Fight Back! How Top Fund Managers Combat Risk

Political risks are rising, at home and overseas. Investors are counting on the Federal Reserve to cut interest rates this year, but if wars in the Middle East or Eastern Europe get worse and disrupt supply chains, the result would be resurgent inflation and a delay in the central bank’s dovish pivot.

Red Sea attacks by Houthis and the intensifying China-Taiwan rivalry add to geopolitical concerns. And as the presidential primary headlines attest, U.S. politics isn’t exactly a rendition of kumbaya, either.

At the same time, the federal budget deficit has been widening, compelling the Treasury Department to issue new debt. This trend could lead to higher rates, which would derail the economy recovery and stock market rally.

Accordingly, during this holiday-shortened week, I sought insights from several top mutual fund managers. These off-the-record conversations have yielded key investing insights. For this article, I gathered them in one place.

While much of their investment process involves painstaking fundamental analysis, their approach to risk mitigation is probably the most salient takeaway for the average investor.

Interestingly, many of the fund managers who post market-beating returns while incurring less risk aren’t necessarily mindful of risk reduction when they’re constructing their portfolios. Instead, this characteristic is merely a byproduct of their security selection.

Want to fight back against the rising risk? Consider the following timeless guidelines.

Shareholder-friendly corporate management…

So what kinds of stocks perform well while incurring less volatility than their peers? Well, the underlying business must have a shrewd management team whose interests are firmly aligned with long-term shareholders.

Nearly every fund manager cites the importance of vetting a company’s management. But while they might be able to fly at a moment’s notice to interview a management team at company headquarters, that kind of access isn’t happening for the retail investor.

Fortunately, most fund managers say their assessment of management’s prowess is based on two key factors: 1) their skill at capital allocation, particularly when it comes to cash flow and 2) high levels of inside ownership.

Like most investors, fund managers welcome price appreciation, but they know that over the long term such gains won’t be made with a management team that destroys shareholder value through empire-building acquisition sprees, excess leverage, or buying back shares at market peaks.

A company’s executives have several options for how they deploy their cash flow. They can use that cash for share repurchases, dividend payouts, reinvestment in growth, paring debt or pursuing acquisitions.

The fiscal discipline imposed by dividends…

As shareholders, fund managers like to get paid first, and that means finding a company that’s dedicated to paying a dividend and growing its payout over time. But they don’t want to see a dividend that’s so high that it impairs a company’s ability to internally finance its growth with the balance of its cash flow.

Depending on the company, prudent fund managers tend to look for companies with dividend payout ratios of 30% to 60%.

The following graphic explains the basic equation behind a dividend payout ratio:

From a cynical perspective, the discipline of maintaining a dividend helps constrain management’s ability to waste capital by simply leaving them with less cash to do so. However, most fund managers want to see what choices a company is making with its cash flow based upon the operating environment, as well as what’s happening in both its sector and the broad market.

Skin in the game…

Insider ownership aligns management with average shareholders. A company whose management has high levels of inside ownership is less likely to be concerned with beating The Street on a short-term basis and far more likely to be focused on creating long-term growth for shareholders.

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After all, as major shareholders themselves, these corporate managers probably stand to benefit the most from the success of their strategic vision.

Asset allocation and rebalancing are key…

The top fund managers focus on portfolio construction through proper position sizing and sector weighting to help reduce risk. Although some funds may be almost fully invested at all times, that hardly means their portfolios are static. Instead, successful managers trim positions as they approach or exceed their valuations and reinvest the proceeds in existing undervalued positions.

Similarly, they adjust sector weightings based on the macro picture. During a bull market, they’ll lean heavily on outperforming sectors, while during bear markets they’ll dial back sector exposures to levels commensurate with their benchmarks.

These efforts are not entirely dissimilar to the rebalancing that most investors perform with their portfolios once or twice a year. But instead of a purely mechanical and infrequent process, the fund managers are making these changes by examining their portfolios at a granular level on an ongoing basis.

Although individual investors may not have the time or resources to analyze their investments like a true portfolio manager, they can at least reduce the risk in their portfolios by paying attention to the aforementioned fundamental characteristics, being disciplined about what they’re willing to pay for a stock, and adjusting stock and sector exposures when conditions get too frothy.

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John Persinos is the editorial director of Investing Daily.

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