If a person jumps out of a plane with a single parachute, their chances of it failing are 0.01%. If a person jumps out of a plane with two parachutes their chances of both failing are 0.01% x 0.01% = 0.0001%. The probability is multiplicative, or nearly 100x less.
At Tema, a very similar principle prevails when it comes to risk management: employing multiple layers gives a much higher chance of catching and preventing failures.
Tema focuses on uncrowded, attractively valued and structurally growing parts of the market. This means that the universes of equities we select from are already positively pre-disposed from a risk management perspective. For example, Tema’s healthcare strategies narrow down to therapeutic areas such as cardiovascular and metabolic, oncology, and neuroscience and mental health. This means we are selecting stocks from a group that are operating in growing markets with large unmet medical needs and strong innovation tailwinds. These forces reduce equity risk.
Risk in an individual equity over the long run shows up in a myriad of places and can be both quantitative and qualitative. Hence identifying, assessing, and managing these risks at the stock selection level is a crucial element of prudent risk management. In the table below are just a few examples of individual company factors that we look to assess and manage.
|
Factor |
Example variables to consider |
Bad examples |
Good examples |
|
Business model |
Gross margin economics at scale |
High fixed cost with high discounting |
Network effects |
|
Cash flow profile |
Free cash flow modelling |
•Persistent negative free cash flow •Not accounting for share issuance |
•High free cash flow conversion |
|
Balance sheets |
Debt profile, off-balance sheet arrangements, pensions |
•High financial leverage combined weak cash generation |
•Low financial debt •Clean profile of non-financial debt |
One area of downside risk management at the stock level is worth calling out. In our experience, equity value is permanently impaired if the full gambit of balance sheet metrics is not analyzed and assessed. You can read about how we do this here along with examples. The second is accounting manipulation, another source of severe downside scenarios.
Once our investment team selects stocks, we employ a systematic portfolio construction process. As we describe here, the genesis of this process was an in-depth multi-faceted review of existing literature and practices on optimal portfolio construction.
At its foundational layer is risk management – how does one size positions and run portfolios to harness the best in stock picking alpha, mitigate behavioral biases and manage risks. For example, we size positions based on three conviction tiers leading to a maximum and minimum position size. Both help reduce risk. A maximum position means we manage concentration individual equities. A minimum position means we avoid too small positions, choosing instead to take conviction views that impact client results, as opposed to having a long tail of small positions that distracts and where alpha decays before they can be scaled up.
Every two weeks each portfolio manager meets with the CIO and goes over a pre-prepared oversight dashboard. This dashboard covers liquidity analysis, exposures by geography, sector, industry, currency and a whole host of other risk and portfolio metrics. Do reach out to our sales team if you would like a demonstration.
As the old saying goes – the worst risks are the one’s you don’t know you are taking. The purpose of this meeting is to create a culture of 1. awareness of all the risks taken at portfolio level, 2. respectful challenge and discussion.
Not enough attention is paid to the operations of an investment business. Here Tema is lucky to have state-of-the-art systems and internal controls to monitor the execution and running of our ETF and other portfolios. These systems are complemented by our world class external partners. We like to have three eyes on every operational issue – investment team, internal operations team and external partners. Trading is a good example – all trades are first logged in an internal decision journal, inputted in a Bloomberg AIM system and communicated parallel to our trading desk, they are then post-trade checked by the fund manager, internal operations and our external partners.
To top off all the other layers is a quarterly firmwide risk management meeting. Here each portfolio is dissected further. A major part is factor analysis using Bloomberg’s MAC3 Equity model to understand the factor exposure of our funds. We also run scenarios. For example, how would this portfolio perform if the global financial crises were to repeat. These analyses help portfolio managers and the CIO understand the investment risks being run. The objective is to reflect and, if necessary, change strategy accordingly.
Tema prides itself on embedding multi-layered risk management in every facet of the firm, to help investors achieve the best possible outcomes.