As with all of our portfolio holdings, this underlying shift has been based solely on individual security idea generation, not any form of top-down calls. However, there naturally have been some overarching market drivers that have made the broad small-cap segment relatively more attractive over the past few years.
1. A surge of passive flows into large-cap companies. Strong inflows into passive vehicles (such as index-based exchange-traded funds) have likely helped fuel recent growing performance divergence between large- and small-cap stocks.5 As shown in Exhibit 1, small caps have lagged across the major global ex-US markets in the past 12 months. One reason for this can be seen in an evaluation of the top international ETFs by sales flows. These vehicles are predominantly made up of large- and mid-cap stocks. This suggests that a substantial proportion of the passive flows have elevated larger-cap company share prices, while having a minimal impact on many smaller-cap companies that comprise a negligible percentage of most international indices. Further, for those small-cap companies that are index constituents, many strategies may not own them. Full replication is frequently inefficient and uneconomical, particularly for smaller, less liquid securities which have a negligible impact on index performance yet are relatively expensive to trade. Synthetic replication through computer-assisted optimization allows passive funds to closely replicate underlying index performance without incurring the transaction costs of thinly traded securities.
Exhibit 1: Significant one-year performance divergence between small- and large-cap stocks
2. Market biases toward large-cap stocks due to greater analyst research coverage. A second explanatory factor stems from the reliance of the investment community on broker-driven research. More brokers are producing frequent and extensive research on larger, more actively traded companies which garner greater commission revenues, while providing sparser, if any, coverage on smaller and more illiquid companies that may be less profitable to cover. To help illustrate this point, we examined the number of analysts covering each company in the Invesco International Select Equity Fund. Unsurprisingly, larger-cap companies received significantly greater – just over double, on average – analyst coverage than small companies (see Exhibit 2). The three smallest companies in the portfolio were covered by a mere four analysts, on average, most of whom were employed by small regional brokerages. We believe greater analyst coverage may translate into more investor interest and more widespread ownership. Conversely, smaller and more illiquid companies that are subject to thinner coverage are likely to draw less portfolio manager interest. Hence, these companies may be more prone to be overlooked.
Exhibit 2: Small-cap companies received notably less average analyst coverage as of Oct. 31, 2019
The pursuit of consistent excess returns over the long term
We believe avoiding common risk constraints can enable skilled active managers to arrive at a more optimal combination of investment ideas, and therefore may result in long-term excess returns. Over the past two years, our highly flexible portfolio approach combined with our independent research led us to double small-cap exposure in Invesco International Select Equity Fund, exploiting extensive broker coverage of larger, more liquid companies and strong inflows into passive vehicles. We have already begun to see the benefits of this positioning, as the market has begun to recognize the merits of many of our small-cap company holdings (Class A shares at NAV of 10.81 compared to MSCI AC World ex-US Growth Index of 9.91, and MSCI AC World ex-US Index of 8.88, from fund inception on Dec. 21, 2015 through Dec. 31, 2019).4
For standardized performance, visit the Invesco International Select Equity Fund product page. Performance quoted is past performance and cannot guarantee comparable future results; current performance may be lower or higher. Visit invesco.com for the most recent month-end performance. Performance figures reflect reinvested distributions and changes in net asset value (NAV). Investment return and principal value will vary so that you may have a gain or loss when you sell shares. Performance shown at NAV does not include applicable front-end sales charges (max. 5.50%), which would have reduced performance. Fund performance reflects any applicable fee waivers and/or expense reimbursements. Had the adviser not waived fees and/or reimbursed expenses currently or in the past, returns would have been lower. See current prospectus for more information.
Without the burden of excessive constraints, we are often able to buy into investment ideas at earlier stages and at more reasonable valuations, while passive vehicles and investors reliant on broker research and/or operating under constraints may be forced to buy at much higher valuations and at a later stage in the growth trajectory. Ultimately, we believe our approach can generate potential returns and provide our investors with confidence as we continue our efforts to grow their capital over time.
1 Holdings are subject to change and are not buy/sell recommendations.
2 Source: Brewers Association annual rankings, March 12, 2019
3 Source: InBev as of Sep. 30, 2019
4 Source: Invesco as of Sep. 30, 2019
5 Source: Morningstar, US Equity, Sector Equity, International Equity Category as of Feb. 11, 2019
Blog header image: HAYDEN WILLIAMS / Stocksy
Derivatives may be more volatile and less liquid than traditional investments and are subject to market, interest rate, credit, leverage, counterparty and management risks. An investment in a derivative could lose more than the cash amount invested.
The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.
The fund may from time to time invest a substantial amount of its assets in securities of issuers located in a single country or a limited number of countries.
Growth stocks can perform differently from the market as a whole as growth stocks tend to be more expensive relative to the issuing company’s earnings or assets compared with other types of stock.
Investments in certain countries in the European Union are susceptible to high economic risks associated with high levels of debt, such as investments in sovereign debt of Greece, Italy, and Spain.
Preferred securities are subject to issuer-specific and market risks applicable generally to equity securities.
The fund is subject to certain other risks. Please see the current prospectus for more information regarding the risks associated with an investment in the fund.
The MSCI All Country World ex USA Large Cap Index is considered representative of large-cap stocks across developed and emerging markets, excluding the US.
The MSCI All Country World ex USA Mid-Cap Index is considered representative of mid-cap stocks across developed and emerging markets, excluding the US.
The MSCI All Country World ex USA Small-Cap Index is considered representative of mid-cap stocks across developed and emerging markets, excluding the US.
The MSCI All Country World ex USA Index is an unmanaged index considered representative of large- and mid-cap stocks across developed and emerging markets, excluding the US. The index is computed using the net return, which withholds applicable taxes for nonresident investors.
The MSCI Europe Large Cap Index is considered representative of large-cap European stocks.
The MSCI Europe Mid Cap Index is considered representative of mid-cap European stocks.
The MSCI Europe Small Cap Index is considered representative of small-cap European stocks.
The MSCI Europe Micro Cap Index is considered representative of micro-cap European stocks.
The MSCI Europe Index is an unmanaged index considered representative of European stocks. The index is computed using the net return, which withholds applicable taxes for non-resident investors.
This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial advisor/financial consultant before making any investment decisions. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
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All data provided by Invesco unless otherwise noted.
Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers including Invesco Distributors, Inc. Each entity is an indirect, wholly owned subsidiary of Invesco Ltd.
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The Power Of Portfolio Flexibility by Invesco US
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