Risk Management

Risk Management

Managing market risk

Our stock selection process is core to the management of risk.  Moreover, though we use the MSCI to measure relative performance, risk in our view is not solely relative performance versus a benchmark but also the prospect of losing money (i.e. absolute returns).

As a result of our stock picking and the formation of the portfolios, the key risks relate to individual stock positions.  We attempt to manage this by means of intensive research and subsequent scrutiny by the peer group.  Our particular focus on companies which are out of favour and our concern with the potential for absolute loss in a stock, goes a long way toward reducing risk in the portfolio.  Within the portfolio, care is taken to avoid excessive exposure to areas that have a high co-variance.  This may be considered by industry or country.  Within a country, there are other considerations such as, among others, susceptibility to currency fluctuations, interest rates and government actions.  At the industry level, consideration will be given to the nature of its structure, such as concentration, cyclicality, relative maturity, threat of substitution and so on.  Regular analysis highlights the characterisation of the portfolio under geographic, industry, emerging market, liquidity and occasional other headings.

From time to time, Platinum may utilise derivatives to manage risk and this can play quite an important role in our investment process.  Typical usage of derivatives would be:

  • To reduce market risk in the portfolio by selling index futures or buying index put options.
  • To reduce the cost and/or possible downside of holding a given stock through purchase of call options or warrants over a security rather than the actual security.
  • Where we have identified stocks that we believe to be overvalued, we may purchase put options over that stock or short sell the stock.

In respect of the Platinum Unhedged Fund, there will be no market risk management undertaken ie. no short selling of indices or stocks.

Managing currency risk

International equity investments create an exposure to foreign currency fluctuations, which can change the value of the equity investments measured in a Portfolio’s reporting currency (AUD and USD).

Assessment of potential returns and risks created by currency exposure, and appropriate positioning of a Fund’s Portfolio to attempt to capture those returns, and minimise those risks, are a component of Platinum’s investment process.

Platinum will seek to manage a Fund’s currency exposure using hedging devices (e.g. foreign exchange forwards, swaps, “non-deliverable” forwards, and currency options) and cash foreign exchange trades.

More generally, Platinum will take account of currency exposures in an attempt to maximise returns and minimise risks in a Fund’s Portfolio.

This includes assessing the indirect impact of currency on a business (e.g. the impact of currency fluctuations on a manufacturing company with significant export sales), and the potential for exchange rate movements to amplify or diminish reporting currency returns for a holding.  The investment of cash holdings is also undertaken with consideration of the potential currency impact on the cash (as well as interest rate and credit risk considerations).

The aim is for a Fund’s Portfolio to be exposed to the greatest extent possible to appreciating currencies and to a minimum to depreciating currencies.

Currency rates are set by supply and demand for the currency.

For freely floating currencies, supply and demand is a function of trade flows (import/export flows), and other cross border payments (e.g. foreign direct investment, borrowings, interest and dividends payments, and capital market flows, including speculative currency flows).  For currencies which are fixed, pegged, or intervened in by governments (to a greater or lesser extent) government policy towards the currency will also affect the exchange rate either exclusively or to some extent.

Platinum assesses the prospects for foreign currencies by analysing these factors and their likely future evolution.  The research process is informed by drawing upon a range of sources, including research from analysts at investment banks and stockbrokers, government papers and statistics, and findings and insights derived from our stock research.  Over any period, movement of currencies can be driven by a number of these factors, and indeed the importance of speculative/capital markets driven flows can be a significant driver in the short to medium term.  Key factors driving these flows include interest rate differentials, economic performance and prospects for a country’s stock market and key industries.  Over the long-term, trade flows, relative inflation rates, purchasing power parity measures, and government policy will be drivers.

Currency management is not undertaken for the Platinum Unhedged Fund.

Short selling

Platinum may use short selling for risk management (that is, to protect a Fund’s Portfolio from either being invested or uninvested) and to take opportunities to increase returns.

We often refer to positions in our portfolios where we have "sold short", "shorted", or had "short positions" in particular shares.  The idea behind short selling of shares is to profit from a fall in the share price of a particular company. How can this be done?

Let's say our analysis shows that XYZ Ltd is overvalued and that we expect the share price to decline.  To take advantage of this view we would "short sell" shares of XYZ.  To do this we would simply sell the shares of XYZ even though we don't currently own them.  The problem we then face is that we must deliver the shares to the buyer.  The way we do that is by borrowing the shares from another shareholder of XYZ, who lends them to us for a fee (in the same way a bank would charge you for borrowing money).  In the meantime, the proceeds from selling these shares are placed on deposit at money market rates.  This interest income accrues to the short seller (ourselves) and depending on the duration of the short position, it would generally pay for the borrowing fee several times over.  Naturally any dividends that are declared while the shares are borrowed accrue to the lender of the shares.  Assuming we sold a share of XYZ at $20 and it then fell to $14, upon buying them back we would make $6!  If instead the share price went up, we would lose money.  Once we have bought the shares back we would "return" the stock to the lender and "close" the loop.

The concept of short selling shares is neither new nor unusual, having been around from the day stock markets were first created.  In fact most stock markets and countries have rules and laws that specify the manner in which short sales can be made.  The major investment banks all run "stock lending" organisations which source the shares from owners who are prepared to lend them (usually the large fund managers) and then on-lend them to the short sellers for a fee.  More often than not, when we take a short position in a share, it is in fact done through what is known as a "swap" arrangement with one of these major investment banks.  This is effectively a contract between us and the bank that has an identical effect to that of a short sale, but is somewhat more efficient from an administrative perspective, and can lower the transaction costs of dealing.