What Is Unconstrained Investing And What Are Its Applications?
Portfolio managers usually approach investments with a set agenda and using benchmarks for their market moves. This is for a good reason too. Market dynamics and stock behaviour can be volatile and tricky. It calls for a measured and restrained approach as the focus is as much on growth as on risk mitigation. This is why the concept of unconstrained investing stands out for being unique yet relevant.
What is Unconstrained Investing?
So what exactly is the concept of unconstrained investing? For an industry like finance that requires high degrees of adherence to formats and benchmarks, managing investments can be a straitjacketed affair. The lack of flexibility and the rigid processes that govern investing can, at times, hinder portfolio growth and returns.
With the traditional strategies used in investing likely to face growth challenges in difficult market conditions, the idea of an unconventional approach finally found acceptance. We will see how that happened in the next section but first, here is a look at what unconstrained investing is all about.
Unconstrained investing is a diversion from the process of investing, as we know it, where fund management is done with a benchmark referenced to. When an index that a fund is benchmarked to starts to do poorly, there is an impact on the portfolio value too.
But, with unconstrained investing, there is the freedom to invest and benchmark over and beyond an index or a set agenda. This can open up the potential for a fund to benefit from better and more investment options.
Why Is Unconstrained Investing Important?
To understand the relevance of unconstrained investing, it is important to rewind to its origins and the reasons that led to the industry taking a new, contrarian concept seriously.
Back in the year 2007, the financial markets the world over started to crumble and go into a tailspin over the crisis that built up. The trusted benchmarks that investment managers and investors alike were using as the foundations of their judgment were no longer reliable indicators. For instance, in the tumultuous market conditions, even the S&P 500 Index was also becoming difficult to use as a benchmark.
When portfolio and fund managers realised that being constrained by the standard operating practices and guidelines were becoming hurdles to the performances of their investments, it was time to introspect. Being inflexible makes it difficult to react to market conditions and to make the most of opportunities in unique scenarios. In 2007 and 2008, the US market scene, with the subprime mortgage fiasco, was a wake-up call that got the industry to find a workaround and reinvent itself.
That spawned, among other things, the idea of unconstrained investing. It was radical and different enough to shake up the purists initially. But once the large players began to embrace it, the concept gradually evolved and gained a level of acceptance.
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Application of Unconstrained Investing
So, how does unconstrained investing work and what does it do differently to rise up to the challenges?
Decouple from traditional benchmarks
Essentially, a portfolio manager has to think differently when making the shift from the traditional investing strategies to an unconstrained approach that defies the conventional tenets of managing funds. Conventional investing strategies involve comparing portfolios with similar standards such as relative returns, tracking errors, and information ratio. So, a big move happening within a sector can be unfavourable for the relative performance of a portfolio. Additionally, portfolio managers are compelled to invest in unpopular sectors in order to stay within strategy guidelines, minimize tracking error, and achieve acceptable benchmark-relative performance.
However, decoupling from traditional benchmarks reduces the pressure on the portfolio manager to merely achieve a specific benchmark-relative position. Also, it gives the portfolio manager the freedom to invest in different sectors or at different concentrations.
While traditional investors mostly depend on volatility-based methodologies to assess portfolio risk, unconstrained investors have relatively high levels of interest rate risk and will not be able to assess risk using these conventional measures and should go for other approaches.
Investors in an unconstrained strategy should accept the fact that they will not be able to assess risk using conventional measures and go for an alternative approach to risk management instead.
Adopt a longer investment horizon
A portfolio manager has to understand that unconstrained investing requires a longer time horizon to create more opportunities. So, get ready for a few losses before significant gains are realized.
Focus on total return, not income
Usually, investment managers focus on income rather than total return. On the other hand, the unconstrained strategy focuses on total return above a specific cash rate. To generate more returns, a profile manager has strategies that work around duration, yield curve, currency, credit selection, security selection and sector rotation.
Cede some asset allocation control
Unconstrained investing requires the investor to give up certain asset allocation decisions. Here, it is the portfolio manager who will take decisions for the investor, wherever necessary. The investor must be comfortable allowing the manager to assign funds across different sectors, locations and individual credits.
Benefits of Unconstrained Investing
The reason why an unconstrained style of investing came into being was the result of a solution to a problem faced with difficult market conditions. With more and more investment managers using this strategy, it is clear that it has its own obvious benefits. Here is a look at the most impactful among them.
✅ A more flexible approach: For conventional investing strategies, investors have to follow the issuance patterns of the major constituents of the indices. Unconstrained investing strategies do not follow a standard benchmark and this allows an investor to allocate capital based on an independent assessment of value and risk.
The broad range of sources available lets you position the fund to benefit from the prevailing economic environment. This allows for more client-friendly strategies including more flexibility and diverse opportunities.
✅ Access to a wider asset base: With an unconstrained approach, a portfolio manager can become more creative and explore for options, new and diverse. He can access a greater number of companies, irrespective of sector, style characteristics or market capitalisation, for the best opportunities.
✅ Return expectations: The very objective of taking a more flexible and out of the box approach was to not just beat the odds in a difficult market but to beat expectations also. This can be possible with this unique strategy and the returns too, therefore, can be potentially higher than what a traditional investing style can offer.
✅ Risk management through flexibility: In terms of risk exposures, an unconstrained investment ensures that assets are efficient and protected. For instance, unconstrained funds can manage interest rate risk by maintaining a shorter duration portfolio than a traditional bond fund, an advantage if rates start to rise.
Drawbacks of Unconstrained Investing
From its initial adoption, unconstrained investing has evolved quite well and its principles are now practised in as professional a manner as the traditional form of investing. So, the benefits far outweigh any possible drawbacks.
But, because every strategy has a potential weakness, even unconstrained investing merits some points of caution.
❌Can be haphazard and disorganised: Unconstrained investing requires a radical shift from the standard form that gives prominence to a set approach and working against benchmarks. While this provides a portfolio manager with a lot of freedom and creativity, there is a risk of randomness creeping in.
Unless the manager maintains a sharp focus on not deviating from the fundamentals of investing, the unconstrained approach can get haphazard and disorganised in concept and execution. It is critical that basic investment hygiene is adhered to even while taking liberties.
❌Element of financial risk: Just as the operations can run the risk of a disorganised approach due to the lack of benchmarks, there is also the real risk of a financial impact. This can directly have a bearing on the fund performance. Here, it is not even about the process of running a fund but the very selection of assets to invest in, how much to invest where and when and so on.
But, here again, when skilled, qualified and experienced managers run the show, this drawback also may be more a theoretical one. In practice, even unconstrained investing can be handled with adequate care and caution.
❌Open to transgressions: One other potential concern about unconstrained investing is the possible chance of any violations, transgressions or an instance of intentional exploitation of the freedom attached to the strategy.
But again, with the right checks and balances and periodic audits, this concern also can be eliminated.
Unconstrained investing cannot replace the long array of conventional investing forms and was never meant to do so. But, for a portfolio manager, the idea of unconstrained investing can be a welcome strategic shift in difficult markets where the conventional approach can be limiting and the results sub-optimal.
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