Active management, but without all the stock picking
New Road Capital offers an interesting approach to portfolio construction. I spoke to CIO Paul Fouche about how the firm has evolved its philosophy.
Boutique manager New Road Capital has been through an interesting evolution.
The company started largely as a DFM running model portfolios that were unitised as funds of funds. Over the last three years, however, it has moved away from this approach to become a fully-fledged asset manager in its own right.
“We are active managers, but not in the sense of being traditional stockpickers,” says CIO Paul Fouche.
“Our philosophy is that you can add value with your few good ideas, but then fill out the portfolio with passives.”
New Road’s approach is to build the core of its portfolios through passive building blocks. This is enhanced with a few, select active ideas.
“Our view of traditional active managers is that as the market gets more efficient, the ideas that can add value have become few and far between,” Fouche says. “They might have three or four really good ideas that add value, but you can’t run a portfolio of just three or four stocks. So they have to fill up their portfolios with counters that they probably wouldn’t own.
“Our philosophy is that you can add value with your few good ideas, but then fill out the portfolio with passives. Because there are really only a few ideas worth investing in above market weight.”
New Road still has four fund of funds portfolios, but has moved almost entirely away from allocating to third-party active managers in these strategies. Apart from a few specialist fixed income managers, their allocations are entirely through index trackers.
Evolving philosophy
The firm’s two other funds represent more clearly where its philosophy is going. The flagship is the New Road BCI Enhanced Opportunities Fund, which sits in the ASISA South Africa multi-asset high equity category.
This portfolio is constructed on three levels.
“We start with asset allocation,” Fouche says. “I’m an engineer by training and everyone in the team is either from an engineering or mathematics background, so we have built very focused, proprietary quant models.
“We use the Calmar ratio (return vs maximum drawdown) to optimise for achieving a target outcome.”
“We think it’s easier to predict a trend than who the winners are going to be within that trend.”
This provides an optimal asset allocation, onto which New Road then builds the basis of the portfolio. This is done through the use of broad-market index trackers.
“For example, the model tells us that offshore equity should be a certain percentage, so we then look at how we build that out,” Fouche says. “The first index we use would be the MSCI ACWI as that gives us the broadest offshore exposure, but then we might want more developed market than emerging market, or more exposure to specific regions. We like the US at the moment, so we have taken more S&P 500.”
The third and final layer is then the addition of specific active ideas through thematic ETFs or individual stocks.
“We think it’s easier to predict a trend than who the winners are going to be within that trend,” Fouche (pictured below) says. “For example, we hold a uranium and nuclear energy ETF and a semiconductor ETF because we like the structural tailwinds there.”
Above this, New Road also includes a few single stock ideas. These may be stocks that they can’t or don’t want to access through an ETF; are selected for particular diversification benefits; or are stocks already captured by one of the thematic funds but that they are particularly positive about.
“We look for companies where the management team has a significant amount of their wealth in the business – preferably the founders,” Fouche says. “We also want to find businesses with high gross margins. They might not be profitable yet because they are reinvesting capital in their growth, but fundamentally they must be able to sell what they are doing for a lot more than it costs them.
“And, finally, they must be in an industry that we believe has a secular tailwind.”
“We are trying to get alpha through our own stockpicking methodology, but not by having high exposure to single stocks.”
A company that meets all those criteria for New Road is Nvidia. However, Fouche explains that they take a conservative approach to how much they are willing to hold.
“We hold Nvidia at the broad index level, in the S&P 500, the Nasdaq, the semiconductor ETF and standalone. But, all-in-all, our total look-through holding in the Enhanced Opportunity fund is only around 4.5%, which is at the roughly at the ceiling we would like any single stock exposure to be.”
In total, the Enhanced Opportunity Fund holds 19 single counters – all offshore – but these constitute a total of around 8% of the portfolio.
“We don’t like to concentrate our holdings,” Fouche says. “We are trying to get alpha through our own stockpicking methodology, but not by having high exposure to single stocks.
“The thematic ETFs in the portfolio also make up around 8%, and we run a quantitative SA government bond strategy that is roughly 20%. The remaining 64% is broad market exposures.”
Risk management
This mindset is largely informed by Fouche’s background as a financial adviser.
“We could put 10% in the fund in Nvidia, but we don’t think that’s prudent from a risk management point of view,” he says. “The ultimate end clients are retail clients, and things like tracking error and volatility matter to them.
“A lot of managers say volatility is not risk, but if you are a retired client and you pulled all your money out of a fund because you had a 10% drawdown, that is a risk. There is a practical element to it that we look to manage.”